Lock In Your Bets: 22 Commercial Real Estate Trends To Expect In 2018
If “cautious optimism” best describes this year’s commercial real estate environment, expectations for 2018 can best be described in four words: slow-and-steady growth.
From the general economy to individual sector fundamentals and investment activity, commercial real estate industry professionals foresee continued growth in the U.S. market, albeit at a slower pace compared to years past.
Keep watch for these 22 trends in 2018, according to the top brokerages, industry reports and experts.
As the industry continues to ride the waves of one of the longest economic expansions in the country’s history, real estate professionals are cautious about its potential impact on individual sector fundamentals. Still, optimism for 2018 performance is strong.
"We expect the national economy to continue to perform well in 2018. It will likely be one of the best growth years of the expansion, and it could well be the strongest year for GDP growth of the entire expansion so far. But, of course, as we look across regions and sectors, there will be many differences in performance,” Cushman & Wakefield Principal Economist Ken McCarthy said.
Ten-X Chief Economist Peter Muoio said the length of the cycle and its impact on property fundamentals will be key in 2018.
“Most segments are now in a down cycle, amid continued economic growth. ... The combination of less space needs from e-retail, consumer preferences shifting to experiences over goods, changed office layouts, cloud computing and home-sharing are limiting what economic gains typically generate in terms of space demand,” Muoio said. “Meanwhile, in the subset of segments [and] markets where demand has been strong, you now have rapidly increasing supply. This all means the industry is challenged by a downturn in fundamentals amid economic expansion.”
Similarly, Resource Portfolio Manager for Real Estate Diversified Income Fund John Snowden said the market is showing signs of maturing. This will cause average rent growth to moderate in 2018 following years of record-strong gains, he said.
“We do believe that growth can still be achieved in certain markets such as the Sun Belt, where strong employment has created robust demand for housing, retail outlets, healthcare centers, office and warehouse space," he said. "Given Sun Belt states have historically had lower property prices than the coastal states, there is more room for rent increases as well as the potential for higher cap rates."
According to a report from research and analysis firm Moody’s, retail bankruptcies are expected to decline in 2018. Moody’s analysts predict the U.S. retail sector’s operating income will increase 3.5% to 4.5% in 2018, with sales jumping 4.5% as well.
“Large discounters like Walmart will improve as growth investments start to pay off, and drug stores like CVS and Walgreens will improve through cost efficiencies and improved front-end sales,” Moody’s Vice President Mickey Chadha said in a statement, according to ICSC. “We also expect losses to begin to taper for department stores, including Macy’s, Kohl’s and Nordstrom.”
Commercial real estate data and research firm Yardi Matrix expected 480,000 apartment units to come online this year, but construction labor woes stalled deliveries.
CBRE reports 2018 will be a strong year for multifamily supply, though not quite hitting the cyclical peak reached this year. According to the brokerage’s 2018 outlook report, next year will mark the second-largest number of completions during this cycle. Whereas roughly 284,000 apartments are expected to deliver by year’s end 2017, 258,000 units will come online in 2018, down 9.8% from 2017.
Transaction volume took a hit in the beginning of the year following the election of President Donald Trump and the Federal Reserve’s gradual boosts to interest rates.
“The other challenge is the falloff in transaction activity due to the wide gap between seller and buyer pricing expectations,” Muoio said. “This widening of the bid-ask spread was sourced over doubts over the continuation of the cycle on the buy-side, a rise in interest rates heading into the year and seller expectations for robust pricing increases. We believe this gap will begin to close in 2018, and it will do so due to sellers accepting the new paradigm.”
Investment activity has rebounded this year and experts predict it will continue to advance, albeit at a glacial pace, in 2018.
“After a year of slow activity we are hopeful that sales volumes will rise in 2018. One important reason for this is the large amount of capital targeting real estate,” McCarthy said. “There is an estimated $152B in dry powder waiting to be deployed. And while investors were cautious in 2017, we anticipate the healthy economy at home and abroad [will] give investors more confidence, leading to stronger sales.”
The general consensus regarding next year’s office real estate performance is that growth will slow and fundamentals will plateau as accelerated construction puts pressure on absorption and vacancy rates.
“Improved U.S. office market fundamentals should continue in 2018, but at a slower pace due to higher completions and the tight labor market’s impact on tenant demand. Older buildings lacking the amenities preferred by today’s workforce and the infrastructure to handle evolving technologies could struggle, particularly in markets where large volumes of high-quality product are being delivered. Meanwhile, suburban submarkets that offer a range of housing choices along with urban amenities — including retail and restaurant options, public transit and walkability — are well-positioned to capture demand from the maturing millennials,” CBRE reported in its 2018 outlook report.
Industrial real estate was the star performer of the industry this year, and experts anticipate the red-hot sector will continue to advance as e-commerce providers demand warehouse and distribution centers close to urban metros and densely populated markets.
“The seismic shifts in economy continue to push the demand for goods (particularly commodity-type goods) online. Construction will start to catch up to absorption in this sector, but record low vacancy will remain the norm for this sector and rents will continue to climb,” McCarthy said.
“We expect 2018 to be yet another strong year for the industrial market. Demand from e-commerce and third-party logistics users continues to drive demand, which according to Colliers research has pushed vacancy down to 5.2%,” Colliers International President of U.S. Brokerage Marty Pupil said. “And developers are doubling down on the hot sector with more than 220M SF currently under construction in Q3. That’s the second-greatest quarterly value on record.”
“U.S. hotel demand will grow while shifting more to leisure travelers than business travelers. Select hotel markets likely will need to adapt to fluctuations in international travel,” CBRE reports. “The oversized growth in leisure demand is partially explained by shifts in the hotel guest profile and in the spending habits of U.S. age cohorts. In 2015, well-heeled, travel-happy senior citizens contributed the largest share of total spending on lodging. Spending by seniors will likely continue to increase as the last cohort of baby boomers enters the seniors age group.”
Publicly traded REIT yields underperformed the broad stock market this year, but industry experts foresee returns bouncing back in 2018.
“REITs were clearly overlooked and undervalued during 2017 relative to both private real estate and non-REIT stocks,” National Real Estate Investment Trust economist Brad Case said. “I expect 2018 to correct both of those situations. Private real estate values became inflated, and they should languish while operating fundamentals catch up. We’ll likely see more takeover offers, but REITs will spurn any that continue to undervalue their assets. I expect strong performance among retail and apartment REITs — the former because they’ve become most undervalued, the latter because household formation will keep demand ahead of supply for years to come — but I think the entire REIT industry will outperform the broader stock market."
“Whenever the economic expansion gets long and resources start getting tight we need to keep an eye out for excesses that could tip the economy into recession,” McCarthy said. “Right now one excess that stands out is the stock market. Values are very high and price-to-earnings ratios are well above their long-term averages. This will be important to keep an eye on in 2018. A major correction in the stock market could have negative economic implications.”
"We expect consumers will continue to invest more capital into private and alternative real estate assets as public markets remain at record highs across all major asset classes,” Property Passbook founder Colin Bogar told Forbes. “Comparable yield risk remains favorable to private real estate versus higher risk bonds and equivalents.”
A massive wall of CMBS loans issued between 2006 and 2007 was set to mature this year. Between June and November, roughly $41.7B in CMBS debt matured and was in need of refinancing.
Though the pace of maturing debt will taper off in 2018, Snowden said there is still $100B in CMBS debt in need of refinancing.
“One area of potential concern for 2018 is the CMBS market,” Snowden said. “Although we will likely see fewer maturities compared to the past two years, up to $100B in CMBS will need to be refinanced. Against the backdrop of slowly rising interest rates and a narrowing yield curve, however, refinancing may prove more expensive than it has in the past, suggesting a potential headwind for commercial REITs.”
The data center industry is gearing up to enter 2018 with a bang, with experts predicting data centers will continue to see demand and attract billions of dollars in investment as public and private operators outperform other real estate asset classes.
CBRE reports there is nearly 300 MW of data center space expected to come online in 2018. The brokerage said investors will look to markets in Northern Virginia, Chicago, North Carolina and Portland for strong demand and returns.
“Our outlook for data center demand remains bullish, fueled by ever-increasing data consumption, storage, compute power and the rapid evolution of technology — from self-driving vehicles, to networked homes, to advancements in mobile, interconnectivity and content delivery,” CBRE reports. “Transformation and flexibility are the key themes in the multi-tenant data center space in 2018."
Now that tax reform is in the bag, 2018 may be the year of infrastructure overhaul. White House officials said Trump’s infrastructure plan will remain a high priority during the year, with the administration planning to roll it out in early January. The proposal will include an estimated $200B spent in federal funds over a 10-year period to incentivize another $800B in state, local and private-sector spending, according to an administration official.
“While there is no evidence of an overt strategy coming from the White House, the dominos seem to be falling in a way that suggests 2018 could be the year for major infrastructure legislation. The urbanization of U.S. cities cannot continue with functionally obsolete roads, bridges and other infrastructure. As upgrades are planned, raw materials will be needed and warehouses to store them,” JLL reports.
Growth in the senior housing sector is expected in the new year, as aging baby boomers stir demand in the active senior segment. According to a CBRE survey, 60% of investors want to increase their exposure to senior living assets in 2018.
“The seniors housing market improved modestly in 2017 and is set to improve further in 2018, largely due to lower construction levels. For the most part, the traditional segments of seniors housing — independent living, assisted living, memory care and nursing care — are not yet benefiting from baby boomer demand. However, the active adult segment will play an increasing and exciting role in the seniors housing industry in the coming years, as seniors housing continues to evolve,” CBRE reports.
“Facing the dueling pressures of delivering a high-quality, high-tech campus experience while reducing costs, higher education leaders in 2018 will look to campus facilities as a source of added value and savings,” JLL Higher Education Practice co-leaders David Houck and Kevin Wayer said in a recent post. “Declining revenues from tuition and public support, coupled with aging facilities and rising pension liabilities, mean all colleges and universities are looking to the private sector for ideas, further bolstered by the rise of more chief business officers being hired from the private sector rather than academia.”
CBRE reports cap rates in the U.S. have compressed by five to 20 basis points through Q3 2017.
“The next three years will likely see cap rates flat at best or rising, which we expect will outstrip property income growth,” CBRE reports. “The economy’s performance over the period will determine whether commercial real estate values continue to rise mildly, remain relatively flat or decline mildly or moderately. Investors should not count on appreciation returns over the period; rather, steady income returns should provide a solid basis for investment strategy as investors wait out the asset value fluctuations. By market, cap rates and asset prices may vary substantially."
It is the survival of the fittest in the retail sector. Only those best positioned to embrace consumers’ changing shopping patterns and accommodate e-commerce will survive the seismic shift. In particular, discount and off-price retailers like Walmart, Dollar General and TJ Maxx will continue to thrive as the retailers appeal to value shoppers like millennials.
“The industry’s bifurcation, i.e. ‘the barbell effect,’ will continue as consumers and subsequently retailers gravitate to either the discount and off-price sectors or luxury. This may create weakness — and, in many cases, investment opportunities — in secondary and suburban markets,” CBRE reports.
Experts foresee major retail consolidation to continue in 2018. Think Amazon and Whole Foods, Unibail and Westfield and Walmart and Jet.com, Bonobos and ModCloth.
“M&A activity in the retail sector is another trend we will likely see an increase in for 2018 as retail REITs continue to trade at significant discounts to their net asset value,” Snowden said. “Looking ahead, we may also see an increase in M&A in other real estate sectors such as office, which is trading on average at a 15% to 25% discount to [net asset value].”
Office occupiers are increasingly reducing their real estate footprint to cut capital expenditures and boost profit margins. Both law firms and financial services companies are growing more conservative in their leasing activity in terms of square footage.
“Another trend we expect to continue is the shrinking of the office footprint. Between the evolution of co-working and more people working from home, companies are finding greater efficiencies to control costs. Even law firms, historically a major user of Class-A office space, have made several adjustments in recent years to keep productivity high while pulling back on real estate footprints,” Pupil said.
Building telecommunications infrastructure is needed for even the most traditional, non-tech companies to operate at full potential. From call centers to day traders, web developers and e-commerce retailers, spotty internet connectivity hinders a company’s productivity and ability to conduct business efficiently. Connectivity is expected to be an increasingly important factor in office selection in 2018.
According to a WiredScore and Radius Global Market Research report, 75% of tenants say poor connectivity impacts their business’ profitability. In addition, 72% of those in charge of leasing decisions say reliable internet connection is paramount.
“The connectivity infrastructure of an office building is critical to current office tenants and they are willing to pay more for better service. Independent certification/testing would generate more interest in a space and specifically, tenants would pay more, sign quicker and prefer leasing office space in a building that is Wired Certified,” WiredScore reports.
“In 2018, we’ll start to see two interrelated trends: increased integrations between CRE software services and also the blurring of lines between CRE, CRE tech, construction and construction tech industries. There has been tremendous progress in leveraging new software point-solutions in various CRE and construction industry segments that deliver better collaboration, process automation and compiling structured data,” Dealpath CEO Mike Sroka said.
“Co-living and community-driven residential will increasingly have a larger impact on the multifamily industry as it changes to reflect a new wave of renter demands and wants,” Doorbell Inc. founder Benjamin Pleat said on Forbes. “Just as amenities have defined the last decade of commercial real estate development, the need for unique experiences and services will heighten competition.”
Rendering of MicroPAD interior
“Tiny apartments and mobile living will be a solution to increasing housing density in overpopulated areas. This will become more of a norm in big cities and will drive up operating income on existing apartment stock. This likely won't have a huge effect on 2018, but it will over the next decade,” AppFolio founder Nathaniel Kunes told Forbes.
“Rental rates have been increasing across urban areas for the last several years, and the most impacted cities have seen a rise in micro-units,” RealtyShares founder Nav Athwal told Forbes. “These well-designed rooms, as small as 200 SF, maximize every square inch available. Places like The Panoramic in San Francisco and Yotel in New York have been the first to embrace the model, and we see this trend expanding over the next year.”
