November 2018 - Sachse Construction

A 200-Year-Old Retailer Makes Big Innovation Leap

Brooks Brothers is adopting artificial intelligence (AI) to make sure that it stays relevant among its loyal customers.

Through a partnership with enterprise software provider ORS Group, the specialty retailer launched an end-to-end AI-powered retail platform, called ORS RETa.i.l. Brooks Brothers is the first fashion retailer in the world to fully integrate AI comprehensively across all business processes, according to the company.

Brooks Brothers will use the platform’s algorithms and AI to gain insights across the entire value chain, a move that will help to improve and automate decision-making, and drive impactful business transformations. It will also power the company’s “buy anything, get it anywhere (BAGA)” platform which manages fulfillment across its stores.

Specifically, the technology will enable the company to ship online orders from stores for same-day delivery, and monitor available stock — two processes that will help to increase sales and convert more visits into purchases, according to Forbes.

The AI architecture to improve efficiency and service to its customers, as well as remove waste, empower management and enhance decision-making capabilities, according to the company.

“Using ORS’ RETa.i.L Platform, we are able to create a highly sensitive and responsive digital supply chain to manage inventories in real-time and to optimize operations end-to-end,” said Gianluca Tanzi, Brooks Brothers COO. “It is a disruptive solution for automated omnichannel fulfillment to help us build a superior customer experience and maximize sales opportunities.”

The company, which celebrated its 200th anniversary in the spring, continues to take steps to remain relevant among its shoppers. In October, the company also added a cloud-based platform that fosters a seamless omnichannel shopping experience. By marrying order management and store fulfillment applications on a single solution, Brooks Brothers associates now have a 360-degree view of customer information and access to the company’s full network of inventory, enabling them to increase the value of the shopper’s experience.

Amazon HQ2 and the New Geography of Work

If you want to know where the future of work is heading, ask Amazon – or better yet, follow them.

Last week, we learned the Seattle-based tech giant will split its much-anticipated HQ2 between Crystal City, VA and Long Island City in Queens, NY. Setting aside the debates about the two winners or their 10-figure incentive packages, it’s worth focusing instead on how Amazon’s decision may reshape the corporate workplace. And like the proposed facilities, the scope is enormous.

Most workplace discussions today revolve around adopting new interior design standards: open versus enclosed workstations; optimal teaming spaces; and emerging, smart office technologies. If they haven’t already, Amazon will address all these issues soon enough. But for now, the big HQ2 takeaway is how geography and mobility are becoming major workplace drivers. By choosing sites in the New York and DC metros, Amazon is reinforcing a trend where increasingly, talented people hunker down in a handful of highly desirable places, mostly coastal US cities. Now companies – and their jobs – come to them.

I call this trend, “upward immobility.”

To date, major corporations tend to consolidate their leaders in a single headquarters location. So while many companies have dozens of sites worldwide, their CEO and key executives still often collocate in one specific place – and in many cases, this place becomes synonymous with the company itself: Think Apple and Cupertino, or Ford and Detroit.

In this scenario, employees do the moving. Before the HQ2 search, if you aspired to be a corporate leader at Amazon, it likely entailed moving to Seattle and immersing yourself in its corporate culture. To attract the best talent, companies like Amazon spend billions to create workplace and amenity hubs to inspire potential employees to move or commute enormous distances to work. These facilities are often conceived as magnets for migratory talent and ideas, and dozens of iconic corporate sites throughout the US illustrate this point—including Amazon’s “HQ1” in South Lake Union. It’s interesting to consider how mobility has often been equated with success. When I was younger, if someone was rising through the corporate ranks, you said they were “going places.” Often literally.

That’s changing. Talented people today—particularly in the tech sectors—are becoming more loyal to particular places than to companies or jobs, and as the HQ2 search illustrates, they are gaining the upper hand in the mobility equation. As a handful of U.S. cities—especially New York, Boston, Washington, San Francisco and Seattle—continue to drive upward immobility, it’s to take stock of where all of this is heading and how it will likely shape the workplace of the future.

More HQ2s in More Places

Don’t be surprised if Amazon chooses to build more HQ2s in the several of its other finalist cities, notably Boston and Chicago. In some ways, this is already happening as Amazon is currently hiring tens of thousands of tech workers outside its three HQ hubs, reinforcing a pattern that other tech giants like Salesforce and Google started with their multiple hubs distributed throughout several U.S. cities. These other cities are also hubs of upward immobility; Boston, for example, can leverage tens of thousands of area students who see the benefit of staying put after graduation.

As work itself grows ever more technology-driven, the ability to spread and connect workers across vast areas will further challenge the value for central leadership facilities. If Amazon is successful in Crystal City and LIC, look for other non-tech companies to follow suit. In 20 years, we may see millions of urban hub-based workers cycling through hundreds of companies in a single place-based career.

Distributed Workforce Strategies

Even if many cities never land an Amazon HQ2 facility—and to be fair, many won’t—Amazon and other technology companies may soon begin building networks of remote employees in suburban and rural areas. Upward immobility applies here too; college towns, smaller cities with legacy talent pools and key individuals in remote places are all in the mix and offer a lot to thousands of talented workers with great ideas and skills who choose not to live in places like Seattle, New York and DC. It may not always seem like it, but far more people live outside these superstar cities than in them, and as soon as U.S. metro markets become saturated with tech jobs, employers will look to the next tier of cities and towns.

Now that Amazon is distributing its core leaders and operations, it will become easier to expand its workplace network to include other, smaller places – that’s how most networks start until functionality becomes ubiquitous. If Amazon’s new facilities are successful, look for them and dozens of other companies to expand this trend as well.

Amazon Prime Real Estate?

Amazon sells and rents things. Is it possible that after years of assembling terabytes of data on nearly every major U.S. city and anchor institution, they might eventually choose to offer commercial real estate to their millions of consumers? That might sound far-fetched, but consider the emerging coworking market which is thriving in Amazon’s key cities. Coworking is ripe for disruption, as it takes the byzantine world of commercial real estate transactions and makes them something more akin to renting movies or buying consumer goods. However this model also takes billions of dollars and enormous IT resources to scale, which limits the ultimate shared workplace market, even for WeWork.

Amazon offers both.

Imagine if Amazon chose to serve upwardly immobile workers by offering literally thousands of workplaces worldwide to talented folks essentially everywhere? Suddenly the hurdle of finding a place to work in most places would give rise to a new marketplace where people can work nearly anywhere, much in the same way that Uber and Airbnb are disrupting their industries. Corporations might one day hire people—and give them credits (Blockchain anyone?) to essentially work where they want in the places they want to be.

There’s a lot on the line. Global commercial real estate is estimated to be a $29 Trillion addressable market. If Jeff Bezos were to pivot and think of Amazon as a commercial real estate engine, he might indeed become the world’s first trillionaire.

All these possibilities are a lot to take in, but this week’s HQ2 announcement is just the beginning of a whole new phase where where you work is increasingly up for grabs and talent is increasingly defining the process.

Who knows, maybe in the future, when we see a talented person thriving, we’ll say “they’re staying places.”

This week, Amazon picked up on that.

Top-Tier Mall REITs Post Solid Performance in the Third Quarter

While the retail sector continues to face challenges, REITs that own top-tier malls are posting solid performance numbers and respectable earnings.

Regional mall REITs can be a solid investment, with returns of 2.14 percent in 2018 compared with 0.53 percent for the S&P 500, Barron’s reported.

Despite record numbers of retail bankruptcies and store closures over the last couple of years, several big mall REITs, including Simon Property Group, Macerich and Taubman Centers, reported increased store sales and occupancies in third quarter, solid measures of how their properties are performing.

And, in fact, REIT-owned regional malls are outperforming malls held by other owners, with same-store net operating income (NOI) increasing 2.1 percent on average in the third quarter—the sector’s strongest quarter in 18 months, NAREIT reports.

REITs generally own malls in areas that are wealthier and have higher population density, according to NAREIT. That means there are more potential shoppers with more money to spend in the areas around REIT-owned malls, says Calvin Schnure, NAREIT’s senior vice president of research and economic analysis.

Population density is 20 percent higher around REIT-owned malls and average incomes are 9 percent higher. The average household income within five miles of a REIT-owned mall is $66,148, compared with $60,877 for other malls.

“This is really important when you’re dealing with the disruptions from e-commerce and bankruptcies and store closures, because the REITs have an easier time refilling the space,” Schnure says.

And that’s net positive for the REITs going forward, he notes, because many of the new tenants signing leases for spaces vacated by retailers like Sears and Bon-Ton are paying more.

“They’re paying higher rates because these are fresh stores coming in with a new product,” he says.

Density and affluence are key, agrees Chris Wimmer, vice president and head of REITs at Morningstar Credit Ratings LLC.

“There’s certainly pain being experienced by traditional brick-and-mortar retailers, but the investment-grade REITs we cover tend to have stronger balance sheets,” he says. In addition, “they have strong relationships with strong retailers… that can offer something not available by mouse click or tap. And third, their locations have good population density and tend to be relatively more affluent.”

Wimmer says this gives REITS not only the flexibility to position their portfolios in a way that helps insulate them from e-commerce competition, but they also have properties that healthy retailers want to be in.

Still a case of the ‘haves’ and ‘have-nots’

A bifurcation between top-tier and lower-tier mall REITs continues. “The higher the quality of the mall, the more resilient we expect them to be,” says Ana Lai, senior director and analytical manager at S&P Global Ratings.

“A”-rated malls outperformed all other retail REIT categories, posting strong NOI growth, further affirming that high-quality properties have held their ground with fewer rent concessions and higher demand from tenants, reported S&P. ‘B’-rated malls continued to struggle to re-lease space as rent renewals are negative, and occupancy levels are lower than the previous year.

Many mall REITs reported third-quarter earnings over the past month. For the most part, much of these companies’ results were positive. Industry analysts say REITs like Macerich and Simon, which boast some of the nation’s top-performing malls, will have little problem weathering the so-called “retail apocalypse.”

However, REITS like CBL Properties and Washington Prime Group, which operate some class-B malls, are struggling, especially when faced with department store closings.

S&P rates Washington Prime “triple B-minus with a negative outlook (BBB-/Negative),” which is at the very low end of investment-grade. Lai says the company’s same-store NOI growth is under pressure primarily due to the ongoing challenges in the retail space.

S&P rates CBL a “double-B rating, with a negative outlook (BB/Negative),” which Lai says is at the low end of the spectrum, so it’s speculative-grade. She says S&P expected negative same-store NOI growth, mainly due to pressure from low rent growth following tenant bankruptcies and store closures.

An ongoing challenge that S&P sees for ‘B’-rated malls is that Sears’ bankruptcy will require these companies to take on a substantial amount of capital expenditures to redevelop and reposition those boxes.

How quickly these companies can redirect their resources and capital to focus on these vacant spaces will determine their success in minimizing disruption to their properties. Bon-Ton storeswere more common in ‘B’-rated malls, which makes the Sears bankruptcy a bigger issue for REITs that have exposure to both retailers.

“The capital required at some of these Sears stores that will be vacated could put pressure on the balance sheet,” Lai says.

What are top mall REITs doing right?

Simon, Macerich and Taubman have been backfilling vacant stores with more restaurants, pop-up stores and “experiential” and service-oriented tenants like gyms, theaters and co-working spaces to drive traffic.

Several REITs, including Simon and Taubman, are also undertaking redevelopments of top-tier malls to create mixed-use properties. Many REITs are also adding clicks-to-bricks retailers  like Warby Parker, Bonobos and Fabletics to their tenant mix.

“Clearly, the ‘A’ mall REITs have been in a better spot than the ‘B’ mall REITs,” says Alexander Goldfarb, a senior analyst at Sandler O’Neill + Partners LP. “That said, it’s not like they’ve been immune, in the sense that you still need to be able to present investors with a growth profile.”

Goldfarb says malls are like fashion: it’s expensive to look good.

“In mall land, you have to keep spending money,” he says. “If you’re always current and you’re spending, then you’re going to be fine. It’s definitely an incremental investment. But if you wait a long time, suddenly, you’ve got to put a lot of money in just to catch back up before you can move it ahead. That’s the biggest issue for the malls.”

Highlights from third-quarter earnings reports

Simon, the largest U.S. mall owner, announced third-quarter earnings that included a 10 percent increase in funds from operations (FFO) to $3.173 billion year-over-year. Sales per sq. ft. for the portfolio increased 4.5 percent year-over-year to $650. Occupancy ticked up to 95.5 percent. Total portfolio NOI growth for the past nine months was 4.1 percent.

Simon has one of the highest credit ratings in the REIT space, at A.

“We have no concerns about Simon at all,” Lai says. “Their rating has stayed at the same level for many years. The performance that they’ve posted so far, including third quarter, has been pretty solid.”

During the company’s earnings call, Simon CEO David Simon told analysts that department store closings like Sears pose a unique opportunity. Simon is converting old Sears’ spaces into new types of retail, gyms, restaurants, hotels and office space.

“We’re putting Sears in our rearview mirror,” Simon said. “We’re planning for the ultimate, unfortunate demise of Sears and we’re ready for it, and we have the balance sheet and the capital with intellectual and human resources to deal with these set of events.”

Simon will invest more than $1 billion to redevelop the Sears stores across its properties. Simon pointed to redevelopments including the Brea Mall in California, Northgate Mall in Seattle and Phipps Plaza in Atlanta—all of which lost Sears stores.

Simon also said more e-commerce brands are opening up brick-and-mortar stores at its malls.

Macerich is an upscale retail REIT boasting 48 centers, many on the East and West Coasts. Sales per sq. ft. for the portfolio increased by 7.3 percent to $707, according to its third-quarter earnings report.

Occupancy ticked up to 95.1 percent. Average rent rose 3.9 percent to $59.09 per sq. ft. Same-center NOI grew by 3.7 percent year-over-year. However, the REIT missed FFO estimates.

Like Simon, Macerich is devising creative ways to fill vacancies, including teaming up with co-working company Industrious to open shared-office spaces at its properties. It also announced a joint venture with Simon to co-develop Los Angeles Premium Outlets.

Taubman’s FFO was up 36.4 percent, and excluding lease cancellation income, same-center NOI growth was up 9.2 percent in the third quarter. Sales per sq. ft. increased 5.8 percent for the quarter—the ninth consecutive quarter of positive sales growth.

“We recently upgraded them ahead of third-quarter earnings on the view that the NOI would improve and it has,” Goldfarb says. “Speaking to management, there’s a lot of upside potential in their NOI profile for next year.”

He says the earnings in their malls are improving, and most importantly, their developments in Puerto Rico, Hawaii and Los Angeles are all coming back on line or improving.

For example, in Puerto Rico, the Mall of San Juan continued its strong post-hurricane ramp-up. Year-to-date, sales per sq. ft. are up nearly 30 percent. Taubman also revealed the $500 million“reimagination” of Beverly Center in Los Angeles.

Meanwhile, consolidation in the sector continues. Following Brookfield Property Partners’ acquisition of GGP, Brookfield said in its earnings call that it plans to convert at least 100 GGP malls into “mini cities.” It will spend as much as $1 billion annually for the next few years to reposition these centers by adding hotels, offices and housing.

USGBC and BRE Form Partnership

The U.S. Green Building Council (USGBC) and the BRE Group (BRE) have formed a partnership to collaborate on standards, platforms, and research.

The organizations will explore ways to:

  • Increase the level of engagement of existing buildings in the measurement, reporting, and improvement of their environmental, social, and wellbeing impact.
  • Embrace a digital strategy to raise combined technological capabilities and establish industry-wide common data standards and protocols to make both platforms simpler, smarter, and more intelligent.
  • Conduct research to identify new transformational opportunities to improve sustainability credentials of the world’s buildings, communities, and cities.

The collaboration will also look to USGBC and BRE’s combined market knowledge, partnerships and collective tools through LEED, BREEAM and other rating systems to address all built environment sectors: new and existing commercial buildings, new and existing homes, infrastructure, landscape, power, waste, and finance. LEED and BREEAM are the two most widely used green building programs in the world, having certified assessments of over 640,000 buildings in 167 countries and territories.

To Build Water-Efficient Cities, Water Managers and Urban Planners must Coordinate Better

For improved water efficiency in cities, water managers and urban planners must coordinate their efforts better, according to a new report led by University of Arizona landscape architecture and planning researchers.

Lack of time and resources and practitioners not in the habit of working together were cited as the main factors stymieing better collaboration, according to responses to a national survey of water managers and urban planners. The report includes a tool for practitioners to identify goals for collaboration and what barriers might stand in their way.

The first steps toward improved collaboration include joint training sessions where water managers and urban planners hear each other’s challenges and brainstorm ways of coordinating their work. Where coordination works well, a water engineer might sit in on development review meetings for new projects and weigh in during permitting to ensure that the new development would achieve groundwater and stormwater goals of regional and state agencies.

In the future, water managers and urban planners could help staff each other’s agencies for a complete integration of the two functions.

Former Urban Big-Boxes, Class-B Office Buildings Are Being Converted to Last Mile Industrial Space

The limited supply of urban industrial inventory available for “last mile” e-commerce distribution space is causing investors and end-users to get creative by repositioning other types of real estate with failed uses or shrinking demand, according to a JLL report, Urban infill: the route to delivery solutions.”  The report notes that annual total e-commerce deliveries have more than tripled over the past five years, but development of new urban industrial infill assets has remained relatively flat.

Despite dwindling opportunities in urban locations, investors remain interested in the 18 percent sales price premium last mile industrial assets command over “first mile” locations, and the higher rents users are willing to pay in order to be near their customer base.

Older office buildings, underused parking structures, abandoned strip centers—even former churches—are now among properties being repositioned as last mile fulfillment centers. E-commerce fulfillment centers are actually “terminal facilities,” as trucks deliver merchandise there to be broken down for home delivery trucks and other types of vehicles, according to Mark Glagola, D.C.-based senior managing director for industrial services with Transwestern. He notes that these distribution facilities are especially critical for time-sensitive merchandise like food products.

Adaptive reuse of class-B office buildings as industrial space is a growing phenomenon that Pete Quinn, Indianapolis-based national director of industrial services, USA, with Colliers International, says investors would have considered a ridiculous proposition 10 years ago. But landlords dealing with falling office occupancy rates are increasingly undertaking such conversions. The JLL report suggests that this makes perfect sense in New Jersey, for example, as the average office vacancy rate has hovered near 25 percent in recent years, while average industrial vacancy has dipped to 5 percent.

A Colliers report notes that smaller, obsolete buildings are being used for e-commerce, merchandise pick-up locations. Online grocery operator Peapod, for example, has repurposed former fast food restaurants and bank branch buildings as grocery pick-up locations. Peapod has also launched “Warerooms,” small, urban community locations of 5,000 to 8,000 sq. ft., where “cross-docking”—moving products from one transportation vehicle to another for delivery—is manually performed in a parking lot, eliminating the need to rent industrial space at all.

Any type of building with a failed use will eventually be converted to a use that makes more money, but Glagola notes that the type of new use generally depends on the neighborhood. Former retail big boxes like Toys ‘R Us and Sears stores tend to be in strategic locations in fairly affluent, residential neighborhoods and so will probably be re-tenanted with other retailers or converted to mixed-use or multifamily use. But buildings with failed uses in transitional, or gentrifying, urban neighborhoods, which may already include industrial uses, are more likely to be repositioned for e-commerce distribution.

There’s a current push toward adaptive reuse of excess retail space for e-commerce distribution, particularly during the holiday season, according to Quinn. Retail giants like Walmart are already using some of their stores as e-commerce pick-up locations and fulfillment centers. Proximity to customers and roadway infrastructure is what makes these locations an excellent choice for last-mile e-commerce operations, according to Conway. He notes that the big-box facilities also have amenities required by modern industrial operations, including two or more dock doors and lots of parking trucks for workers.

Empty grocery stores offer tremendous potential as last mile space, he notes, as they tend to be in dense urban locations, and there are so many available due to competition among grocers that has forced store closings and buyouts. Quinn is currently working on a deal in the Indianapolis area that would reposition closed stores owned by a grocery chain that is downsizing into industrial space.

Zoning issues have prevented more conversions from retail to industrial use, according to Ben Conwell, Seattle-based senior managing director and practice leader for Cushman & Wakefield’s e-commerce and electronic fulfillment specialty practice group for the Americas. There’s also the fact that some local government officials haven’t given up the dream for another retail tenant taking up the space and the tax revenue a retailer would generate. He says, however, that investors and owners are beginning to work together with municipalities to create hybrid properties with retail in the front portion of buildings and e-commerce operations in the rear.

Investors are also replacing low-grade office and obsolete industrial buildings in strategic, high-density, urban locations with modern industrial facilities Glagola cites, for example, a project that demolished a 200,000-sq.-ft. building formerly occupied by USA Today’s “Army Times” offices and printing plant. Located at the intersection of I-395 and I95 in Springfield, Va., this new 190,000-sq.-ft. warehouse, which was built on the old building’s foundation, is just four miles from downtown Washington, D.C., and nearby by one the two Amazon HQ2 projects.

Obsolete warehouses in urban locations are also being rehabbed for modern use. For example, a NAIOP report cited the redevelopment of an obsolete, 312,000-sq.-ft. warehouse on 13.2 acres in Chicago by local developer One Real Estate and New York-based DRA Advisors LLC as a prime example of value-add opportunities available to investors in urban infill locations,

This was a typical, older inner-city structure, but it had attributes that made it an ideal candidate for redevelopment, including: a 28- to 30-foot clear height ceiling, 50-by-60-foot bay spacing and five acres of extra land that could be used for car or truck parking. The building also had food storage and distribution infrastructure. Even more important was its location near the city’s gentrifying Pilsen neighborhood, which provided access to a deep labor pool and public transportation.

The JLL report notes that the higher rents and values associated with last mile warehouses in certain dense, urban markets have made the high cost of constructing multi-level warehouses feasible. Four multi-level projects are currently under construction or will soon break ground in Seattle, San Francisco and New York City, and many more planned projects will be announced in the coming months, according to Rob Kossar, vice chairman and head of the Northeast industrial region at JLL.

“There’s a lot of money to be made, but these projects are a risky proposition,” warns Conwell. He notes that rehabbing older industrial buildings or redeveloping industrial sites present physical risks associated with environmental clean-up, particularly if the building or site was formerly occupied by a manufacturing operation. The clean-up can be costly and time-consuming.

Access to a sustainable labor pool—the biggest concern for today’s industrial users—presents another risk for industrial investors, particularly with high competition for labor in the current full-employment environment, according to Conwell. He notes that projects need to provide access to mass transit and/or sufficient employee parking spaces.

Five Takeaways from Marcus & Millichap’s 2019 Office and Industrial Forecast

  1. All suburban office properties are not the same. Prices are at record highs for office assets located in highly walkable suburban areas, particularly compared to somewhat walkable and car-dependent locations, said Jim Costello, senior vice presidents at research firm Real Capital Analytics (RCA), who was a panelist on Tuesday. “Definitely it’s the case that you’re getting higher cap rates looking into suburban areas, and the further out you go into more car culture areas, you’re getting a higher cap rate,” he said. “That’s just part of the dynamics there.” There is also a fairly wide gap in cap rates between assets located in highly walkable and car-dependent locations, meaning investors need to make asset-level decisions on acquisitions, noted panelist Alan Pontius, senior vice president and national director of specialty divisions at Marcus & Millichap.
  2. Single-asset suburban office sales were at record levels in the third quarter. “We’re well above where we had been before the pre-GFC [great financial crisis] peak,” Costello said.
  3. This economic cycle has been one of the longest in the U.S., but one metric that could signal restrained growth is labor force shortages, said panelist John Chang, senior vice president of research services at Marcus & Millichap. This has led to a more competitive recruiting environment and has started to impact office space allocation and desirability of locations, he notes. There are 7 million job openings currently, but just 6.1 million people looking for work, generating more demand for office space as well, he noted.
  4. Two big inflationary metrics to watch: tariffs and rising construction costs because of labor and material price increases, Chang said. “Both of these are inflationary in nature,” he added. Chang said the cost of construction labor has accelerated, impacting development pipelines. Meanwhile, rising tariff prices hike up materials costs for new developments, and those hikes could soon be passed on to consumers, Chang said. President Donald Trump on Monday said he expects to boost tariff levels on $200 billion of Chinese goods to 25 percent, the Wall Street Journal reported.
  5. Industrial construction is slowing, but vacancies remain steady. The industry is starting to respond to higher costs, helping to ease construction rush, Chang said. Meanwhile, vacancy rates nationally hover in the 4 percent range. Major industrial hub markets, such as Dallas and Chicago, have seen a flattening of vacancy rates because of construction there. Meanwhile, port markets—such as Houston or Seattle—are very tight, with little room to compress, Chang said. The same goes for local service markets like Cleveland, for example.

Defying Gravity

Multifamily has enjoyed a long run as a favored commercial property type over the past decade. And despite a recent surge in new supply that has taken some of the edge off of enthusiasm, market participants are holding onto a positive outlook.

Exclusive research conducted by NREI shows that a majority of survey respondents are predicting stable or improving fundamentals in the coming year, with a continued appetite to maintain or expand portfolios. The market remains optimistic even as concerns about high levels of construction move higher. Views on whether there is too much new construction occurring increased from 36.5 percent a year ago to 43 percent who now believe there is too much construction. Nearly one-third (35 percent) believe it is the right amount and 12 percent think it is too little, while 10 percent said they were unsure of the answer.

People often think there is a lot of development occurring just by looking at all of the construction cranes in their respective markets. However, once you dig into the supply and demand numbers, developers are building enough properties to meet the demand, says Richard Campo, chairman and CEO of Camden Property Trust. “Multifamily demand has outstripped supply in most markets. So, I think we’re pretty much in balance,” he says.

Survey results also appear to support the view that the market is maintaining a healthy balance, with a forecast for stable occupancies ahead. In all, 41 percent of respondents believe occupancy rates will rise over the next 12 months, while one-third say there will be no change and 26 percent think occupancies will fall. Although a sizable number are anticipating improvement in occupancies ahead, respondents are not expecting any big moves. Among those who do predict an increase, most believe occupancies will increase by fewer than 50 basis points, with a mean response among all respondents at a nominal increase of six basis points.

“What the statistics don’t really reveal is that we’re replacing obsolete or undesirable housing,” says Steven Fifield, founder and CEO of Fifield Companies and a principal at Century West Partners. “Our business has been so transformed over the last decade. What we are building today bears no resemblance to projects that were being delivered 10 to 15 years ago,” he says. For example, Fifield Companies is building transit-oriented  projects in Chicago and Southern California that feature modern amenities, such as bike storage rooms, lap pools and shared co-working and community spaces to accommodate the increase in people who are working from home. Occupancies for its stabilized projects range between 95 percent and 97 percent.

Respondents are also predicting that while rent growth will slow, it will still remain positive. Two-thirds of respondents expect rents to rise in the next 12 months, while 14 percent say there will be no change and 19 percent believe rents will fall. However, the amount of rent growth anticipated is lower than in past surveys, with a mean increase of 1.3 percent.

Survey results are consistent with what many operators are experiencing within their portfolios. “It depends on the individual market, but generally we’re seeing rent growth of 2.0 to 2.5 percent and occupancies that are stabilized,” says Matt Heslin, co-founder and managing partner of Los Angeles-based Oak Coast Properties, which has a portfolio of about 6,000 apartments across the United States. “I don’t see occupancies going up and I don’t see rent growth exceeding inflation” he adds.

Sentiment takes a step back

Survey results show respondents still have a bullish view of apartments compared to other sectors. When asked to rate the attractiveness for each property sector, multifamily and industrial both rate the highest, with a mean score of 7.7, followed by hotels at 6.1, office at 5.9 and retail at 4.8.

Although survey results show continued confidence in the sector, views are slightly less optimistic than in past surveys. In 2016 and 2017, half of respondents predicted that occupancies would rise, compared to the 41 percent in the current survey. Sentiment on rent growth has also been slowly cooling. Two-thirds of respondents say that rents will rise in the coming year, which is a decline from 74 percent who held that view a year ago and a bigger drop from the record high of 81 percent who thought rents would rise in the 2014 survey.

“This has been quite a long cycle and the fundamentals still look really good as far as rent growth and occupancies,” says Caitlin Walter, vice president for research at the National Multifamily Housing Council (NMHC). That being said, the NMHC’s third quarter survey of apartment market conditions also showed a further decline in its Market Tightness Index, which measures rents and vacancies. The index decreased from 46 to 41 in the latest survey, marking the 12th consecutive quarter of overall declining conditions.

The pullback in sentiment is not surprising considering that nearly two-thirds of respondents think that the commercial real estate cycle is at its peak as compared to a minority of 13 percent who believe it is still in recovery/expansion. Nine percent have a more negative view, including 5 percent who said the market is in recession and 4 percent a trough. Another 11 percent of respondents were unsure of the cycle phase.

Yet there are some indicators that suggest that this peak could, in fact, be a nice plateau. “With this cycle in particular, you have seen how the demographics are changing with people who view renting as a lifestyle choice,” says Walter. The NMHC forecasts that the U.S. needs about 328,000 new units per year to satisfy growing renter demand, and that demand is not coming from just millennials, but also Gen X and baby boomers, she says.

Vacancies have been rising slightly due to new supply coming on-line but remain at healthy levels. According to Reis, vacancies reached 4.8 percent in third quarter, which marks a 40 basis point increase compared to the same period a year ago. Reis data also shows that rent growth has accelerated this year. The firm is forecasting that effective rents will finish the year with a growth rate of 4.4 percent, which is slightly stronger than 2017.

One reason for that acceleration is that employment growth has been exceeding expectations this year, with estimates that the U.S. will add more than 2.5 million new jobs in 2018. “A lot of those jobs are going to our customers, the 20-year-old to 34-year-old cohort, and there is still a fair amount of pent-up demand from adults who are living at home or with roommates,” says Campo. On top of that is a behavioral shift with millennials who are delaying decisions for marriage, family and home ownership, which also bodes well for sustained renter demand.

Optimism also appears stronger where population and job growth is occurring. When asked to rate the strength of the multifamily market by region, respondents rated the West/Mountain/Pacific as the strongest area of the country at a 7.9 out of 10. That is not surprising as that region includes California and other top-performing metros such as Seattle and Denver. The South/Southeast/Southwest and East were both close behind, at 7.7 and 7.5 respectively. Meanwhile, the Midwest and Central regions lagged the rest of the country at 6.7.

Those results are not surprising given that most of the job growth has been in the smile states from Seattle and California through the southern states and up the Eastern Seaboard that tends to miss the Midwest. For example, Camden tracks the top 42 markets in the country. Midwestern cities tend to rank low on that list in terms of apartment revenue growth. For example, Chicago ranks 42nd for projected rent growth for 2018-2021 and St. Louis ranks 35th.

Buyers face stiff competition

Respondents continue to exhibit a strong appetite to buy more apartments, with 41 percent in the current survey who plan to expand holdings in the coming year. Another 44 percent are content to hold existing assets and a minority of 14 percent plan to sell assets. Once again, that sentiment is lower compared to the 47 percent who said they planned to buy more in the 2017 survey. The change in sentiment could be due to a combination of factors, including views that the market is at its peak, rising interest rates and a competitive investment market.

Oak Coast Properties has been very active for the past several years buying value-add assets in markets such as Atlanta, Denver, Seattle and Houston. However, aggressive pricing in the value-add space has pushed the firm largely to the sidelines. IRRs, cash-on-cash returns and multiples on the money have all dropped to the point where Oak Coast is not buying much of anything right now, says Heslin. “We would like to buy, we just can’t find deals that are priced appropriately for the risk-return that we’re looking for,” he says.

The investment climate is likely to get even more challenging as interest rates move higher. Deals are already getting repriced based on the interest rate moves that have take place. Since the start of 2018, the 10-year Treasury has increased by about 60 to 70 basis points. “I think there is going to be more repricing of deals going forward and there’s going to be an adjustment in buyer and seller expectations,” says Heslin. That shift in pricing could prompt more selling activity in the coming year as owners look to capitalize on value appreciation. For example, Oak Coast is currently evaluating about 2,000 units or about one-third of its portfolio for potential sale.

Sellers continue to be in a strong position. However, they are as concerned about the redeployment of capital and where to place capital after the sale as they are with the final pricing they achieve, adds Blake Okland, head of multifamily investment sales at Newmark Knight Frank. “Buyers are frustrated about the lack of available deals and the stubbornness of low cap rates amid rising interest rates,” he says.

Camden has dialed back its budget for acquisitions this year from $500 million to $300 million due to competition and aggressive pricing. The firm acquired one property in the third quarter with the $90 million purchase of a 299-unit property in Orlando and does not expect to close on any assets in the fourth quarter. “What’s basically happening is that there is a wall of institutional capital that is available for apartments,” says Campo. According to Real Capital Analytics, apartment sales during the first three quarters of the year were up 12 percent compared to the same period in 2017, with a transaction volume of $120.1 billion.

Plenty of capital available

A majority of respondents do expect interest rates to continue rising (90 percent), while 8 percent think they will remain the same and only 2 percent said they will decrease over the next 12 months. Despite expectations for higher interest rates, views on availability of capital for multifamily properties remain optimistic—and consistent with past surveys. Most respondents (43 percent) believe the amount of equity available for multifamily over the next year will remain the same, while 28 percent think it could be more widely available and 22 percent say it will be less available. Seven percent were unsure.

Views on availability of debt are very similar. In all, 46 percent believe availability of debt will be the same as it was 12 months ago, while 28 percent predict that it will be less available, 21 percent said it will be more available and 4 percent were unsure of the answer.

“The capital markets, both debt and equity, are flooded with cash,” says Fifield. Last year, Fifield Companies refinanced several of its apartment projects through life insurance company lenders and the agencies. However, the firm recently refinanced its recently completed NEXT on Sixth development in L.A.’s Koreatown with a new $125 million bank loan with a five-year term. The project features 398 units on top of a lower level Target store. Banks are more competitive with the insurance companies and the agencies and are getting into the interim financing business, notes Fifield. However, financing for new construction is more selective, he adds.

Respondents are accessing debt from a variety of sources. When asked to rate their use of sources of capital on a scale of 1 to 10, with 1 being no use and 10 being a significant source, most are likely to seek loans from Fannie/Freddie, with a mean score of 7.3. Local/regional banks, national banks and institutional lenders all rated next highest, with a mean score of 6.6.

When asked about anticipated changes to financing for multifamily over the next 12 months, more than half of respondents expect LTVs and debt service coverage ratios to remain the same, at 58 percent and 59 percent respectively. Twenty-three percent said that LTVs could decrease and 19 percent predict an increase in LTVs. Along those same lines, 30 percent think debt service coverage ratios could increase compared to 11 percent who anticipate a decrease, suggesting that respondents are more likely to believe lending availability could tighten in the coming year.

Rising Cap Rates

Investors are keeping a close eye on the impact of rising interest rates on cap rates. Nearly half of respondents (49 percent) said that the risk premium will rise over the next year, meaning that the spread between the 10-year and cap rates will increase. Given expectations for rising interest rates, that suggests that people think that a rise in interest rates will outpace an increase in cap rates. However, another 37 percent do not believe the risk premium will change, and only 14 percent predict a decrease in that spread.

“The general market sentiment right now among buyers and sellers is one of concern, because interest rate increases have two effects,” says Josh Goldfarb, vice chair, Southeast multifamily advisory group at Cushman & Wakefield. First, higher interest rates impact underwriting by undermining leverage returns. Second, clients are concerned about the impact of rising interest rates on the cost of capital, which may lead to a tempering of pricing and activity, he says. “There is a tension between having a sense of urgency to sell now versus taking a wait-and-see approach for next year,” adds Goldfarb. And of late, more clients have been taking the latter wait-and-see approach, he adds.

More than two thirds of respondents (69 percent) expect cap rates for multifamily properties to rise over the next 12 months as compared to 17 percent who said there will be no change and 14 percent who predict a decline in cap rates. However, respondents are anticipating only modest increases. Thirty-one percent believe cap rates will rise by less than 40 basis points; 25 percent think the increase could be between 40 and 50 basis points; and 12 percent said that rates will rise by more than 50 basis points.

“Regarding the pricing gap, we’ve been able to achieve higher pricing than anticipated through third quarter because there is an abundance of capital facing a finite number of deals,” says Goldfarb. According to Real Capital Analytics, cap rates averaged 5.4 percent in the third quarter, which reflects a slight year-over-year drop of 12 basis points.

However, the dynamic could shift more towards a buyers’ market as rising interest rates create pressure and cause the gap to widen the spread between the bid and the ask, notes Susan Tjarksen, managing director, Midwest multifamily advisory group at Cushman & Wakefield. “We have seen that there are still strong offers out there, but buyers are being much more conservative and therefore pickier due to their underwriting,” she says. Assets with a solid and proven track record certainly have an advantage among these buyers, she adds.