Why Commercial Real Estate Is Nearing Its Peak

Art by JooHee Yoon

“Growth is slowing, and we are at the late stages of the cycle,” said Renee Csuhran, managing director for real estate and community lending at Huntington National Bank.

For sure, the single-family housing market is anemic, as home prices become less affordable and fewer dwellings are built. On the commercial front—office, industrial, retail, and apartments—signs of a coming slowdown are just starting to appear.

Rising interest rates, over-building, and an expected recession (the betting now is for a 2020 downturn) threaten to end the party. As always, the strength of the US economy is the most potent determining factor for commercial property. Whenever a recession erupts, real estate dips or, depending on the sector, outright tanks. Long-term, commercial property makes sense as an asset class: Businesses always will need roofs over their heads.

For investors, the trick is parsing out the best sectors to be in. Some have better staying power than others, for reasons ranging from demographics to technological change. Industrial, thanks to the expansion of online delivery, may have the sturdiest ability to withstand an economic downturn. Retail, beset by e-commerce-driven changes, is the area most vulnerable.

Across the real estate spectrum, returns today, while strong, are on the brink of decelerating, according to PGIM Real Estate, an arm of Prudential Financial. The firm estimates that commercial property returns will rise to 10.7% this year, from 10.5% in 2017, but then fall as low as 4.8% over the next several years.

Meanwhile, the rate of growth has slipped for commercial real estate loans, which now total $1.4 trillion in the US. New lending growth, by the reckoning of BankRegData, topped out at $32 billion in 2015’s last quarter and has added just $11 billion in this year’s first period. The inflow of foreign capital focused on American real estate has slowed 25% since late 2016.

A look at prospects in the major commercial sectors, which in most cases shows a solid base at present, finds a lot of pluses, but some worrisome minuses starting to appear:

Office. Performance continues to shine here. A Cushman & Wakefield report notes “steady leasing volumes, healthy absorption, and rising asking rents” in the second quarter. The highest rents are on the coasts, particularly in New York’s Midtown and San Francisco. Construction of new buildings is robust, with 18 million square feet completed in the second period, up from 10 million in the previous quarter.

While a trend has developed toward working remotely, that hasn’t dented corporate demand for office space. An even greater shift is underway to open plans, where separate offices and even cubicles give way to long tables that allow employees to interact more frequently. “Companies value collaboration,” said Fred Stoops, head of real estate at Vident Financial, pointing to the enormous open-plan buildings that Facebook uses.

All the new supply has led to an uptick in office vacancy rates, rising nationally to 13.4% most recently from 13.2% the year before. This is hardly alarming at the moment: The historical average is 14.7%.

Nevertheless, a troubling aspect is the large number of buildings that are being erected on spec—meaning, without tenants already signed up. Once the recession hits, owners of these vacant structures will have a big problem. “That’s frightening,” said Jonathan Lewis, partner and co-founder at JLJ Capital, which makes real estate loans.

Industrial. A true powerhouse. Only a sliver of the new inventory is from manufacturing, which has slowly rebounded in the aftermath of the Great Recession. The bulk of the buildout is in warehouses, a.k.a., distribution centers, which service the explosion of online product purchases. The surge in home deliveries, begun by Amazon, has been further fueled by Walmart, Target, and scads of other merchandisers.

Absorption of industrial real estate—that is, new leased-out space—totaled 6.41 million square feet in the second quarter, a 4.9% increase from the year-before period, Cushman & Wakefield figures indicate. The vacancy rate is falling, now at 5%. In some of the hottest markets, like Los Angeles, Jacksonville, Florida, and central New Jersey, the rate is 3% or lower.

But this can only go so far. Rental growth, up 7.2% recently, will begin to ebb next year, Cushman & Wakefield forecasts.

Retail. Here’s where the biggest troubles are. Absorption is minimal, and thus new construction is, also. Vacancies are just above 10%, little improved from the recession. Rent hikes are a measly 2%. The suffering is the most acute at old-school department stores like Sears and J.C. Penney, which have struggled to re-connect with customers.

Developers built too many malls. Hundreds of them are dead. In the 1990s, the US had 1,500 malls. Today: 1,100. A quarter of these are at risk of closing over the next five years, Credit Suisse estimates.

As a result, some mall owners are scrambling to convert empty department stores, which once were anchor tenants, to alternate uses, such as hotels or restaurants. Others retailers, such as Walmart, are experimenting with valet parking and using stores as pickup sites for online orders.

The malls that killed off many a Main Street shopping district are themselves the victims of changing tastes. The iconic teen film of 1982, “Fast Times at Ridgemont High,” was set in the Sherman Oaks Galleria, where the kids would hang out. They’re not there nowadays.

Apartments. Demographics loom large in the multi-family segment, as apartments are known. Millennials are less inclined than previous generations in their 20s to purchase homes.

For one thing, they can’t afford to buy. Many have crushing student debt and until recently suffered from a lack of well-paying jobs, plus mortgage lenders have become more restrictive. “They are renters by need,” said Phil McAndrews, head of real estate equity at Aegon Asset Management, adding that more baby boomers, giving up their houses now that they’re empty nesters, are turning to apartments, too.

After a rapid amount of building earlier this decade, the pace has slackened off. Vacancy rates are low at around 5%. Cushman & Wakefield projects that vacancies will inch up, though still remain low.

“Everything looks good now,” Vident’s Stoops said of commercial real estate in general. “But it depends on the broader economy.” And once that tilts downward, commercial property inevitably will follow.