Arrested U.S. economic recovery—employment fades, business held back
Following a bounce back in economic activity early in the summer, the recovery has slowed down significantly. In September, employment rose by 0.7 million, a far cry from May’s 2.7 million and June’s 4.8 million new job creations. Social distancing requirements continued to constrain operating capacities and slowed the recovery in the service sector. Further bifurcation is expected between sectors with manufacturing far less constrained by social distancing and likely to improve, while the service sector remains under pressure.
Going forward, elevated unemployment and uncertainty around future government support are likely to take a toll on personal income and consumer confidence. At the end of September, employment was 10.7 million below prepandemic levels, with the unemployment rate standing at 7.9%. For businesses, heightened geopolitical risk prompted by U.S.-China disputes, an uncertain Brexit, and discussions between the EU and Russia could weigh heavily on sentiment and impede the economic recovery.
Forward guidance from the U.S. Federal Reserve indicates that low interest rates will persist over the next three to five years. Combined with the capacity to intervene in credit markets, these policies should support asset values, consumer spending, and business investment over the long term.
U.S. commercial real estate market review and investment markets outlook¹
In Q3, transaction volumes began to edge higher as the partial lifting of pandemic-related restrictions and more clarity around commercial real estate restored some confidence in the market. Although positive preliminary data indicates that total Q3 transaction volumes for most property types was up by about 30% quarter over quarter, to $56 billion, the pandemic has caused further bifurcation in investment markets. In our opinion, with multifamily and industrial increasing their lead over other property types, it reaffirms property fundamentals and long-term demand drivers remain solid in these sectors.
Over the past five years, the multifamily sector has garnered the lion’s share of investment volume, with the pandemic only enhancing its investment appeal. In the third quarter, multifamily asset investment volume stood at $23 billion, accounting for 40% of all U.S. real estate investments².
Apart from the retail and hotel sectors, which were hit hard by pandemic-related restrictions, the overall impact of economic uncertainty on real estate capital values has been fairly mild. As expected, stronger investment demand led to better pricing for multifamily and industrial real estate, which have continued to realize capital value stability.
Looking ahead, there are bright spots in the market. Healthy occupancy levels in most U.S. real estate markets will likely provide a buffer by absorbing some lost demand before severe supply/demand imbalances can materialize, while the long-term nature of commercial leases may act as a property income shield against short- to medium-term market fluctuations.
While real estate may continue to be affected by the pandemic, in our view, investing in this space remains a compelling proposition given the low interest-rate environment.
Mounting job losses and uncertainty around the corporate office model weighed heavily on third-quarter leasing, with negative 34 million square feet (SF) of net absorption in office space nationwide—the biggest one-quarter loss in occupancy in the past 20 years³.
With the current lack of leasing demand, landlords are competing hard for tenants to maintain occupancy levels. Average national office asking rent growth was flat in Q3 on a year-over-year basis—the lowest growth rate since the global financial crisis. Overall, office rents will likely remain under pressure over the next 12 months, although the impact is likely to vary by building class. For example, a greater emphasis on employee health and well-being could translate into increased interest in high-quality, well-located assets. Rents and occupancy levels for these assets may, as a result, stay more resilient than in other parts of the market.
On the supply side, while mandated work restrictions and social distancing limitations continued to hold construction in check, activity began to pick up with developers completing 14 million SF of net new office space over the quarter. Weaker demand combined with new supply pushed average vacancies up 60bps to 10.7% quarter over quarter.
This trend in increased construction activity has been in place over the past three years and is currently at 156 million SF, equivalent to 1.9% of total current office inventory. While the tech hubs—Austin, San Jose, San Francisco, and Seattle—are experiencing most of the new project activity, once the economy starts to reenergize, they should be better positioned to return to the upswing and absorb new supply. The pace of new project completions will likely decline in the near term due to weaker demand and logistics challenges, and in the face of poor demand, this could have the benefit of reducing the impact of new supply on the market.
Changes in office workspace planning are a risk factor for the sector, although it’s not clear whether demand for office space will be substantially affected. The widespread work-from-home experiment prompted by COVID-19 could prove that many employees can continue to work from home and still be productive. While we do envision employers will generally be more flexible around the employee workplace arrangement, it’s unlikely the role of physical office space will diminish. Priorities like preserving a firm-wide culture and maintaining collaborative/creative functions are helped by having employees under one roof, and the right office space can help attract talent, establish credibility, and provide prestige. Furthermore, changes in workspace planning—de-densification of office space and increased provision for social areas and larger collaborative spaces— should offset some of the impact of the expanded work-from-home arrangements. We also expect some structural shift in demand balance, such as the desire for shorter commutes and economic constraints, could give a boost to suburban markets.
Despite the economic slowdown, demand for industrial real estate continues to benefit from the surge in online shopping. Competition over shorter delivery times is resulting in retailers needing to build out their distribution network—a trend especially beneficial for warehouse properties near dense population centers.
Q3 net absorption was 39 million SF, in line with average quarterly rate over the past two years. The pandemic, however, has done little to slow the strong pace of new supply coming onto the market with third-quarter net completions at 64 million SF—one of the highest on record. This has resulted in a slight uptick of the average national vacancy rate by 10 basis points (bps) to 5.6%.
With construction activity remaining near historic highs, at the end of Q3 there was 334 million SF of industrial space under construction, equivalent to 2.0% of the total market.
New supply, however, is concentrated in a handful of national and regional distribution centers, with the top five markets accounting for one-third of all construction. The upward trend in construction over the past two years has helped reduce supply/demand imbalances, and, combined with some economic uncertainty, has moderated industrial rent growth to 3.5%—the lowest rate since 2012.
The steady build-out of retail distribution networks and e-commerce fulfillment platforms has helped bolster demand for industrial space, from both existing and new tenants—a trend further amplified by the COVID-19 pandemic. Large bay, high clear height warehouse space, as well as smaller, lower clear height facilities near urban areas, which can serve as last-mile delivery facilities, are especially benefiting from e-commerce-related demand.
Industrial real estate could also see an increase in demand driven by structural changes in manufacturing and supply chains. For example, with COVID-19 challenging global trade and supply chain networks, businesses are likely to turn to local manufacturing and build up inventories in local markets.
Demand for multifamily residential rebounded sharply in the third quarter, reaching 113,000 units. This turnaround can be attributed to pent-up demand from the first half of the year when pandemic-related lockdowns reduced leasing activity. However, third-quarter near-record high levels of new supply—112,000 units—kept the average national vacancy rate relatively flat at around 6.8%.
Even though construction activity has experienced a slow down over the past year, it remains at historic highs. As of the third quarter, there were 594,000 units under construction, equivalent to 3.4% of current stock.
Q3 national average multifamily rents have remained relatively flat on a year-over-year basis. However, average figures can be deceptive as they mask variations across product types. Specifically, expensive high-end urban-core products, encumbered with less favorable supply/demand conditions, are experiencing rent pressure, while cheaper suburban products are showing greater rent stability.
While demand for multifamily tends to be less cyclical than other property types, the job losses and social distancing measures we’ve seen recently may continue to affect leasing activity to a certain extent going forward. Further economic constraints combined with here-to-stay workplace flexibility may shift some demand away from expensive high-end urban-core products to suburban products that offer larger units at a more affordable price point. High-priced urban products, also facing increasing competition from new supply, may put even further pressure on occupancy and rent growth.
Overall, the outlook for multifamily is on the plus side. The federal government’s relief package, which included direct payments to low-income households, should help cushion the impact on rental income. Multifamily rentals also benefit from several secular demand drivers that can help reduce occupancy volatility: an overall shortage of housing options, home ownership affordability challenges, and demographic trends such as an increase in both the median age of marriage and the number of single person households.
1 All market fundamental statistics, including vacancy, absorption, completion, under-construction, and rent growth sourced from CoStar, as of Q3 2020. All capital market statistics, including transaction volumes, cap rates, and price index sourced from Real Capital Analytics, as of Q3 2020. 2 Real Capital Analytics (RCA), as of Q3 2020. 3 CoStar, as of Q3 2020.
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