U.S. commercial real estate: Q4 2018 review and outlook
American economic growth of close to 3.0% in 2018 outpaced the rest of the developed world, boosted by robust consumer activity and fiscal stimulus. The economy also added 2.6 million jobs during the year.
Real estate investment markets grew by 15%, in sharp contrast to a 15% drop over the previous two years. Prices remained relatively stable, except that demand dynamics produced by e-commerce growth caused the pricing in the industrial and retail segments to trend in opposite directions.
In office real estate markets, supply and demand were relatively balanced for the first half of the year, but in the second half, demand accelerated while the rate of new project completion slowed. The heightened demand for office space mirrored the employment growth trend.
Industrial real estate market demand continued to outpace overall economic growth, driven by e-commerce growth and the unique space requirements of e-commerce companies. Rent growth edged down in 2018 after achieving a historically high rate in 2017, but still remained elevated at 5.4%.¹
Multifamily market fundamentals remained robust in 2018, fueling an average national rent growth of 3.1%. Construction activity was at a 20-year high of 653,000 units under construction, with the activity concentrated in major geographic markets.¹
United States: above-trend growth continues
Strong consumer spending and increased business investment have given a boost to the U.S. economy, with 2018 growth close to 3.0%—pacing faster than economic growth in any other developed country. Despite tightening monetary policy, slowing global growth, and ongoing trade disputes, we believe robust consumer activity, along with fiscal stimulus, should continue to spur growth. Consensus estimates generally corroborate this view, with the average forecast still calling for above-trend growth of 2.5% in 2019.²
Late-cycle economic expansion driving strong employment gains—Job growth in December surged to 312,000, surprising analysts, who were expecting the number to be closer to 180,000.³ Overall, the U.S. economy added 2.6 million jobs in 2018—20.0% more than the 2017 increase. With unemployment at 3.9% as of December 2018, the labor market was tight, which means continued upward pressure on wages, already on the rise since mid-2016. The chief growth driver has been consumer spending—strong consumer confidence, driven in part by strength of the labor market, which continues to translate into robust consumption. Although recent data shows retail sales growth slowed somewhat in November, consumer spending has held up well so far, increasing 4.7% year over year (YoY).⁴ Even though financial market volatility and the U.S. government shutdown have added some short-term uncertainty for the consumer during the first quarter of 2019, strong wage growth, lower gas prices, the recent pullback in interest rates, as well as the deferred benefits from the 2017 tax bill, should all contribute to consumer strength in the first half of 2019.
Business investment challenged by slower growth and rising cost of capital—Bolstered by corporate tax cuts and healthy demand, business investment intensified during the first half of 2018. Conversely, global trade uncertainty, higher interest rates for most of the year, concerns about slowing global growth, and greater volatility for equities are all potential sources of downward pressure on business spending in 2019.
Monetary policy could provide some measure of relief, but given that the U.S. Federal Reserve’s dual mandate of full employment and price stability is currently being fulfilled, the central bank has signaled its intent to be patient. This dovish fiscal restraint (communicated at the end of 2018) has predictably put downward pressure on interest rates, which should provide some incremental relief. Yet there are a few dark clouds on the horizon. While domestic demand remains healthy, continuing trade tensions between the United States, China—and now possibly Europe—along with broader geopolitical uncertainties and a slowing global economy, could all weigh on growth. Further out, a potential fiscal cliff in 2020 could hurt U.S. growth, while higher levels of nonfinancial corporate debt could lead to problems in the event of interest-rate volatility.
Investment markets grew by 15% in 2018, in contrast to a cumulative 15% drop in volume over the previous 2 years. The 2018 growth was achieved despite slower market activity near the end of the year, driven by a spike in 10-year U.S. Treasury yields in late September and early October.
Real estate investment trends have been uneven across property types, with retail and industrial properties leading with 30% and 24% annual growth, respectively. Growth in the retail segment has primarily been driven by entity-level transactions, while both portfolio and individual asset acquisition continued to decline, which suggests prevailing reluctance on the part of investors. The multifamily segment has been the top asset class in terms of transaction volumes over the past three years, showing a healthy growth of 10% in 2018. The suburban office segment is experiencing forward momentum, driven by yield spreads and strengthening demand fundamentals. However, growth in suburban markets was offset by a decline in downtown markets and, as a result, total office volumes remained unchanged YoY.
Overall pricing remained relatively stable in 2018, but with growth in e-commerce driving the interplay between demand for industrial and demand for retail, the pricing in these two segments continued to trend in opposite directions. The industrial cap rate compressed by 6 basis points (bps), while the retail cap rate expanded by 5bps in 2018. Office and apartment cap rates remained relatively unchanged.
Although office supply and demand remained relatively balanced for the first half of the year, demand accelerated while the rate of new project completion slowed in the second half. Increased demand for office space in 2018 mirrored the trend in employment growth, which also accelerated throughout the year.
For the full year, there was 68 million square feet (SF) of net absorption against 49 million SF of net completions, lowering the average national office vacancy rate to below 10% for the first time since 2000. Although supply is set to rise substantially in 2019 and 2020, demand is also forecast to trend higher, keeping vacancies below 10% through 2021.¹
With the unemployment rate for educated labor at a near historic low of 2.1%⁶ 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. Naturally, markets with greater growth in their educated working age population are more likely to attract employers and experience stronger demand fundamentals. Furthermore, as labor markets tighten, the quality of office space will likely become an increasingly important factor in attracting and retaining talent. We estimate that well-located, high-quality assets will capture a disproportionately high share of demand.
Rent growth peaked at 6.0% in 2017, and has gradually declined toward the long-term average since then, achieving only a 2.1% increase in 2018. Although there's a wide spread across geographic markets, nearly all major markets experienced some rent growth in 2018. Notable exceptions were Houston and New York, where rental rates declined by 0.1% and 0.6%, respectively.¹
Construction activity has remained stable YoY, with a total of 134 million SF of space under construction—equivalent to 1.7% of existing stock—as of the end of 2018.¹ Construction activity varies widely, with the three most active markets, San Jose, San Francisco, and Seattle, experiencing construction activity of more than 4.0% of existing stock.
Industrial real estate continues to be driven by the logistics related to e-commerce, with the result that demand is outpacing overall economic growth. Demand was consistent through 2018, with total net absorption of 227 million SF against net completions of 211 million SF, pushing down the average national vacancy rate to 4.7%, a level not seen since the 1980s.
Historically, industrial sector demand has maintained a one-to-one relationship with overall economic growth. In recent years, however, demand has accelerated to 1.3x GDP.⁷ This additional appetite derives from the space requirements of e-commerce companies: They need large regional and superregional warehouses and small last-mile fulfillment centers. These unexpectedly high demand fundamentals, along with a slow supply response earlier in the cycle, have produced strong occupancy gains in recent years.
Rent growth has also accelerated in recent years, to a historically high rate of 6.0% in 2017. Although this growth edged down in 2018, it still remained elevated at 5.4%. With supply forecast to outpace demand over the next three years, rent growth will likely decelerate to long-term trends. However, given physical constraints affecting development of last-mile and infill/local facilities, and the key role they play in e-commerce logistics, we expect continuing occupancy and stronger rent growth fundamentals for those segments.
With the overall U.S. housing market continuing to be undersupplied and demographic trends supporting demand, multifamily fundamentals remain robust. In 2018, total demand for multifamily space was 348,000 units, while 289,000 units were added to the market on a net basis. As a result, the average national vacancy rate decreased by 50bps, to 6.0%.
Despite increased supply in recent years, overall, U.S. housing markets remain undersupplied. 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-family and multifamily units averaged less than 1.0 million units per year.⁶ As economic and lifestyle factors that are supportive of renting continue to strengthen, pressure on overall supply intensifies. Lifestyle factors include the increasing median age of marriage and the percentage of people living alone. Economic factors that have eroded home ownership affordability include ballooning student debt and weak wage growth during the current economic cycle.
Strong occupancy fundamentals have also helped to fuel rent growth, with an average national growth of 3.1% in 2018, up from 2.6% the previous year. However, this growth hasn't been the same across all segments, with higher-end units in core central business district markets experiencing flat to declining net effective rent growth.
Construction activity remained elevated at a 20-year high of 653,000 units under construction—equivalent to 4.1% of existing stock—although construction activity is highly concentrated in major markets, with the top 15 markets accounting for half of all national construction under way.
1 CoStar, as of Q4 2018. 2 Bloomberg, as of January 17, 2019. 3 The New York Times, as of January 4, 2019. 4 Thomson Reuters Datastream, Manulife Investment Management, November 2018. 5 CoStar, as of Q4 2018. All market fundamental statistics, including vacancy, absorption, completion, under construction, and rent growth. Real Capital Analytics, as of Q4 2018. All capital market statistics, including transaction volume, cap rates, and price index. 6 Bureau of Labor Statistics, December 2018. 7 CoStar Portfolio Strategy, December 2018.
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