2017 Real Estate Forecast: Looking for Reliable Clues to an Uncertain Year Ahead
Clouds of uncertainty hang as the White House changes hands, but here are 8 things to watch in 2017
In the 2016 BL outlook we said “forget forecasts” and argued that the die was cast for the year. We saw strong trends in place and a series of events at the end of 2015 that would drive the year forward, with the exception of some urban centers—which we predicted would cool.
Many have cooled, with sales at the high end of many winning urban markets slowing down, prices taking chops and now contracts blowing up. The rest of 2016 played out as we expected. Interest rates rose, but remained historically low. Record capital flows entered the United States. Oil and electricity prices were huge tailwinds advantaging U.S. businesses and consumers. The solar boom shined on brilliantly. And the battle against blight beefed up, especially in certain urban residential areas.
This year we are much less certain.
Most big trends are still in place. North America still has big advantages. Many big projects are moving, and even mega-projects have returned in a way reminiscent of bygone industrial heydays. Big cities are back in a big way, and urban modes of living are returning to prominence—even in the suburbs. Corporate profits are high, labor markets are tight and some fear an overheating economy will start driving inflation, which speaks to how far we’ve come from the depths of the twin financial and commodity shocks of 2007/’08.
But while many cities have flourished, others are lagging behind. And many rural areas have been left behind completely in depressed conditions.
Eight years ago, President Obama ran on change but delivered truly remarkable stability in the economy, on jobs and in markets. This period of steady calm seems to be giving way to one of increasing risk; e.g. of higher interest rates, inflation, full employment and others as the cycle matures. But then President Trump ran and won on disrupting the status quo, like NAFTA, the NATO alliance and the UN, just to name a few. The election alone would be enough to raise a yellow caution flag on the year.
It’s very hard to predict outcomes from such systemic and structural shakeup, but we must endeavor to plan through uncertainty nevertheless. Future-proofing is not about obtaining a risk free way forward, but is an exercise to learn from. In this forecast, we start by identifying the conditions and trends we see setting the table in 2017 and beyond:
Putting aside uncertainty from a sweeping Trump administration policy realignment, the real estate market is too cautious to overheat. The shock of the last cycle’s bust has not worn off, least of all in the real estate space—the epicenter of catastrophe. It still echoes in a very real and psychological way. The memory—or hangover—from the painful lessons learned after the lofty heights of the last bubble are still fresh in the minds of most everyone.
Prices show signs of rolling over in some markets, but there is little evidence of the mountains of froth seen in the last cycle. Balance sheets are much stronger among real estate developers, as well as banks and other financial institutions. In fact, many argue there’s too much cash lying around and capital reserves are too high. New bank regulations—such as Dodd-Frank—and other risk rules are squeezing lending and keeping a lid on development.
Thanks to record corporate profits in recent years, there is over $2.5 Trillion in profits stashed overseas by U.S. corporations waiting to be repatriated back home. Whispers are growing louder in Washington that a deal might be made to bring this money home in a one-time tax holiday (done successfully in the past) and use the public proceeds to seed a national infrastructure bank. President Trump has proposed his own tax holiday. There are workable plans floating around, so this could happen relatively quickly—although it could also become mired in big taxer reform efforts that will be coming from the White House and Capitol Hill.
If an agreement stalls but weakness emerges in the economy, it should give President Trump the political capital he needs to make good on his mandate to rebuild America's infrastructure and inner cities to close the investment gap.
Labor Scarcity – Where are the Workers?
Millennials are now the largest segment of the workforce, but more boomers are now retiring than millennials are entering the labor force, and it’s helping to hollow out the labor pool. The labor force participation rate is also declining, which is starting to cause stresses in the labor market in the form of chronically high open positions and higher wages. The construction industry is among those most directly affected by the lack of skilled (and "unskilled") labor.
The Labor Department reported that initial claims for state unemployment benefits fell to 234,000 for the week ending Jan. 14th—just below the 233,000 level recorded in mid-November, which was the lowest since November 1973. This marked the 98th straight week that claims remained below 300,000 (the benchmark of a healthy labor market). It is the longest run since 1970, and arguably a better run given the much larger and more dynamic labor market today.
There’s a lot of gnashing and noise made of the declining labor force participation rate. The percentage of the civilian population 16 years or older who are working or are actively looking for work has dropped following the global financial crisis. But it peaked in 1997 at 67.1% and has been falling since 2000. The participation rate for men has been in steady decline since the late 1940s. The female participation rate peaked at 60% percent in 1999 and has been declining ever since. The reasons are less specifically related to the Great Recession and more the result of other structural adjustments. Some drop off from a state of “total war” in the 1940’s is inevitable, but also the simple result of students staying in school longer and acquiring more education, which also takes them out of the workforce.
And demographics play a role too. Every time a baby boomer retires, it puts downward pressure on labor force participation.
Technology is the other primary driver. An explosion of household productivity in recent decades is a drag on labor force participation. Household production isn’t calculated in GDP figures either, but the productive power of the modern household is a strong draw from the traditional labor force. The app and gig economies are also giving birth to a contemporary cottage industry of microenterprise of every kind, from style consultant and personal trainer, to software engineer and even craft-makers of old (thanks to platforms like Etsy). The pajama entrepreneurs are now legion, and these new ways of working and sources of productivity aren’t being picked up perfectly by our traditional methods of measurement.
The trade, barter and share economy is also returning to a scale not seen since simpler days of civilization, and it’s creating real livings in the unofficial economy. Today’s unofficial or underground economy, both legal and illegal, is hard to quantify, but indications are it is very large indeed. Seizures of counterfeit goods from Asia will give one measure of the vast black market. Drug seizures will give another. In total, this substantial slice of the economic pie helps explain how overall retail sales have continued to grow faster than the overall economy and deliver record-breaking holiday shopping seasons the last five years in a row. We cannot measure the jobs or the GDP of the underground economy, but the cash is showing up at the register come Christmas time.
It showed up in Colorado when marijuana was legalized. There as a rush on warehouse space which shot from ~$4-$6 a foot to $16 in one summer—just one sign of how quickly market conditions can change. And in the years since, the projections proved to underestimate the size of the marijuana economy (And now investors bet legal marijuana will boost warehouse rents across the nation). Another example of meteoric turnaround is the shale rush to the Bakken formation, which kicked off the post 2008 recovery period with such a boom that some workers were making $100,000 but sleeping in their cars at night because the local real estate market simply couldn’t respond fast enough.
So even with the post-recession sobering up in the real estate sector and cautious financial enviroment mentioned above, many sectors and cities are returning to growth they have not seen in ten years or more. For example, in Chicago today there are 44 high rises under construction in a very strong cycle being led by positive migration to the core and near-neighborhoods, generational low office vacancy rates in the Loop business district, and a burst of corporate relocations—most recently and notably, the new headquarters of McDonald’s moving from its suburban Hamburger University Campus in Oakbrook, Illinois to a Chicago neighborhood next door to the Loop. McDonald’s was actually a bit late to the Chicago HQ-relocation party. Chicago relocated more corporate headquarters than any other city in 2015.
Business and consumer confidence is up after the election—small business confidence is way up—but the argument that the current cycle is reaching an unsustainable duration is gaining voices. Bloomberg's survey of economic expectations reached 56.0 in January, the highest level since 2002.
Now in its 90th month of expansion—one of the longest in U.S. economic history—the post-2008 recovery is much longer than the post WWII-average of 58 months. Homes are flying off the MLS. 2016 set a record for the shortest residential listing time, as homes couldn’t stay on the market.
But commercial sales are slowing. Real Capital Analytics tracked commercial property sales volume down 8.6% in the first nine months of 2016, to $345.4 billion. And there is little in macroeconomic data to suggest the economy is overheating, the typical sign of trouble ahead for an economy running too hot for too long. And cycles have been getting longer and longer as the modern, technology-driven economy has matured, with periods of growth lasting 92 and 120 months in the 80’s and 90’s, respectively.
It’s an atypical real estate cycle in many respects. Like the overall economy, real estate transaction volume has rebounded across the country since 2008, but activity in most development segments in most markets remains below historical precedent. Financing regulations and restrictions on borrowing have limited construction in every segment, which is preventing oversupply conditions—typical of most late-cycle periods—from emerging.
This has caused available space to dry up and tight market conditions to emerge in residential, commercial and even some industrial markets. The continued capital rush into prime markets and core properties has pushed prices higher than the peak of the prior cycle in many markets. And while everyone seemed to agree cap rates were destined to go up not too long ago, now consensus has pivoted towards expectations of modest decline and rising risk premiums. Cap-rate compression is spilling into secondary markets, which we expect to continue even more meaningfully in 2017.
Combining cautious real estate decision makers treading lightly, low volumes, and tight lending conditions, the current cycle seems unlikely to be a source of crisis causing the next recession. Plus, the “next” crisis usually doesn’t come in the same form as the last one.
But there is one last big wave of loans to digest this year: ten-year loans issued in 2007 are coming due. And while the economy has recovered and property values are rising, many borrowers still won’t able to make good on terms from the top of the bubble. Morningstar predicts borrowers won’t be able to pay off roughly 40% of the commercial mortgage-backed securities loans coming due this year. Suburban office and shopping centers properties will face the brunt of the pain.
Already defaults are on the rise. More than 5.6% of securitized commercial mortgages were more than 60 days late in payment in September, according to Moody’s Investors Service– up from a 4.6% delinquency rate earlier in 2016. The Pittsburgh Mills mall was sold this month for $100 to Wells Fargo in “consensual foreclosure"—after being valued at nearly $200 million a decade ago.
With unfortunate timing for borrowers, new Dodd-Frank risk-retention rules that went into effect on Christmas Eve require issuers of commercial mortgage-backed securities to keep at least 5% of the securities they create. This will have the effect of raising borrowing costs, which isn’t good news if you’re trying to refinance your 2007 loan. Rising interest rates are even worse news.
President-elect Trump has repeatedly aimed at repealing Dodd-Frank, but it’s likely to be a tougher lift than repealing the ACA. Many provisions of Dodd-Frank, like the risk retention rules and lending requirements, are likely to remain intact.
Is a perfect storm of higher costs, higher interest rates, inflation and defaults on the horizon? We think not, because of the abundance of caution and financial health previously mentioned, but also because everyone sees this wave coming. In this seller’s market, where available land is scarce and most real estate segments remain undersupplied, there will be many buyers waiting to pick up opportunities as they come to market.
This may give the capital spilling over from prime markets and properties a place to go.
As the new cycle matures, the rotation toward secondary markets, near core and next-core properties that we forecast last year will accelerate because prime and core assets have reached near term limits. Costs, sales prices and rents are already high enough in many major markets that landlords are seeing a slowdown in sales and rising vacancy rates in multifamily housing units and office space. Luxury categories too will lag for being the only oversupplied product—but more importantly, because development demand will slide down the spectrum thanks to steadily improving employment, rising wages and limited supply to serve the middle class and small and medium-sized business segments.
The pivot is already underway, but it’s constrained by construction finance, labor, and the supply of land. Nearly two-thirds of home builders reported low or very low supply of available lots in their markets to the National Association of Home Builders in a 2016 survey—the highest level of land scarcity ever sampled since the survey began in 1997.
Already, developers have been snapping up un-finished lots in abandoned or half-built subdivisions stalled or killed by the last bubble. “I think they’re all panicking,” a large owner who land banked more than 25,000 lots in abandoned developments since 2011 told the Wall St. Journal. “They’re trying to get lot positions wherever they can.”
Pushed out of prime markets by record high dirt prices, developers are looking for profits in new places. The supply of developed but vacant lots—many in subdivision long written off for dead—has decreased by more than 20% across more than 80 major U.S. markets since 2011, according to data from housing research firm Metrostudy. Much of this land is already entitled, platted into parcels, cleared and graded, along with utilities, roads and more or less ready to go.
As the Wall St. Journal reported:
“Shedding prior stigmas” will sound familiar to the brownfield and greyfield crowds. What’s this, greenfield stigma?
Some forecasters are calling for a return of the suburbs and the end an urban migration bubble, but there will be opportunities and pitfalls in both transects. The suburbs were due to bounce, if only because of overly stressed conditions from the bubble. Urban revitalization, renewal and repopulation is not a spurt, but a super cycle reemerging after taking a century-long break. The real story is density, which will continue to be the primary driver in urban development—as well as in suburban and rural areas, where dense forms still win for developers, consumers, civic balance sheets and overall quality of life.
Density has been the real story since the 1990’s when sprawl started stalling out. You can see it in USDA's 2010 National Resources Inventory data (right). Post 2008 building in edge cities and far-flung exurbs has been severely depressed, suffering hard shocks when the housing bubble burst. But some are beginning to thaw. The imbalance between depressed conditions in exurbs and hot urban cores is wide enough that the cost advantage of living in less dense areas makes the longer commute seem like a fair trade again.
U.S. population growth has been the envy of the developed world, and it solves a lot of problems. If developers aren’t building, a little population growth goes a long way. Along with the success of more dense suburbs and near-in cities, some exurbs and outer-ring areas don’t seem as “far out” to today’s more numerous consumers. As capital spills over into these secondary markets and the quality of design, amenity and place catches up to urban markets, demand distribution should begin to equalize.
Location utility and convenience will, however, remain key features of the market going forward. More affordable markets with cheap land and lower cost of living will attract capital, people and businesses—spilling over most to those markets with highest quality of life and advantageous locations first and foremost. So in terms of emerging growth—aside from TODs—look to suburbs short distances from a rail station or other mass transit hub, as well as underperforming or “undiscovered” urban neighborhoods near downtown cores, major corridors or in walkable neighborhoods near large employers (e.g., “Eds and Meds”).
Looking ahead, the quality of place cold war has turned into a placemaking hot war, because everyone has finally realized that people like to walk in parks and sit for a coffee, beer or book in a pleasant public place. Amenities sell real estate and make people happy. Look for cities to seize on opportunities for multi-functional amenities, like green infrastructure, which can add green space and public space while also helping to manage storm, flood and waste waters more sustainably and cost-effectively.
Logistics. Logistics. Logistics.
First driven by rising fuel costs and transportation prices, and now bolstered by tailwinds of consumer convenience and same-day delivery, our logistics system continues to evolve rapidly—even as public investment in infrastructure lags demand by trillions of dollars. Distribution networks are winding tighter and driving up demand for mid-sized lots in cities across the country. Amazon has been building the mother of all distribution networks and keeping site selectors busy across the country for many years now. The online delivery company recently announced 100,000 new hires in 2017.
If customers are willing to pay up to benefit from delivery within a few hours or less (like this drone test that only took 13 minutes from click to deliver), online retailers must have robust inventory able to serve high densities to be profitable. That requires multi-story structures less than 100,000 feet in size with great location and good ingress/egress. Luckily, that is what the logistics system looked like before the great suburban super cycle of the last century remade the landscape.
These obsolete brownfield and greyfield properties have been passed over and sat idle or underutilized for too long. Now they have found new life as the perfect sites for profitable e-commerce distribution. As a result, there is a realignment taking place in facilities between 20,000 and 100,000 square feet within a 10-30 minute radius of city centers in primary, secondary and select tertiary markets—and sweet spots in between cities.
Shrinking footprints are being experimented with in varying degree in many real estate formats. WalMart, Target and other retailers have been investing in small-footprint stores for a number of years, with variable success so far. Advanced manufacturers require smaller footprints than their industrial predecessors as well—and are far less obtrusive, making them much more suitable in dense areas near residential neighborhoods.
This is big news for small parcels everywhere, forgotten in the bygone “go big in the burbs” era. And great news small business developers who are able to take on this scale of commercial and industrial projects—opening new possibilites for an entire class of real estate actors and investors.
But it’s also important to note that the investment in the “big logistics” of the last 10-20 years is not lost. The new lightning fast micro networks are only possible sitting on top of the mega-logistics chain doing the heavy lifting in the global economy. The need for mega-warehouses with multiple acres under roof isn’t going away anytime soon. The era of mega cold-storage may be just beginning. And the era of massive liquefied natural gas export has just arrived. The new, larger and recently opened Panama Canal—Panamax—already revitalized ports across the southeast in the run up.
So, we’ve got Giga-factories on one end and single-serving drones delivering your custom order pizza by flying it through the air autonomously on the other. With innovation happening at every scale in between. The impact on real estate is being felt more than ever, and one of the world’s oldest and slowest professions—real estate—struggles to keep up with the speed of modern business.
With so much change and innovation, there are new opportunities emerging in every real estate segment. New sources of demand and new end uses are putting obsolete buildings and once-avoided land back in demand. It’s not just Amazon that’s in-filling. Legions of last-mile delivery servicers are rising up to fulfill the need for delivery of everything from groceries, to take out, to dry-cleaning, to doggie daycare.
Retail modes are transforming into offering experiences as much, or more so, than selling retail goods. As online retailers thrive more than ever, retail property owners must find new sources of foot traffic. The good news is millennials are the experience generation. And they don’t mind living above or nearby retail and value the convenience of well-made places, transit options and car-free living (and shopping). More and more retirees and boomers are also realizing the value and convenience of living nearby a grocery around one corner, a shop around the other, and a park down the street with a nice bench.
Shopping centers, dead malls, overbuilt office parks and other greyfields are being remade into residential communities, senior living centers, and many other creative uses. Soon they may find use as distribution centers, if robust logistic development continues and the clicks keep killing the bricks.
But advances in technology are also pushing land use limits, and opening up new means of productive use on old land of every kind. Data centers are finding homes in sturdy old buildings unsuitable for most other uses without (more) expensive refits than servers and communication hardware require. Solar developers are installing solar power on top of old landfills. Wind developers are building offshore.
Ride-sharing apps are adding needed layers to transportation systems with no public investment—adding transit options in neighborhoods that need them badly. Minibus, rapid bus, tram and streetcar services are being (re)introduced in places like Chicago, Milwaukee and Brooklyn. Thousands more miles of bike lanes will be added in 2017. New trail and rails-to-trails will add thousands of miles of safe transit paths for pedestrians of all kinds, from the disabled and movement-challenged and the elderly, to youth and moms-with-strollers.
One thing seems clear, the renaissance elevating the form and function of our built-environment will continue. The health of our economy, our people and our planet will depend on how we deploy our real estate to rise with our potential. And how we adapt our real estate to rise to challenges of the 21st century.
The world's first floating city to be constructed off the waters of French Polynesia after the Government signed an agreement with the Seasteading Institute in San Francisco this month to build the permanent floating community.
Rising Global Risk — Risks around the world are certainly rising, and look to go even higher. But with less than 10% of its economy dependent on trade, the U.S. is the most independent major economy in the world and has everything it needs to win the century. Nevertheless, even a lukewarm trade war would be very painful—particularly for large corporations and Wall St.—for the rest of the world most of all. With the EU under stress, regional instability increasing in multiple hot spots and global growth forecasts coming down, a more fragile world is emerging. One ill-equipped to handle wild currency fluctuations or a major recession.
What to expect: higher volatility, but no meltdowns. Economic tailwinds continue to push the U.S. onward and upward, for now.
What to watch: the VIX and geopolitical tensions.
Oil & Energy — Oil and electricity prices will remain low in the U.S. and a competitive advantage over other economies. Unlike in the 1970’s OPEC was not able to kill U.S. shale producers in a price war. Higher cost Canadian oil and tarsand projects lost this round. U.S. producers learned how to cut costs and now U.S. shale is no longer a high priced producer, with some choice fields profitable in the $20 per barrel range—some of the cheapest oil in the world. Natural gas prices could rise as exports begin at scale, but not enough to disrupt low electricity rate—thanks also to solar and wind costs that will keep falling.
What to expect: a lid on oil and energy prices. If President Trump stimulates the domestic oil & gas sector, prices could adjust to even lower levels. Sustained high oil prices will be met by oil rigs firing up across the U.S. in turn. U.S. LNG exports begin in earnest this year and at a scale to start rivaling Russia, which is the largest natural gas exporter in the world.
What to watch: geopolitical consequences of the global energy order being reshaken towards North America abundance once again.
Interest Rates — U.S. interest rates are rising, but can it be the only one raising rates in unstable world? We think not.
What to expect: global risks and foreign central banks will keep rates down like an anchor. Even if the U.S. economy continues to outperform, the Federal Reserve simply won’t be able to raise rates too high without causing currency and other problems. In case of a major economic downturn, look for rates to hold flat or be cut at home, and more quantitative easing abroad.
What to watch: overseas economic performance and U.S. overperformance. If the economies around the world are suprisingly strong or the U.S. economy becomes too strong, interest rates could start rising more quickly.