Economist’s View: Investment Is About Expected Returns

My column in the December 2019 issue of Commercial Property Executive delved into the details of the consumption sector of the U.S. economy, which represents about 70 percent of our GDP. Personal consumption expenditures continued to make a positive contribution to growth in last year’s final quarter, according to the Advance Estimate of GDP issued by the Bureau of Economic Analysis on Jan. 30, 2020. That estimate showed the economy growing at a 2.1 percent annual rate, and 1.2 points of that stemmed from the consumer sector.

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Sadly, though, Gross Private Domestic Investment moved in the other direction, accounting for a 1.1 percentage point drag in the Fourth Quarter, the third consecutive period where investment restrained the level of output of goods and services. Compared with the same quarter a year ago, private investment is down 1.9 percent or $53.2 billion. Since residential investment is actually up over the period, the decline is overweighted in the business sector. That should give us pause in evaluating the economic and real estate market prospects for 2020 and beyond.

Let’s start on the brighter side, though. There has been a recent turnaround in housing investment―evident in positive change in residential investment during the second half of the year―after posting negative change in eight of the preceding 10 quarters since the start of 2017. Rising home prices and low interest rates have provided a welcome impetus for the housing sector in recent months.

There is still considerable catch-up needed, however, as the Census Bureau’s tally of New Construction Put in Place shows new single-family construction down year-over-year by 0.3 percent in the single-family sector and by 3.9 percent in the multifamily sector, as of November 2019 (the latest data point for this measure). Moody’s Analytics, meanwhile, indicates we continue to run a 300,000-unit annual deficit in housing production compared with underlying housing demand. That’s a key element in the price increases and widening affordability gap for lower and middle-income households.

Thus far, though, neither low interest rates nor the exceptionally favorable treatment of business in the 2017 Tax Cut and Job Act has spurred much in the way of non-residential private investment. This is particularly true in the subcategories of investment in structures and in equipment. What positive news we have seen has been restricted to intellectual property products. This last category is important, unquestionably, but it represents $989 billion (36 percent) of the total 2.7 trillion for non-residential investment. Put another way, the remaining 64 percent of the business investment category has been in decline.

We should be worried about such a trend because of what it signals about expected future returns. Businesses make investments because they anticipate a payoff in the form of profits, capturing a growing amount of final demand in the economy. A drop in investment activity occurs when businesses are uncertain about the potential for return on those investments. Or, worse, when the outlook for future returns is not just uncertain but is pessimistic.

Hugh Kelly, PhD., CRE

Although the stock market has remained generally bullish, those managing America’s businesses are decidedly less so. As of the end of January, the price/earnings ratio of the S&P 500 stood at 24.5, well in excess of its historic mean of 15.8. It seems that executives, however, are more focused on the prospects for much lower demand growth in the 2020s, with job growth shrinking from 200,000 per month in the later 2010s to about 50,000 per month for most of the 2020-2029 period.

That sensibility shows up in the year-end Report on Business from the Institute of Supply Management’s “Purchasing Managers Index” for manufacturing. Although the overall economy has continued expanding, with a record 128 months of growth, the goods production sector has been in contraction since last summer. The purchasing managers report difficulty in the volume of new orders, overall production, employment, customers’ inventories and their backlog of orders. The PMI hit its lowest level since June 2009―not a particularly confidence-inducing comparison. And while the non-manufacturing sector reported greater strength, its year-end business activity index was down significantly from levels achieved in the First Quarter 2019.

How is the cautious investment mood translating into real estate behaviors? Year-end tallies from Real Capital Analytics present a mixed picture that is actually fairly consonant with the macroeconomic pattern. Overall transaction activity in real property assets fell a modest 2 percent in 2019. But there is a wide range in the details. Multifamily asset sales were up a modest 4 percent and office deals up 2 percent for the year. Industrial trades―spurred by ecommerce―advanced a notable 14 percent. But the retail property sector was down 28 percent and hotel investment dropped 15 percent. And, with an eye to future demand, capital commitments to new development sites was down 17 percent in 2019.

If “follow the money” remains a sound analytical maxim, it seems that those responsible for deploying capital are at odds with the public enthusiasm propelling the equities markets. Real estate seems to have a more sober outlook. Commercial may perhaps be less subject to a price correction as the likelihood of sharply reduced final demand becomes more widely appreciated in the business and general press.

Hugh F. Kelly is director of graduate programs & chair of the executive advisory council curriculum committee at the Fordham University Real Estate Institute, and chair of the institute’s executive advisory council curriculum committee. He is a principal at Hugh F. Kelly Real Estate Economics, a consultancy. Kelly is the author, most recently, of 24-Hour Cities: Real Investment Performance, Not Just Promises (Routledge/Taylor & Francis).

Read the March 2020 issue of CPE.