A great deal of uncertainty still hangs over the economy, financial markets and commercial real estate as the new administration settles in at the White House. But President Donald Trump's initial actions appear to create positive tail winds for commercial real estate.
The president's support of lower corporate taxes and deregulation are favorable, as is his stated intention to grow the economy at a faster rate than we have seen over the past several years. Perhaps counterbalancing these is the Federal Reserve's forecast it will raise interest rates two or even three times later this year. That will put pressure on commercial real estate yield spreads, but could also encourage more bank lending.
A strong case can be made that banks will increase lending in response to a new regulatory paradigm, higher interest rates and a stronger economy. The Trump administration's executive order aimed at scaling back the Dodd-Frank Act, as well as his freeze on new or pending regulations means banks should be able to do business without worrying about new restrictions or penalties for the first time since the financial crisis. Higher interest rates should also make banks more willing to lend because loan spreads will be more attractive.
Typically, that which is good for the economy is good for commercial real estate. The administration's support for lower taxes and infrastructure spending, such as his plan to build a wall along the Mexican border, should spur economic growth. This “Trump bump” is expected to encourage more bank lending and greater activity in the capital markets as structured market participants depend on underlying growth to issue new commercial mortgage-backed securities. A total of $76 billion in CMBS was issued last year, in addition to $111 billion by government-sponsored enterprises. That amount could easily be exceeded this year, especially as maturing loans and structures get repackaged as new CMBS. One concern involves new risk retention rules that went into effect at the end of last year. The rules require banks to retain “skin in the game,” which could slow issuance. That said, the market appears to be finding solutions to working within the new rules.
At the same time, however, Mr. Trump's combative rhetoric and rash approach to politics are making investors anxious. The president's protectionist stance on trade and the refugee crisis have generated concerns about global economic growth, giving investors pause. In the CRE market, the president's opposition to illegal immigration, as well as the high percentage of illegal immigrants in the construction industry, might exacerbate existing construction labor shortages.
Despite these concerns, it is expected commercial real estate will continue to perform satisfactorily in 2017. Driven by solid fundamentals, historically low interest rates, good value and strong total returns, CRE has outperformed, on a risk-adjusted basis, its alternative investment competitors since the financial crisis. Further, unlike previous cycles, the market has performed well without overheating. Prices are back to pre-crisis levels for most major property types but the pace of gains has eased as investors and developers have demonstrated more investment discipline. Bank capital, at least until now, has also been restricted, while underwriting criteria have come in within reasonable boundaries. All of these factors have helped create a stable foundation for the market and point convincingly to continued sustainable growth.
Longer term, however, most CRE investors are focused on whether the market is getting closer to the end of its current cycle and whether it is reaching a peak. CRE has grown for the past seven years with cap rate compression — which measures a property's potential rate of return based on expected income — reaching record lows for many property types. Both because of Mr. Trump and the market's solid foundation, we expect the near term to be strong but beyond that we are more cautious as historical economic and market cycles take greater hold, especially if interest rates rise significantly.
Investors can still find solid value in CRE, but they have to look more carefully. Major markets like New York and the San Francisco Bay Area might be fully priced but smaller markets may not be. Alternative property types, such as student housing, storage, medical-related assets are gaining appeal; assets that need repositioning, what the industry refers to as “core plus,” is the bull's-eye for many current investment strategies. For example, a hotel that is converting to a condo or apartment complex could offer investors enticingly higher returns. REITs are also a consideration but, bear in mind, the appeal of CRE for many investors is the ability to select an investment that is tailored to their specific needs, requirements and control.
Kenneth Riggs Jr. is president of Situs RERC. The views expressed herein are Mr. Riggs' and do not necessarily represent the views of the entire Situs Group. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I’s editorial team.