Originally published in UrbanLand Magazine by Beth Mattson-Teig on October 7, 2019.

The persistent theme over the current economic cycle of “lower for longer” growth has contributed to a record expansion cycle that has surpassed 10 years. Results from ULI’s latest “Real Estate Economic Forecast” show that the trend is likely to continue into 2021.

The consensus is that the economy and real estate performance are coming in for a soft landing, with more moderate growth ahead. The ULI forecast conclusions are based on an August 2019 survey of 41 economists and analysts at 32 leading real estate organizations.

Global growth has been slowing since 2017, and the fiscal stimulus that the U.S. economy saw following tax cuts that went into effect in 2018 is starting to dissipate. “Growth is going to slow. We all seem to agree on that. It’s a question of how much is it going to slow,” said Stuart Hoffman, senior vice president, and chief economist for the PNC Financial Services Group and panelists in a webinar discussion of the forecast results.

The Cushman & Wakefield outlook for the 2019 and 2020 timeframe mirrors what was outlined in the ULI forecast. The new federal government spending bill should help maintain growth. However, looking further out into 2021 and beyond, the risks are tilted a little more to the downside, said Rebecca Rockey, global head of forecasting at Cushman & Wakefield.

“The real story that we’re trying to figure out as we look out to 2021 is what’s going on beneath the surface as we turn from a place where we were firing economically pretty much on all cylinders, and we transition to an environment where we are increasingly leaning on the consumer segment and the services segment of the economy,” said Rockey. What that shift means is that there is less bandwidth to absorb some of the downside risk, she added.

Favorable Outlook for Capital Costs

Slowing economic growth has contributed to a big drop in the 10-year Treasury note this year. Although that is welcome news for borrowers. It does raise a yellow flag of concern that the economy could stall, noted Hoffman. Historically, an inverted yield curve has preceded a recession within 18 to 24 months. Currently, the 10-year Treasury yield is hovering at about 1.6 percent, with the ULI forecast predicting it will end the year at 1.8 percent, before rising to 2.0 percent in 2020 and 2.3 percent in 2021.

Panelists seem to agree that the forecast for rising interest rates may be overly pessimistic. The Fed has indicated it could cut rates again when it meets again later in October. After cutting rates in October, the Fed is likely to go dormant and hold the federal funds rate at 1.5 to 1.75 percent for the duration of this year and all of next year ahead of the 2020 presidential election, noted Hoffman. “We don’t see the 10-year moving above 2 percent anytime in the next two years, assuming we don’t have a recession,” he said.

The drop in the 10-year Treasury is not expected to create a corresponding drop in cap rates. In fact, the survey forecast is for the National Council of Real Estate Investment Fiduciaries (NCREIF) cap rate to rise from 4.8 percent to 5.0 percent in 2020 and 2021. “We have hit a point where investors are at the low end of the return spectrum, and they are comfortable with the risks they’re taking,” said Rockey. If it is not worth taking the risk, investors are willing to wait for the right opportunities, which could be a sign that investors are pivoting to more defensive strategies, she said.

Industrial Remains a Front-Runner

The industrial sector remains the darling of the commercial real estate market. “We’re seeing some big moves in NOI [net operating income] growth for industrial, and that will continue to be the leading sector,” said William Maher, director of America’s strategy and research at LaSalle Investment Management. Although growth will moderate, fundamentals are still healthy, with industrial vacancies that are forecast to climb from 7.0 percent in 2018 and 2019 to 7.4 percent by 2021, and rent growth slowing from 3.6 percent in 2019 to 3.0 percent in 2020 and 2.4 percent in 2021.

Industrial vacancies are rising in conjunction with a wave of new supply. However, vacancies remain anchored well below the 20-year average of 10.2 percent. Cushman & Wakefield is tracking 327 million square feet (30 million sq m) of space that is expected to hit the market. One-third of that is build-to-suit, and lease-up rates on spec projects have been pretty quick, said Rockey. So, the industrial story remains very positive. Analysis of rents is more nuanced because much of the available inventory is functionally obsolete, which could be weighing on asking rents, she noted. In particular, strong investor demand can be found in supply-constrained markets and in-fill locations.

“Retail is the big wild card,” adds Maher. The ULI forecast predicts that retail vacancies will trend higher, rising from 9.0 percent in 2019 to 9.5 percent in 2021 and rent growth declining from 1.8 percent to 1.0 percent in both 2020 and 2021. However, NCREIF vacancy data for retail space shows a bigger increase in mall vacancies, which have risen from 6 percent to 9 percent in the past three years, compared with relatively flat vacancies in neighborhood centers. “So, it is a tale of two cities in retail,” said Maher. On one end, apparel and mall-related retailers are struggling, and on the other end, necessity and grocer retailers will be stable overall but could see some contagion from the overall tarnish on retail, he added.

Job Growth Fuels Steady Demand

Employment growth is forecast to remain above the long-term average over the next three years but will decline from 2.68 million in 2018 to 2.25 million in 2019, 1.4 million in 2020, and 1.5 million in 2021. Job growth has been underpinning steady property demand and a fairly stable outlook for both the office and multifamily sectors.

There are some pockets of the market where cap rates in office properties are edging higher, such as Chicago and New York City. However, the office sector is generally stable, noted Rockey. The ULI forecast shows that NCREIF total returns in the office sector are likely to edge lower, from 6.9 percent in 2018 to 6.0 percent this year and 5.1 percent in both 2020 and 2021.

The apartment sector has continued to perform well despite the active development pipeline. Vacancy rates are forecast to decline another 10 basis points to 4.3 percent by the end of 2019 before increasing to 4.5 percent in 2020 and 4.7 percent in 2021. Rental rates, which have experienced nine consecutive years of growth topping 2 percent, will dip from 3.2 percent in 2018 to 3 percent this year and then slow further to 2.3 percent in 2020 and 2021.

Apartment developers have added plenty of new supply to urban markets. However, it will be more challenging to accommodate shifting demand from aging millennials who will want to live in close-in suburbs, Maher said. “It’s very hard to build condos and rentals in those markets, so I think there will be a mismatch in those close-in suburbs with better school districts,” he said.

Another wild card in the current three-year forecast is the geopolitical climate and upcoming 2020 presidential election. There may not be a resolution to the trade war with China in the near term, but there could be more of a truce, with a freeze on further increases in tariffs, Hoffman said. Canadian Prime Minister Justin Trudeau also is up for reelection later this month. Partisan politics in Washington and the outcome of the Canadian election could affect the United States–Mexico–Canada Agreement, so outside of the survey results, political uncertainty does create more downside risks to the economy during the 2019–2021 forecast period, he added.

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