In my last article I briefly discussed the current state of the commercial real estate market and pointed out a few things that could be done ahead of the potential commercial real estate (CRE) downturn. As a real estate practitioner, I frequently get asked what the current state of the real estate market is. There are hundreds of articles published about this issue and many offer different opinions and show economic indicators that suggest we are very close to a recession. However, I have also read many publications that show the economy is thriving and GDP growth has reached a 10 year high and consumer confidence is extremely high. Even in Mississippi we had the highest annual growth we have seen probably in 10-12 years. A lot of this was contributed from our ports and rail access, as well as, industrial and manufacturing.
I recently attended a CCIM Institute economic forecast lunch and the speaker, who is an economist, made a comment that if we do not enter into a recession in 2019, then this would be the first time in over a 100 years (Year 1857) that a recession did not start with the years ending in 7s, 8s or 9s. Historically, all recessions typically start every 9-11 years such as the great recession in 2008. The speaker also suggested that our previous recession was very deep and was not only related to real estate, but a host of other professions and industries and for this reason it only comes to reason that our recovery would be longer than normal.
I do believe we are headed for a slowdown; however, contrary to a lot of other real estate professionals, I don’t believe it will be anything like the last recession of 2008, 2009 and 2010. In many articles you hear the analogy of innings or quarters as to suggest the cycle is similar to a game in which there is an ending. Stealing from another professional, I like to think of it as similar to “slowdown” so maybe we will go from 5th gear to 3rd gear, but not a complete stop or “game over” scenario. My opinion is not only for the overall commercial real estate market, but also the Mississippi market as well. I have listed below three (3) things that I believe have contributed to a “soft” recession this time around.
First is discipline. From buyers to lenders there is no question since the previous recession there has been much more discipline in the market. As an investment property broker I advise most buyers to only purchase on “in-place” net operating income and not pro forma or future income. In addition, loan to values are still 75 percent to 80 percent of acquisition costs with most requiring reserves for tenant improvements and leasing commissions. Lenders have also relying more on debt coverage ratio, which is the property’s ability to cover all expenses and debt service with a percentage of cushion. In addition, certain property types are scrutinized much harder by buyers and lenders and a lot of thought has been given to the how the increase in internet sales and communication will affect the property and its tenants long-term.
Second are interest rates. There is no doubt many complaints have been made regarding the increase in interest rates; however, rates are still at historical lows and most properties are being purchased with a 300 to 400 basis point spread between interest rates and cap rates. Most lenders are offering 20 amortization schedules. So based on the rate spread and amortization, most investors should have a good cushion for cash flow, even in a potential CRE downturn. For investors doing smaller loans, there is interest rate risk with loans that balloon every five (5) years; however, again, rates have increased, but not by much and should not significantly impact cash flow.
Third is construction costs. Most buyers and developers are experiencing unprecedented costs of construction. Material and labor shortage has greatly impacted both the costs and timing of new developments and large renovations. I believe this has also kept many projects from being built and has contributed to little supply hitting most markets. As mentioned previously, interest rates are low and the market is active, but the absence of new office buildings, retail centers and industrial buildings have contributed to more “equilibrium” in the market. In Mississippi, rental rates generally remain flat to modest increases, the feasibility rent of most projects are not high enough to justify new construction. There are obviously markets and sub-markets in Mississippi that have greater demand for retail and office space and most of these markets are already seeing new construction. In general, the costs of construction and long development timelines have kept the market from overbuilding.
Overall, the economy is thriving was some markets in the US experiencing enormous growth and other markets remaining relatively flat but experiencing some GDP growth, such as most markets in Mississippi. The timing of the next CRE downturn is uncertain, but most economists agree we are heading in that direction and several economic indicators, such as the yield curve, suggest we are very close. Some markets will fall harder than others, but I do believe any sort of economic distress will come mainly from undisciplined investors and/or properties whose tenant’s business or industry are consistently being interrupted by e-commerce.
» BRIAN E. ESTES is president and investment adviser with the Estes Group and can be reached at email@example.com.
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