Executive summary
The commercial real estate (CRE) market has continued growing at a moderate pace in the second half of the year, though significant risks remain. Resilience of the U.S. economy in the face of global pressures has provided a steadying hand to domestic property markets. Lower interest rates provide a tailwind for the CRE market in the short term, though they also offer a stark reminder that trade, geopolitical uncertainty and decelerating global growth each pose significant risks to this record-long real estate cycle.
Transaction volume in 2019 has so far fallen short of 2018 levels, and there are some warning signs that volatility may be impacting investor sentiment. Cross-border investment turned negative over the first six months of the year as foreigners became net sellers of U.S. property for the first time since 2012. Foreigners may be reading the late-cycle tea leaves, opting to move up the capital structure and invest in CRE debt rather than equity. Property prices continued their slow moderation, with year-over-year growth at 6.7% through August. While prices in each major sector have increased this year, the industrial sector is the only space that has seen the rate of price growth increase since last year.¹
Lower interest rates have driven commercial mortgage rates down 100 bps since the beginning of the year, making debt financing even more attractive. The financing spread, or difference between an owner’s yield on a property and the cost of debt, has widened to cycle averages, providing a boost for property returns. Borrowers have started to, and will likely continue to, look to lock in low-cost fixed rate debt. While some may worry that lower rates could lead to increased leverage, it is key to remember that yields have been low for this entire cycle, and debt markets have remained healthy and disciplined. Loan-to-value (LTV) ratios are well below pre-crisis averages, and debt service coverage metrics remain near cycle highs.¹ We see well-functioning debt markets as a key driver of continued price growth in the CRE market.
Price growth in the CRE market continues to be lopsided on a sector basis, as the industrial sector has outpaced the rest of the CRE space with 12.2% year-over-year appreciation. Demand for industrial units continues to be robust, driven especially by last-mile distribution, while supply remains somewhat constrained. In the multifamily space, lower interest rates, which have driven down mortgage rates, have not necessarily caused a shift from renting to owning homes. While price growth has declined for the multifamily sector this year, demographics and a strong labor market are supportive for the sector.¹
Our outlook for the rest of 2019 is for a continuation of the trends we have seen this year. As U.S. economic growth decelerates, property price growth will likely follow suit. Low interest rates should be a tailwind for the space, enabling attractive debt financing while combating any potential upward pressure on cap rates. However, risks linger. U.S.-China trade tensions remain a top concern and have already negatively impacted business investment. Further escalation could impact demand for real estate. Additionally, there is risk that market volatility could deal a blow to sky-high consumer sentiment, pressuring rent levels at a time when they are a critical component of real estate returns.
