On October 26th 2017, PwC and the Urban Land Institute (ULI) released their “Emerging Trends in Real Estate 2018 Report.” According to PwC leaders, the annual report looks forward to the year ahead, unlike most reports that look back at the last quarter or year. The report was compiled from surveys and interviews of over 1,600 real estate executives, investors, developers and market experts. To summarize the consensus of the “Emerging Trends” 2018 survey respondents, “We are in a long cycle, not in a boom/bust.  The key to the next few years is to expand horizons, market by market, property type by property type.”

The “Emerging Trend” interviewees seem tired of using the “what inning are we in” baseball metaphor.  They have the sense that no particular clock is ticking on this real estate cycle.  Very few are willing to identify signs of a coming downturn.  While it has been a very long time since economists have seen a “soft landing” in their projections, we may indeed be on a glide path to that result.  Importantly, it seems that many in this industry are implicitly anticipating such a scenario.

The case for the soft landing starts with the slow pace and moderate scale of the post-global financial crisis (GFC) recovery.  Based on Newton’s third law (”For every action, there is an equal and opposite reaction”), the gradual slope of economic increase since 2010 lacks the obvious characteristics of a “boom” that would trigger a compensating “bust” to correct its excesses.  This recovery has seen gross domestic product (GDP) growth averaging just 2.1 percent annually—hardly a “boom.”

The pool of debt and equity is deep and diverse, and should be expected to remain healthy through the foreseeable future.  The depth of the pool, in particular, reflects both the growth in aggregate global savings and the inclination of investors to increasingly favor real estate as a vehicle for returns on and of capital.  Slow growth in the economy is anticipated, and so both lenders and borrowers will be taking a conservative tack, especially if the “slow glide to a soft landing” economic scenario continues to play out.

“For the first time in five years, people feel comfortable with the cycle; about 80 percent of survey respondents expect good to excellent profitability,” noted PwC’s Andrew Warren in summarizing the report.

As to new and expanding horizons, the report asserts that they are likely to be in smaller and secondary markets.  “The growing interest in smaller cities by real estate investors is influenced by their relative affordability, coupled with a concentration of young, skilled workers,” said Mitch Roschelle, a partner and business development leader at PwC.  “The diverse, robust economies of these smaller cities make them very desirable to investors.”  Secondary markets have dominated population growth in the last decade, with higher levels of in-migration than gateway cities.

The South remains popular with the survey respondents in 2018 with seven of the top 20 ranked markets being located in the South.  “The South is again benefiting from increase in mobility of the U.S. population.”  The reasons most often cited for the region’s attractiveness can be categorized as positive demographics supported by very competitive living and business costs.

The markets in the South region are extremely diverse and categorized by interviewees as burgeoning gateway markets like Atlanta and Dallas/Fort Worth, as well as, the top 18-hour cities of Austin, Nashville, Charlotte, and Raleigh/Durham.  The region also has specific industry hubs like Greenville, Louisville, and Memphis.

Not only do markets in the South enjoy strong demographic growth, they are also seeing the benefits from being home to well-trained labor forces.  Raleigh/Durham has long credited its recent economic strength to its highly educated workforce there.  Every market in the South region is quick to point to the benefits of having a college or university in its market.  Raleigh/Durham is also experiencing the benefits of the National Institutes of Health’s investment in local companies.

The top cities in the South all credit strong population growth as a key contributor to their real estate investment attractiveness.  More specifically, Austin, Nashville, and Charlotte say that the attractiveness of the market to millennials has been key to recent economic growth.

Whether you believe that jobs follow people or people follow jobs, a number of markets in the South say that employment growth and the addition of new employees is having a positive impact on their economic performance.  In 2018, Atlanta should continue to benefit from recent corporate relocations and will most likely remain attractive to companies considering relocation.  Louisville and Greenville cite the growth in national and regional manufacturing firms as driving growth and diversity in their economies.

For the past four years, industrial has been the top-ranked property sector in the “Emerging Trends” survey and it remains so for the year ahead.  Market fundamentals have only gotten better in the last year, with supply and demand in balance, market vacancies at a historically low level, and unleveraged total returns still running in the double digits.  Looking ahead, the supply picture has matured and will drive more differentiation by market.  Critically, users of industrial space are demonstrating a willingness to pay for space that best fits within their supply chains, leading to continued elevated rent growth.  Taken together, it is no surprise that industrial still ranks as the top sector for investment and for development.  And while the cycle continues to evolve and mature, growth factors still appear poised to continue to lift the sector higher.  Notwithstanding new uncertainties that are emerging, rent and value growth appear poised to continue to outperform.

A primary challenge to owners and operators will be to capture recent and continuing market growth in the industrial sector.  Considerable rent growth so far in the expansion has translated to a record-wide gap between in-place and market rents.  NOI growth is as visible as ever, occurring as in-place leases roll to market rates.

The office sector, as rated by the “Emerging Trends” survey, remains relatively unchanged from the last year.  National occupancy remains high, and absorption has sustained a positive trend, bolstering both central business district (CBD) as well as suburban markets.

Geography still matters.  Half of new office jobs over the past year occurred in just 13 markets, mostly tech and high-growth coastal and southern markets.

The office sector houses a large and growing part of the U.S. economy.  Office job growth is strong—expanding by 2.2 percent on average in this recovery as compared with 1.6 percent total job growth.  In a race for talent, office space is now a key tool for tenants to attract and retain employees.

Millennials, now representing nearly a third of the office- using employment base, are reaching their marriage, first-time home-buying, and child-bearing years, and are thought to be a major driver of suburban demand.  Suburban office investors believe that this demographic trend, combined with lower rents, could drive office demand going forward.

A survey of 2,000 millennials indicated further need for amenities such as rest areas, wellness facilities, greenspace, game rooms, convenience stores, and daycare facilities.  This is not limited to CBD locations. Suburban owners are upping “fitness, food, and fun” through activities such as bringing in food trucks and offering more on-site fitness options and outdoor meeting areas.  Larger common spaces also allow tenants to save costs by minimizing open space in their leased area.

Investors remain positive but cautious about the upcoming year.  Unlevered core office returns are expected to be in the single digits, a reflection of the mature market.  While it is becoming harder to find attractive risk-adjusted returns, one global investor notes that “markets are at very different points of their cycle.  There are markets that just started recovering 18 months ago.”

Investors are optimistic that this cycle is moderating as appropriate.  In the United States, the volume of projects under construction has already slowed.  In addition, investors are remaining true to their strategies, instead of chasing high-cap rate markets.

According to the National Association of Realtor’s “Commercial Real Estate (CRE) Outlook: 2017 Q3,” issued on September 12, 2017, major commercial real estate fundamentals continue to improve, particularly in smaller markets. Tenant demand remained strongest in the 5,000 square feet and below segment, accounting for 76.0 percent of leased properties. Office net absorption totaled 8.8 million square feet, based on data from JLL.  Overall office vacancies were at 12.7 percent in the second quarter. Leasing volume advanced 6.5 percent from the prior quarter. Leasing rates rose by 2.8 percent in the second quarter, as concessions declined 4.6 percent.  Industrial net absorption totaled 101.0 million square feet over the first half of the year, according to JLL.  Warehouse and distribution centers accounted for the largest share of demand. Industrial vacancies were at 9.2 percent in the second quarter.

As the economic underpinnings advance at a moderate pace, commercial fundamentals are expected to maintain an upward trajectory.  With employment in business and professional services still driving growth, demand for offices should remain solid.  The industrial sector continues to ride the tail winds of trade and e-commerce.

As domestic and international investors across the value spectrum broadened their search for yield into secondary and tertiary markets, the shortage of available inventory remained the number one concern for commercial realtors. Prices for commercial properties increased 6.7 percent compared with the second quarter of 2016.  In light of the tight inventory, the gap in pricing between buyers and sellers weighed on markets, ranking at number two of top concerns.

The latest “Beige Book” report, issued by the Federal Reserve Board October 18, 2017, based on information collected on or before October 6, 2017, suggests that economic activity expanded across all twelve Federal districts in September through early October, with a pace of growth ranging from modest to moderate.

In Richmond’s Fifth District, economic activity grew at a moderate pace since the previous Beige Book report. Commercial real estate leasing increased modestly in recent weeks as brokers reported more demand in urban localities. Rental rates were stable to increasing moderately, with reports of rising rate pressure in the industrial market due to lack of inventory.  Office and industrial warehouse construction increased in Raleigh and Charlotte, North Carolina and in Charleston, South Carolina.

In Philadelphia’s Third District, contacts reported slight growth in construction activity, which had been flat last period.  Leasing activity also appeared to grow slightly. Contractors reported that despite a slight softening over the summer, overall, labor hours have picked up in September, suggesting more new construction activity.  This year has been the second most active year in the past five years (behind 2016), and contacts expect activity to keep up in 2018.

In Atlanta’s Sixth District, which includes Nashville, TN and Jacksonville, FL, commercial real estate contacts reported improvements in demand that resulted in rent growth, but cautioned that the rate of improvement continued to vary by metropolitan area, sub-market, and property type. The majority of commercial contractors indicated that the pace of nonresidential construction activity had increased from one year ago.  Most contacts reported healthy backlogs.  Florida contacts suggested that construction activity will increase significantly due to hurricane rebuilding efforts.

Updated 11/1/17