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: 2018 Q1,” issued on February 27, 2018, 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 82.0 percent of leased properties. Overall office vacancies were at 12.0 percent in the third quarter. Leasing rates rose by 3.3 percent in the fourth quarter, as concessions declined 2.8 percent.  The industrial sector continued on its hot streak during the third quarter of this year, as e-commerce demand increased.  Industrial net absorption totaled 44.4 million square feet during the fourth quarter, according to CBRE data. Industrial vacancies declined to 4.5 percent in the fourth quarter. Industrial asking rents advanced in the fourth quarter by 0.6 percent, to $6.92 per square foot.

Office demand softened in the fourth quarter of 2017, even as employment in office-using industries expanded.  Net absorption of office spaces totaled 6.9 million square feet during the quarter, according to CBRE.  Office construction accounted for 11.1 million square feet of new space for the quarter, wrapping up the year with 46.3 million square feet.

Continuing a trend which has increased in visibility during this cycle, smaller – secondary and tertiary – markets posted a better year in 2017 than their larger counterparts.  The six major markets experienced a 14 percent decline in investment sales over the year.  Meanwhile, strengthening economics, employment and higher yields, have brought smaller markets to investors’ attention.

According to CBRE Research’s 2018 Southeast U.S. Real Estate Market Outlook report, developers are now responding to several years of strong office absorption by delivering new product but are still expected to fall short of anticipated rates of absorption, resulting in further declining vacancies.  The region’s mid-sized markets are seeing the most development traction.  Nashville, Charlotte and Raleigh will account for more than half of the region’s development activity over the next two years.  Office asking rates continue to rise, with Charlotte and Nashville witnessing increases of 30% or more over the last five years.

The latest “Beige Book” report, issued by the Federal Reserve Board July 18, 2018, based on information collected on or before July 9, 2018, suggests that economic activity continued to expand moderately in 10 of the 12 Federal districts during June and early July. The outliers were Dallas which reported strong growth and St. Louis, where growth was slight.

In Richmond’s Fifth District, the economy expanded at a moderate pace in recent weeks. On the whole, commercial real estate leasing rose moderately in recent weeks, as brokers reported strong demand for industrial space.  Vacancy rates remained low across markets. Rental rates were stable to increasing modestly across the District.  Commercial sales rose modestly.

Aggregate business activity in Philadelphia’s Third District continued at a modest pace of growth during the current Beige Book period.  Nonresidential real estate contacts reported no change in the modest growth of leasing activity.  High levels of construction activity have seen a slow and steady decline as several of the major projects reach or near completion in Philadelphia.

In Atlanta’s Sixth District, which includes Nashville, TN and Jacksonville, FL, commercial real estate contacts reported strong demand. Contacts sited that vacancy rates have been steady or falling and the rate of concessions has been steady over the last 90 days.  The majority of commercial contractors indicated that the pace of nonresidential construction activity matched the one year ago level.  Most contacts reported a healthy pipeline of activity, with backlogs greater than or equal to the previous year’s level.

Updated 7/18/18