Time To Worry? The Economic Warning Signs, Reasons For Hope And Safe Places In CRE

The U.S. is in the midst of the longest uninterrupted economic expansion in modern history, and for several years, the chatter in commercial real estate circles has been that a recession might be just around the corner. As most developers, landlords and investors no longer assume the economy will keep expanding, some have decided it is time to start playing it safe.

That could mean sticking with projects in the strongest gateway markets, concentrating in sectors considered recession-proof, such as healthcare or e-commerce-related logistics, or making sure new developments are not overleveraged.

New warnings about possible economic fragility recently appeared, bolstering widespread fears that ongoing trade disputes between the Trump administration and nations such as China will eventually choke off the decade-long recovery, and experts say it could cause even more developers to hunker down.   

“This week we got a fresh batch of news that points to a certain number of dark clouds on the horizon,” CoStar Group Director of Market Analytics Brandon Svec said.

He pointed to the Institute of Supply Management’s widely respected Manufacturing Index, which on Tuesday showed American manufacturing activity fell in September to its lowest level in a decade. Furthermore, on Wednesday the ADP National Employment Report was published, showing the economy created about 135,000 jobs last month, a somewhat slower pace compared to earlier in the year.

“There seems to be more bad news than good news lately,” Svec said.

He will speak at Bisnow’s Chicago State of the Market conference Oct. 24.

Not everyone believes a recession is imminent, and contrarians can point to other metrics that paint a much sunnier picture.

“Consumers are still engaged, employed, and they are happily spending,” CCIM Chief Economist K.C. Conway said.

In August personal consumption expenditures grew another $20B, according to the U.S. Bureau of Economic Analysis, continuing a pattern of growth seen throughout the year.

Spending by U.S. consumers far outweighs the economic impact of overseas trade, Conway said. If jobs creation numbers remain relatively steady and personal incomes also keep growing, that could sustain the economy over whatever rough patches it hits due to trade disputes.

Those calculations may change in 2020, however, if trade with Canada and Mexico falls into the same uncertainty now gripping U.S. relations with China and Europe, Conway said. The failure of Congress to approve the new NAFTA deal, which will govern trade relations with these two countries, is a warning sign, and shows how political volatility could drag down the U.S. economy even if its fundamentals stay strong.

“Congress doesn’t want to give [President Donald] Trump a win, and Trump doesn’t want to give Congress any credit,” he said.  

Still, if you look past all the headlines about trade wars, so far the amount of serious disruption has been minimal.

“We haven’t seen shortages of any materials or huge price increases,” Conway said. “This was always going to be a big lesson in supply chain management, and companies are finding ways to boost efficiency and streamline operations to make up for the relatively small price increases we have seen.”

He isn’t too concerned about the recent slowdown in hiring, and believes the economy can’t be expected to create new jobs as quickly as it did when the unemployment rate was higher. The first sign of a true recession will be if job creation numbers fall below the amount needed to keep up with population growth, about 110,000 a month, and if companies begin instituting layoffs.

Dangers can still crop up from unexpected directions. Conway said the pace of rental increases in many sectors is not keeping up with rapidly increasing U.S. construction costs, which rose on average roughly 5.7% in 2018. In some markets, that inflation is now hitting double digits, and construction loans made several years ago may not cover expected costs.

“I think we may have a day of reckoning coming,” he said.

Whatever direction the economy eventually takes, it is definitely a complex environment with a certain degree of uncertainty, Svec said. He advises caution.

“If I was an asset manager, I would de-risk my portfolio, and pivot away from value-add projects or new, ground-up construction,” he said. “Those have generated nice returns over this cycle, but if we go into a recession, that is not the side of the sandbox I would want to be playing in.”

It also might be time to pull back from some secondary and tertiary markets, he added.  

He said investors just need to make sure they are paying attention to the fundamentals market-by-market as some smaller cities, such as Minneapolis and Nashville, consistently outperform the national average, and should remain solid investments.   

Lessening risk could also involve going into real estate sectors that proved resilient during the recession, such as high-street retail or workforce housing.

“The market for workforce housing is already tight, and demand may even strengthen during a downturn if we see a lot of two-income families become one-income families,” he said. “At the very worst, it will be a stable performer.”  

In other sectors, such as multifamily or office, Svec believes it is time to lock in current tenants to long-term deals that will outlast any downturn, even if it means offering discounts.  

Industrial could be one of the few sectors that floats above whatever economic troubles eventually develop.

The manufacturing slowdown could be significant, according to Michael Podboy, the new president of CA Industrial, but logistics has become the major driver of the industrial sector’s recent expansion. Corporate America is in the midst of a massive reconstruction of its logistics supply chain, he said, and developers have responded by opening new logistics facilities across both Tier 1 and Tier 2 markets.

“Not only are consumers demanding next-day delivery for products bought online, now businesses are starting to do so as well, and that’s putting wind in the sails of industrial.”  

Podboy also believes the nation is in the early stages of this transition.

“My gut tells me this industrial modernization will closely track with wherever online sales settle out.”

E-commerce sales hit $139.7B in this year’s second quarter, an 8.3% increase over the first quarter, and 10.1% of all retail sales, according to U.S. census figures.

Online sales could eventually rise to 20% or even 30% of retail sales, Podboy said, which would mean the reconstruction of the logistics supply chain is less than half complete.

“I’m not saying industrial is immune to a recession, just that on a relative basis, it is far better positioned.”