Unfolding Trends That Will Dominate the Next Year - Sachse Construction
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Unfolding Trends That Will Dominate the Next Year

In a prestigious office tower minutes away from Philadelphia’s City Hall in the heart of its downtown, you can find a Primrose school, one of a national system of accredited private preschools. You can also find one at a 53-acre mixed-use community in Brookhaven, GA, which features residential units and 66,000 square feet of retail space. In the Grant Park submarket of Atlanta, there is a Primrose School occupying the space where an obsolete warehouse used to sit.

Move over street-level retail and green walking trails. The latest amenity for mixed-use projects is a school, according to Jo Kirchner, CEO of the educational institution. There are more than 25 million children under the age of 5 living in the US today and the majority of their families live in child care deserts, she explains. Which is certainly of interest to city and school officials, but mixed-use developers? Yes, Kirchner says. “Primrose schools, for instance, draw in parents twice-a-day, five-days-a-week, many of whom are higher-income millennials—the most active generation of homebuyers in the nation.”

You have to hand it to Kirchner. She may well have pinpointed the emergence of the latest CRE trend. Kirchner is usually buried in the day-to-day operations of her role but as the end of the year nears, her thoughts—and ours—turn to 2020 and what big-picture changes we will see.

For all intents, 2019 has been good for commercial real estate. The cycle, aged though it is, continues to run. The larger US economy has weathered a trade war with China. Fundamentals are sound and, to cite one example, it appears as though the multifamily asset class will end 2019 on a high note after encountering some headwinds earlier in the year. Liquidity is plentiful, while overbuilding has remained at bay.

2020, at least for the first half, promises much of the same. That is not to say that the CRE environment will be stagnant; as always there will be changes. Some of these will be subtle while others may well be more ground shaking—and likely due to outside circumstances.  Here are examples that we think you should consider.

Interest Rates

One of the major business stories of the year was the direction of interest rates. Would the Federal Reserve continue to trim the rates or did it feel comfortable enough with economic growth to leave them where they were?

Heidi Learner, chief economist at Savills, thinks this same story will play out in 2020. Namely, that growth continues to plod ahead at a 2% pace, that the consumer remains willing to pick up the slack from a lack of business fixed investment, and that job growth continues to slow—but not too much.  “The extent of upside surprises is somewhat limited; while a resolution to the ongoing saga that is Brexit or US/China trade negotiations would be welcome, an end to these issues alone doesn’t translate into positive stimulus,” she says.  And don’t expect fiscal policy to provide any boost to growth, particularly as we head into an election year, she warns.

As for interest rates, the Fed appears to be taking a wait-and-see approach to future policy action, Learner observes. Presently the market is only pricing in one cut in 2020.  “At near 2% on 10-year US Treasuries, my bet is that we hit 1.50% (again) before 2%.”

The ramifications of low interest rates are well known for real estate. First, of course, dropping interest rates means cheaper borrowing costs. “Assuming that interest rates stay near levels where they are—which we expect for the next year—that will continue to fuel transaction volumes and a wider array of properties available on the market from core to value-add,” says Lee Menifee, head of Americas Investment Research at PGIM Real Estate.

Low interest rates, however, also tend to drive up prices of CRE assets as investors seek out alternative assets for yield—and it is difficult to predict when or if a significant drop will occur. Cap rates on prime CBD office properties have fluctuated in a tight range around 5% for the last three years, Learner notes. She adds that it’s hard to see a sustained drop without a major change in policy such as the resumption of quantitative easing at longer maturities. Unfortunately, she says, “the deterioration in fundamentals that would bring about such policy action likely means suggests stagnant or falling rents and slowing NOI growth—not a rosy outcome,” Learner says.

Changing Nature of Office Demand

Job growth in the US has remained strong, although it has shown signs of a growth slowdown in recent reports. That said, given the nature of the job growth, which has been strong in the business and finance sectors, the office asset class should have seen stronger rent growth than it has, Menifee says. Instead rent growth has been decelerating largely due to the countervailing trend of tenant expectations. Simply put, they want more from building owners. “In a normal cycle rent growth should be accelerating well into mid-to-high single digits,” Menifee says. “Instead growth has been very slight. That tells a different story about how much employers are actually willing to spend on office space and how that employment growth translates into rent growth.”

Tech-Enabling Platforms

For 2020, PwC partner Tim Bodner predicts there will be more investment by traditional real estate sectors in tech-enabling platforms.

For example, Bodner noted in a recent report that changes in hospitality trends and guest preferences have led to differentiation in hoteling. “Professionals are increasingly using hotel lobbies and other common areas for conducting business. Some hotels are profiting by embracing the coworking model and adapting to demand for nontraditional workspace.” The report points out that Accor Hotels launched its Wojo coworking concept in 80 locations, while Hoxton Hotel plans to introduce its “Working From” space in Chicago and London.

The larger point is that opportunities in traditional real estate exist for investors willing to look at new technology trends. “The shift in trends and preferences in many sub-sectors opens the way for differentiation backed by many types of investors seeking higher yields,” the report said. “We expect to see the introduction of unique offerings in real estate that capitalize on emerging social, demographic, and economic trends.”

Or put another way: expect to see traditional CRE asset classes evolve to more of an operating business instead of just a passive way to collect cash flow, Menifee says. This trend is emerging in the gaming industry as owners sell off their real estate and remain as operators. MGM Resorts, for example, says it is evolving its model away from a brick & mortar real estate business towards being a developer, manager and operator of leading gaming, hospitality and entertainment properties. Also consider retail: the sector has realized it must create an overall environment that supports its sales, Menifee says. “The winners and losers will shake out depending on how well capitalized they are and how much expertise they have,” he says.

Proptech, of course, will play an integral role and increasingly new offerings will come to market aimed at delivering a better experience for CRE users. “It’s still early stages but even what we are seeing now reinforces the need to invest in technology that allows you to operate a property better and more efficiently,” Menifee says.

Technology is also having an impact on projected demand for certain assets, specifically senior housing. Demand in this space can be uncertain, and more importantly, can change abruptly, according to Kroll Bond Rating Agency. It points to a  report by the AARP Public Policy Institute found that 87% of adults age 65 and older want to stay in their current homes as they age. This is not surprising though—through the ages, the elderly have wanted to remain in familiar surroundings but often could not. Now technology that facilities aging in place will allow more seniors to stay in their homes.  “Some portion of the senior population may also leverage tech services such as Uber, Amazon, and TaskRabbit to help facilitate aging in place, as well as various in-home wellness programs,” Kroll says.

A Two-Tier Apartment Market

As rent control measures continue to make their way onto city and state legislature, a two-tier apartment market will develop, according to Joseph J. Ori, executive managing director of Paramount Capital Corp.

The top or A tier will be states with no rent control and market-oriented rent and business policies, he explains. The bottom or B tier will be  the states that have implemented rent control policies. “During the next five to seven years, institutional debt and equity capital for apartment acquisitions and developments from banks, REITs, insurance companies, pension funds and private equity firms will begin to flow primarily to the tier A states,” Ori predicts.

The gap between these two tiers will inevitably widen as tier B states will see a lack of capital and investment demand for new and existing apartments. “Apartments less than 15 years old, that are currently exempt from the above rent control laws, will fall in value as the end of the exemption period approaches,” he says. Apartment values, rent levels and new construction in the Tier A states will rise and be vibrant, Ori says, while the tier B rent control states will see higher cap rates and less demand for investment and development. “Look for many of the large public REITs and other institutional investors to begin shifting their portfolios to these market rent states during the next few years,” he forecasts.

Investors Get Realistic About Opportunity Zones

When Opportunity Zones first debuted in 2018, CRE interest was undeniably high. Since then interest has moderated as investors gain a more realistic view of their pros and cons. Overall, according to CBRE statistics, investment volumes in Opportunity Zones appear to be primarily influenced by cyclical factors, and not so much their tax advantages. The transactions in Opportunity Zones since the first quarter of 2018 have accounted for 10.5% of overall US volume. This remains largely unchanged compared with the transactions in the 18 months prior to the program, which clocked in at 10.7%.  Furthermore, CBRE notes that annual volume growth in Opportunity Zones has been reflective of the broader market throughout the entire cycle, even during the past 18 months (6.7% vs 7.2%) when compared with the preceding 18 months.

Heading into 2020, it’s become clearer that while Opportunity Zones are sweetening some deals, they do not work for all—including for multifamily buildings, says Jon Morgan, co-founder and managing principal of Chicago-based Interra Realty. With most of these buildings, you can’t invest a renovation amount equal to the purchase price—which is a requirement for Opportunity Zones—and have them pencil out, he says. The only buildings that may make sense are the very cheapest, vacant buildings, he says. For instance, a viable project could be a vacant building that will be converted to another use. Ground up construction is another example.

That said, many projects are penciling—and in fact, would not have at all without the tax benefits afforded Opportunity Zones.

Ogden Commons is a $200 million 10-acre mixed-use project in Chicago’s North Lawndale neighborhood that Habitat Affordable Group is developing in partnership with the Chicago Housing Authority, Sinai Health System, Cinespace Chicago Film Studios and the city of Chicago.

“It has been to the utmost benefit of Ogden Commons for it to be located in an Opportunity Zone—particularly with our first phase of commercial/retail,” says  Charlton Hamer, senior vice president of Habitat Affordable Group. Previously Habitat sought out New Market Tax Credits to provide needed equity, he explains. Unfortunately, the process, competitiveness, complexity and timing for acquiring NMTCs became very burdensome.  “Finding investors for this project has had significantly fewer difficulties and hurdles to place the capital to the project than using NMTC,” Hamer says. “If it were not for Ogden Common’s location in an Opportunity Zone our timing to initiate construction would be much longer.”

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