Pressure points for U.S. commercial real estate

In the U.S., commercial real estate benefits when both the economy and labour market gain. And this is exactly what we’ve been seeing south of the border.

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“Several months ago, our view [was] that the GDP outlook for the U.S. was moderately positive, in the range of 2% year-over-year growth for 2016 and 2017 and, hopefully, 2018. That’s below trend [but] it’s still a supportive environment for the critical drivers of demand for virtually all kinds of commercial real estate,” says Chip McKinley, senior vice-president and portfolio manager with Cohen & Steers in New York. Among other real estate funds, McKinley manages the Renaissance Global Real Estate Fund.

As it turns out, U.S. GDP grew at the fastest pace in two years in Q3, according to the Commerce Department. Growth is expected to slow in Q4 but to still hover around 2%.

That level of growth is positive for commercial real estate, says McKinley, because a 2% gain is equivalent to about 3% nominal growth, which “tends to result in relatively healthy job growth.”

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This matters because “job growth is the number-one driver of demand for offices, hotels, industrial warehouse space [and] self-storage space,” he adds. “Basically, [it’s a driver] of the supply and demand dynamic that is critically important to the fundamentals in the valuation of real estate.”

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That said, “The rate of [U.S.] job growth in 2016 is going to be a little bit slower than 2015—and 2017 will be even slower—[even though] it’s still moderately strong. In 2015, job growth was about 2.7 million jobs and it’s going to be about 2.1 million jobs in 2016. For 2017, [it] will be somewhere around 1.9 million to 2 million jobs.”

So what’s happening now?

Currently, says McKinley, “the demand side is holding out very well.” But he’s still concerned about the supply and demand balance for some types of real estate.

“It’s still been a healthy environment for most types of commercial real estate,” he says. “But a couple of years ago, you could say supply [wasn’t] a concern anywhere and that’s changed a little bit.”

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Take the supply growth of luxury apartments in coastal markets, says McKinley, who notes the supply of these types of apartments “has accelerated rapidly, to the point where [supply has] now caught up to demand. [The issue is] demand emanating from job and economic growth is a little bit slower; it’s still strong but not as strong as in 2015. So, supply is catching up and that means landlords in this space are beginning to see diminished ability to push occupancy and rents.”

There are many more hotels and self-storage units as well, says McKinley. In particular, “hotels […] started to see [a] strong increase in supply delivery of new developments in a few key markets like New York, Chicago and Miami and, in the last six months, San Francisco. It’s not a nationwide problem, but it is becoming an issue in core critical markets.”

Even more recently, he adds, “we’ve seen self-storage supply start to accelerate in some of those varied markets as well, although I would expand that to include broader reaches of the major city centres along both coasts and even some of the interior cities. So, supply is spreading a little bit more. But again, self storage is a very tiny [part of the] sector and hotels are a very tiny sector, whereas apartments are very big.”

The good news, says McKinley, is when you look at supply and demand across the whole real estate sector—think of commercial offices and industrial warehouse spaces, as well as healthcare facilities and malls—growth of supply is much lower.

As a result, “the vast majority of REITs in the U.S. are [seeing] a very healthy supply-demand balance that is firmly in favour of landlords.”

Developers, too, are benefiting from low supply growth. Says McKinley, “[They’re] not competing against a lot of other development. So [building is] still a very accretive, value-creating endeavour for them. Overall the balance is still favourable; it’s just not quite as favourable as it was a year or two ago.”

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