U.S. commercial real estate: Q1 2019 market outlook

U.S. GDP and employment growth accelerated in Q1, but they will likely moderate going forward.

First-quarter headline U.S. economic data was impressive by any measure, with GDP growth coming in at 3.2%¹ and employment showing gains of 557,000, which pushed the unemployment rate down by 10 basis points (bps), to 3.8%.² Given this record, we believe consumer spending, bolstered by strong labor markets, will be the primary growth driver going forward. On the other hand, first-quarter growth was conditioned by a number of factors—probably temporary in nature—and, as a result, we expect that overall economic growth will likely moderate through the remainder of the year.

First-quarter growth is likely to moderate

First-quarter GDP growth was mainly driven by net exports, inventory accumulation, and government spending, all of which are expected to moderate through the rest of this year. The growth in net exports was due to weaker imports, following a spike last year as firms attempted to get out in front of impending tariffs. As for inventory accumulation, it may drive growth in a single period, but firms eventually have to sell down the accumulated stock, which may cast the current high levels of inventory as a potential drag on future growth. Finally, government spending in Q1 was driven by defense spending, which is typically on a contract basis with lumpy payouts and unlikely to show growth through the rest of the year. With all the principal Q1 growth drivers likely to diminish over the remainder of the year, we believe GDP growth is bound to trend down from the current level.

A strong labor market drove wage growth

Employment gains over the first three months in Q1 may have been volatile, but the overall addition of 557,000 jobs showed that the job market’s strong, especially given that the unemployment rate is hovering near a 50-year low. More recent data suggests ongoing momentum in employment gains, with a preliminary April job gains estimated at 263,000, pushing unemployment down even further, by 20bps, to 3.6%.² For the first time in this cycle, continued tight labor market conditions have resulted in strong wage growth, which has hovered above 3.0% since October 2018.²

The U.S. Federal Reserve is staying on the sidelines

Even though recent GDP and employment data all point to above-average growth, inflation pressure remains muted. The core Consumer Price Index for inflation, which excludes the more volatile food and energy categories, hit the U.S. Federal Reserve (Fed) target of 2.0%, as of March 2019. With the Fed outlook taking into account slowing global economic growth and uncertainty over trade policy, we believe the likelihood of a rate hike in the near future has diminished.

Chart of real GDP growth, 2013 to 2021 (forecast). The chart shows that GDP growth for Q1 2019 reached 3.2%, with future growth forecast to moderate through to 2021.
Chart of wages and employment cost growth, year-over-year, 2009 to 2019. Chart shows average hourly earnings growth of just over 3% in Q2, while the employment cost index hit 3%.

Investment markets³

Economic uncertainty and the spike in 10-year U.S. Treasury yields to above 3.0% late last year led to investors pulling back, with total investment volumes falling 11.0% year over year (YoY) for the first quarter of 2019. Since then, however, healthy economic growth and the easing of 10-year Treasury rates to 2.5% suggest that this trend could reverse going forward.

The Q1 slowdown in investment activity affected all property types except multifamily, and so registered a decline in overall volumes. Retail real estate investment saw the biggest downturn, of 16%; followed by industrial, down 15%; and office, down 14%. Multifamily transaction volumes remained relatively unchanged, growing by just 1% YoY

The uncertain environment late last year caused investors to pull back from major deals, so Q1 activities this year have been affected by a decline in portfolio and entity transactions. If we exclude these, individual asset transaction volumes were down by 8% YoY in Q1 2019.

Despite the slowdown in activities, pricing has been stable, with average transaction yields compressing marginally by about 5bps YoY. Multifamily continues to outperform the overall market, with average transaction cap rates falling by about 15bps.

Chart of annual real estate transaction volume, Q1 2016 to Q1 2019. The chart shows individual transaction volumes fell by 8% year-over-year for Q1 2019.
Chart of transaction cap rate, 12-month average (%), Q1 2015 to Q1 2019. Chart shows retail real estate investment saw the biggest downturn, of 16%; followed by industrial, down 15%; and office, down 14%. Multifamily transaction volumes grew by just 1% year-over-year.

Office markets

Although the overall pace of supply remains moderate, lower net absorption in the first quarter saw vacancies rise marginally, by less than 5bps. The forecast for completions is that they’ll rise by 60% this year,⁴ but demand is expected to keep up with new supply, providing stable vacancies through to the end of the year.

Construction activity overall has remained even since early 2016, with space under way as a percentage of existing stock still at ~1.7%. Although the current level is nearing peak activity for this cycle, construction activity is fairly conservative compared with prior cycles—in the 2000s, it peaked at double the current level. Current supply under way is highly concentrated in major markets, especially in those traditionally considered supply constrained, such as New York and San Francisco.

Demand for office space continues to be conditioned by labor market dynamics. With the unemployment rate for those with a bachelor’s degree or higher near the historic low of 2.1%⁵ and baby boomers beginning to exit the workforce, the availability of educated labor will be a major limiting factor for employment and office market growth over the next decade. As is to be expected, markets with more robust growth in their educated working age demographic are more likely to attract employers and experience stronger demand fundamentals.

Competition from new supply is putting pressure on rent growth, which has continued to decelerate from 2015 peak levels and was at 2.1% as of Q1. Western region markets are still the frontrunners, with San Jose, Seattle, San Francisco, and Sacramento among the top five markets with the highest rent growth.

Chart of office supply and demand fundamentals, Q4 2017 to Q1 2019. Chart shows net absorption lowered in the first quarter, resulting in a small rise in vacancies of less than five basis points
Chart of office rent growth, Q1 2015 to Q1 2019. Chart shows rent growth continuing to slow down from its 2015 peak to reach 2.1% in Q1.
Chart of office space under construction as a percentage of stock. Chart shows construction activity has remained fairly static since 2016, with office space under way as a percentage of existing stock at under 1.7%.

Industrial markets

E-commerce logistics continue to be the primary demand driver for the industrial segment, accounting for 50% of absorption in 2018. Given the accelerating spread of e-commerce, demand for industrial space continues to outpace overall economic growth. At the same time, construction activity has trended up over the past two quarters, exceeding demand. With total net absorption of 24 million square feet (SF) against net completions of 38 million SF, vacancies have risen by 8bps, to 4.84%, as of Q1 2019.

E-commerce logistics require a complex network of industrial space, including large regional and super-regional warehouses and small last-mile fulfillment centers. While overall supply was relatively slow earlier in the cycle, the supply of large regional and super-regional products is expected to catch up with demand in most markets this year.

As supply/demand dynamics achieve greater balance, rent growth will likely trend toward long-term averages. National annual rent growth was 5.6% as of Q1 2019, about 80bps lower than peak rates in 2018. Individual markets, however, show a wide spread, with the top three, Sacramento, Inland Empire (in Southern California), and Orlando, experiencing rent growth of above 9%.

Although industrial rent growth will likely decelerate over the next few years, it’s still expected to continue outpacing all other property types. With relatively low capital expenditure requirements, we believe industrial real estate is well positioned to generate stronger cash flow growth and investment returns over the next few years.

Chart of industrial supply and demand fundamentals, Q4 2017 to Q1 2019. The chart shows that with total net absorption of 24 million square feet against net completions of 38 million square feet, vacancies have risen by 8bps, to 4.84%
Chart of industrial rent growth, Q1 2015 to Q1 2019. Chart shows that national annual rent growth was 5.6% as of Q1 2019, about 80bps lower than peak rates in 2018.
Chart of industrial property under construction as percentage of total stock, Q1 2015 to Q1 2019. Chart shows construction activity has trended upwards over the past two quarters, exceeding demand.

Multiresidential markets

Although multiresidential real estate construction remains strong, it continues to lag demand. First-quarter 2019 demand for multiresidential totaled 65,000 units, with 55,000 units added to the market on a net basis. This translated into an average national vacancy rate decrease of 10bps quarter over quarter, to 6%.

Despite an increase in supply in recent years, U.S. housing markets remain undersupplied today. To fully meet the demand created by new household formation and the need to replace old units, some 1.4 million housing units per year would have been required over the last seven years. But in fact, total completions of single- and multifamily units averaged less than 1.0 million units per year.⁴ Further putting pressure on supply, economic and lifestyle factors supportive of renting continue to strengthen, such as the increasing median age of marriage and the percentage of people living alone. Economic factors eroding home ownership affordability include ballooning student debt and weak wage growth over the current economic cycle.

Strong occupancy fundamentals have also helped fuel rent growth, which showed an average national growth rate of 3.2% as of Q1 2019.⁴ With the higher-end space in core central business districts receiving a disproportionate share of supply, rent growth in those areas continued to lag the overall market.

Construction activity remains strong, at a 20-year high of 666,000 units under construction—equivalent to 4% of existing stock—although this activity is highly concentrated in major markets, with the top 15 accounting for half of all national construction under way.

Chart of mulitresidential supply and demand fundamentals, Q4 2017 to Q1 2019. Chart shows that demand for multiresidential totaled 65,000 units in Q1 2019, with 55,000 units added to the market on a net basis. This translated into an average national vacancy rate decrease of 10bps quarter over quarter, to 6%.
Chart of multiresidential rent growth, Q1 2015 to Q1 2019. Chart shows rent growth posted an average national growth rate of 3.2% as of Q1 2019, supported by strong occupancy fundamentals.
Chart of multiresidential under construction as percentage of stock, Q1 2015 to Q1 2019. Chart shows construction activity hit a 20-year high of 666,000 units under construction in Q1—equivalent to 4% of existing stock.

 

 

 

1 U.S. Bureau of Economic Analysis, as of April 26, 2019. 2 U.S. Bureau of Labor Statistics, as of May 3, 2019. 3 Market fundamental statistics, including vacancy, absorption, completion, under construction, and rent growth, CoStar, Q1 2019. Capital market statistics, including transaction volume, cap rates, and price index, Real Capital Analytics, Q1 2019. 4 CoStar, as of Q1 2019. 5 U.S. Bureau of Labor Statistics, April 2019.

Information in this document may be sourced from Real Capital Analytics. © 2019 Real Capital Analytics, Inc. All rights reserved.

CoStar disclosure

CoStar Group, Inc. and its affiliates (collectively, CoStar) have assumed and relied on, without independent verification, the accuracy and completeness of such third-party information in preparing these materials. The modeling, calculations, forecasts, projections, evaluations, analyses, simulations, or other forward-looking information prepared by CoStar and presented here (the CoStar materials) are based on various assumptions concerning future events and circumstances, all of which are uncertain and subject to change without notice. Actual results and events may differ materially from the projections presented. All CoStar materials speak only as of the date referenced with respect to such data and may have changed since such date, which changes may bematerial. You should not construe any of the CoStar materials as investment, tax, accounting, or legal advice.

CoStar does not purport that the CoStar materials here are comprehensive, and, while they are believed to be accurate, are not guaranteed to be free from error, omission, or misstatement. CoStar has no obligation to update any of the CoStar materials included in this document. Any user of any such CoStar materials accepts them as is, without any warranties whatsoever, either express or implied, including, but not limited to, the implied warranties of merchantability, noninfringement, title, fitness for any particular purpose. Under no circumstances shall CoStar, or any of their directors, officers, employees, or agents, be liable for any indirect, incidental, or consequential damages whatsoever arising out of the CoStar materials, even if CoStar has been advised as to the possibility of such damages.

Manulife Investment Management

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material, intended for the exclusive use by the recipients who are allowable to receive this document under the applicable laws and regulations of the relevant jurisdictions, was produced by, and the opinions expressed are those of, Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only as current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit nor protect against loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than 150 years of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

These materials have not been reviewed by, are not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at www.manulifeim.com/institutional.

Australia: Hancock Natural Resource Group Australasia Pty Limited, Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area and United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority, Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Asset Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad (formerly known as Manulife Asset Management Services Berhad) 200801033087 (834424-U) Philippines: Manulife Asset Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. Thailand: Manulife Asset Management (Thailand) Company Limited. United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Hancock Capital Investment Management, LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited. 

492440

William McPadden, CPA

William McPadden, CPA, 

Global Head of Real Estate

Manulife Investment Management

Read bio
Matthew Morano

Matthew Morano , 

Portfolio Manager, Real Estate Equity

Manulife Investment Management

Read bio
Greg Spafford

Greg Spafford, 

Senior Portfolio Manager, Real Estate Equity

Manulife Investment Management

Read bio
Matthew S. Warner

Matthew S. Warner , 

Portfolio Manager, Real Estate Equity

Manulife Investment Management

Read bio
Greg Wood

Greg Wood, 

Global Head of Real Estate Debt

Manulife Investment Management

Read bio