With interest rates poised to rise, NREI recently talked with Richard Barkham, Ph.D., executive director and global chief economist at commercial real estate services firm CBRE to discuss what lies ahead for the U.S. commercial real estate market in 2016.
NREI: It looks like the Fed will finally raise interest rates in December. Do you agree with that consensus?
Barkham: I do. It looks pretty certain now that the Fed is going to raise rates in December, absent some type of major international crisis. With employment at 5 percent, the Fed has left it a lot longer than it normally would do. But then this recovery has been very challenged.
Twenty five basis points for an initial rise is not anything here nor there, but I think this is a start of a trend upwards. I expect to see interest rates continuing to rise over the next three years, but it will be slow and gradual. There is still quite a lot of fragility in the world economy, and many other economic blocks, such as the Euro Zone and Japan, are still [doing] quantitative easing. China and Asia are reducing rates. Internationally, the Fed does not have that much scope to raise interest rates quickly.
NREI: Do you think this increase will have much impact on commercial real estate specifically?
Barkham: No, at this stage, I don’t think that it will. The rates will be low and measured. The market has certainly anticipated this move. We have had low rates for seven years. There might be some volatility around the stock market, but the key drivers in real estate markets are GDP growth and confidence, and they are still pretty high at the moment. There is a reasonably good recovery in North America and Europe, and that is quite a big portion of the global economy.
Where I do think there might be an issue is if we get any sort of indication that the Fed is behind the curve. I don’t think that we will get that, but one of the things that has allowed the Fed to keep rates so low is that there has been no wage inflation. Over the next six months if there is a sudden jump up in hourly earnings—by say 2.5 to 3.2 percent—then that gives a real firm view that the labor market is really tight. That would hit the bond market.
Inflation and wage rises are pretty tame at the moment, but it is not impossible with unemployment at 5 percent and going lower that we could get an unanticipated uptick in average earnings. Then I think the long end of the market would notch up. I still don’t think it would be enough to destabilize the real estate market, but you could get a couple of weeks or a month or two of serious concern.
NREI: What is your big picture outlook for the commercial real estate industry in 2016? Do you think we will stay on the course of steady improvement?
Barkham: Yes, I do actually. One of the characteristics of this cycle, perhaps because of the financial disruption at the early stage of the cycle and then the problems in the Euro Zone, is that the development lending has not been quite as aggressive as it normally is. So broadly speaking, as the economy grows there is more of an uptick in net absorption and vacancy rates are coming down, and I don’t see why that shouldn’t continue through 2016 and into 2017.
This is not the most robust of economic recoveries, because in the early part of the recovery banks had to clear their balance sheets up. Then they ran into the Euro Zone crisis. Now there is a slowdown in China. There are all sorts of headwinds out there. But, by and large, in all sectors you see positive net absorption, falling vacancy and reasonably good rental growth. Rental growth will probably be above inflation.
The fact is that there is so much capital in the world that cap rates have come down. Even with rental growth, real estate returns are not quite as high as they were in previous cycles, but that is true of all asset classes. We live in an era of lower returns, because bond rates are lower and interest rates are lower generally. So fundamentals are good and generating rental growth giving you positive returns, but returns that are perhaps lower than previous cycles.
NREI: What is your view on investment sales? Do you think investors will just adjust expectations and accept lower yields?
Barkham: Yes, I do. That is partly driven by the fact that there is so much capital to invest and yields have come down, but there are still very good spreads over bond rates. Even if you have a bond rate increase, you’ve still got positive spreads with some rental growth and a relatively good returning, relatively stable asset.
I see two potential problems. One is that quite a lot of the investment demand or global savings, maybe 40 percent, has come from the oil-producing countries. The fall in oil prices means that they have to find the revenue to bankroll their states. Saudi Arabia, for example, is withdrawing about $50 billion from its asset managers. So there could be some withdrawal of oil money from global investment because of the falling oil price. But, against that, I only see capital increasing from Asia, and China in particular. So there should be enough capital to replace any lost from the oil-producing countries.
The other potential problem I see is more on the confidence side. We are broadly optimistic about the global economy, and I have been quite optimistic that the rise in interest rates would not impact the U.S. economy. But I think the rise in the U.S. rate and the rise in the dollar and other problems in emerging markets mean that there could, potentially, be some sort of emerging markets crisis.
There has been a lot of dollar borrowing in emerging markets. The dollar is going up, their currencies are going down. Some of those countries don’t have the foreign currency reserves to be able to repay those loans. There could be some sort of defaults in emerging markets. If that came about and some of the low grade corporate debt in the oil sector or energy sector started defaulting, potentially, you would have some sort of financial crisis that is unrelated to real estate. The emerging markets crisis could get quite nasty, and that could hurt confidence.
NREI: Do you think the terrorist attacks in France could shake that confidence more or impact the global economy?
Barkham: No, I don’t. I have done some analysis of this, tracking GDP growth in relation to terror incidents and wars. Individual acts of terror typically don’t effect GDP growth or the economic trajectory of big economies.
NREI: What do you think will be the top issues to watch for commercial real estate in 2016?
Barkham: In the U.S., you have to be watching the labor market and wage growth, because that could lead to potential inflation in the year ahead. Core inflation is very subdued at the moment, but it is edging back to where it should be. Those are the things that I would watch domestically. I do think there might be some defaults in the energy sector that might cause problems. I think we need to watch emerging markets like a hawk—export statistics and the currency situation—to get a feel for just how bad the slowdown in emerging markets is.
NREI: Which sectors of the commercial/multifamily real estate markets do you think will be the big leaders or laggards in 2016?
Barkham: Multifamily is a sector that had both a cyclical uplift and a big structural uplift from the reduction in home ownership. There is a reasonable supply pipeline there. With the vacancy rates that it currently has and the forecast demand, it should continue to generate good rental rate growth.
Retail: As unemployment comes down and consumers start spending more aggressively from their savings in gas, the outlook for retail is quite good. There are some structural issues in retail, mainly the challenge from e-commerce and the challenge from very successful discounting firms like Wal-mart. There may be a bigger challenge there for grade-B and grade-C malls, but there is also more new investment going on as shopping centers look to reposition themselves or change their offering a little bit. The outlook is reasonably good for bricks-and-mortar retail if it can continue to make itself relevant to consumers.
Office: The demand for office has been a little bit sluggish this cycle, and that is due to the finance sector not being as strong as it has been in previous cycles. Banks have had to deal with a lot of new regulation. The savior of the office sector is that not much is being built. So I think the demand will generate above average rent growth across the board.
Industrial: There is still a great deal of interest from investors in that sector. While grade-B and grade-C malls are losing out, industrial and logistics [sector] is seeing so much development and change that centers around making supply chains more efficient, infrastructure changes, plus the focus on same-day performance from the e-commerce sector. So the occupier demand and investor demand speak to another good year for industrial and logistics.
NREI: Overall, do you have a very positive outlook for 2016?
Barkham: Broadly, we are optimistic. But there is a noticeable headwind coming out of the slowdown in the emerging markets. The unpredictable thing in the global economy is the slowdown in China. It will be a soft landing, not a hard landing. But there will continue to be negative news out of China for at least another nine months. The slower growth from China could lead to trade shock in emerging markets, many of which have borrowed heavily in dollars. So a strong dollar will have quite a negative effect on those emerging markets.
We are more than cautiously optimistic, but we are not wildly bullish. We know there are risks out there. But I think it will be another pretty good year for real estate. There is good growth and plenty of capital still for real estate. There will probably be rental rate growth in all sectors of between 2 to 4 percent and probably further cap rate compression.