To get a good look at what we should expect in 2015, I spoke to Bob O'Brien, Global Real Estate Sector Leader from Deloitte, on a recent episode of the Commercial Real Estate Show. Deloitte had just released its annual 2015 Commercial Real Estate Outlook and Bob gave us a custom tour of what’s going to be hot this year.
Number 1: MacroEconomic Fundamentals
The US economy is the standout, doing really well while Europe and Asia are struggling, O’Brien said. China’s economy is slowing, and Japan is essentially in a recession. The eyes of the world are on us.
The US has had multiple quarters of strong growth, and going into 2015 it’s looking really good. GDP is around 4% for the past few quarters, which is very consistent growth, great for jobs. So good we think people can even look forward to increased pay.
Housing is seeing some recovery, but it’s unsteady, and quite variable across geography. The availability of mortgage financing continues to be a bottleneck for the housing industry, and it’s still a challenge for the first time buyer.
Will interest remain low? Everyone was expecting an increase, but now that oil prices are falling we may see yet another year of low interest.
Nationally, top CRE executives are all quite optimistic for a great year in 2015.
Number 2: Globalization
Capital flow from global sources is stronger than ever. Foreign investors love US CRE. Global investment in the US is up 40%. Transactions were up in 2014, and over 10% of CRE transactions are offshore money. The Chinese really turned on the spigot last year buying high profile deals in most major metros.
Foreign investors are motivated more by safety than yield. Chinese in particular are in it to learn rather than earn, eager to incorporate their experience into development at home. Like most foreign investors, they are willing to pay more for our stable economy. That means tough competition for the average domestic investor.
US investors are buying overseas. Some opportunistic funds are picking up distressed commercial real estate in the UK. US private equity is getting interested in Asia and India. US investors are chasing yield, as it’s getting difficult to generate large yields in the US. US REITs, meanwhile, are staying close to home.
Number 3: REITs
REITs had a great 2014, up 25% compared to the S&P, a great performance after a tough 2013.
The REIT strategy is to rationalize their portfolios, and solidify success in raising funds. They are recycling their capital, selling non-core properties, and are increasingly involved in development.
With such strong performance there is significant investor interest, and the institutional investors are clearly devoting more of their portfolio to commercial real estate via REITs.
Number 4: Financing
“It’s as good as it gets.” O’Brien says bluntly.
Broadly across asset types, across geography, there is a lot of capital available for commercial real estate. Money is out there. Banks have been conservative on development loans, but other capital sources have stepped up. Innovating funding options like crowd funding are increasing opportunity, but still a small blip on the radar.
One concern are CMBS loans, an issue still navigating regulatory challenges. There will be some legacy CMBS coming due in the next three years that may prove challenging to refinance.
But what about those interest rates?
“Some experts think the market can absorb a 100 basis point uptick,” says O’Brien. “I’m not one of them. This will create higher return expectations, and negatively impact the market.”
But the new twist is falling oil prices, bringing the shadow of deflation, which may keep rates low.
“Take advantage of these low rates now. Extend terms, and lock in those rates. Lenders are getting more aggressive right now, so make that work for you and get your project going.”
Number 5: Transaction Activity
Commercial property has seen a steady uptick in transactions since 2009. Last year approached the highest on record. With all the capital on the market 2015 should be very busy, the only braking factor could be interest rates.
Transaction volume grew 16.4 percent in the first seven months of 2014 to 204.2 billion, driven by REITs and international investors. Secondary markets have picked up strong activity across property types as investors seek opportunity with less competition.
Retail led the growth with a 40% rise in sales in the first seven months of 2014, while apartments were the only sector to show a decline from 2013.
Number 6: Property-Specific Fundamentals
Multifamily: has a lot of new product coming online. With the stronger economy we’re expecting increase in household formation, but the difficulty of borrowing for first time homebuyers bodes well for apartments. However we're unlikely to see rent growth quite as spectacular as the last few years.
We’re most optimistic about Industrial sector, primarily warehouse. With ecommerce growing, US manufacturing rebounding and global trade bouncing back, we’re seeing lively development and transactions. Vacancy is down, rents are rising, and cap rates are compressing as the demand for space keeps growing.
Early in the recovery,Office was initially strengthened by very little new product in development. We’ve heard talk about square-feet per person decline for over a decade now, and this has played out. Millennials are entering the workforce creating more demand. Later this year and next we’ll see some tapering off due to development coming online.
Retail: A tale of two cities, with those big A-class regional malls, with the right mix of entertainment, shopping and food doing very well, while B and C centers are struggling. You may see some redevelopment of weaker malls, but the excess inventory continues. The basic community and strip centers are not impacted – they rise and fall with the local economy.
Lodging. New inventory will impact occupancy in this sector, which is growing well as business travel picks up again. Average room nights are going up, another sign of our improving economy.
Healthcare & Senior We’re seeing a lot of mergers and acquisitions in recent years. Demographics mean that steadily increasing demand will continue for some time. As the housing market improves, seniors gain capital that they are investing in quality senior facilities, becoming savvy shoppers, so expect more choices in retirement development.
Number 7: Sustainability
No longer just a hip idea, sustainability continues to build momentum. What used to be just a buzzword has become a source of real cost savings. Tenants have their own sustainability policies and demand space to match.
Investors are willing to pay a premium for LEED certified buildings. Investors who demand improved sustainability are getting better ROI.
Number 8: Technology
As technology has improved for building systems, we get smarter and greener buildings. Technology is also creating more interconnectivity between building owners and tenants, helping them manage energy costs.
Improved connectivity is used to improve attraction, satisfaction and retention of tenants, because tenant replacement is such a significant cost.
We’re watching the disrupters as well: new concepts like shared office space, AirBnB, hoteling office space, incubation labs, and drop-in space. Expect new ideas to keep rolling in, and don’t underestimate innovation.
Number 9: Security & Privacy
Commercial real estate professionals didn’t used to worry about cyber security, but today’s interconnectivity means more sensitive financial data flowing between tenants and management. This requires prioritizing the security of the firm’s systems and networks.
The keys are: Vigilance, safeguards, and resilience. Can you recover from a cyber attack? Some clients actually conduct “war games” in order to prepare for cyber attack.
Number 10: Regulations
Regulatory changes provide continuing uncertainty, particularly the following:
FIRPTA, the Foreign Investment in Real Estate Property Tax Act: if a foreign investor bought 100 shares of Google, they are not taxed on the proceeds, but if they profit on a company that owns real estate, they pay taxes. There is bipartisan support for reforming FIRPTA. This is not expected to eliminate but reduce that tax burden thus allowing more foreign investment to flow in.
Corporate tax reforms are floated but unlikely to see any confirmation in 2015
Lease accounting standard adjustments may affect tenants’ bottom line