By Ken Riggs
The U.S. economy is approaching its longest expansion in history. If it continues through June 2019, it will reach 120 months and surpass the previous longest-ever expansion, from 1991 to 2001, going back to when records started being kept in the 1850s. As the commercial real estate cycle continues into its ninth year amid rising interest rates, commercial real estate total returns are expected to continue to decline from their recent peaks. With price and value gains now slowing to more of a measured pace, and net operating income (NOI) continuing on pace with a slow level of growth, commercial real estate will rely on income to drive total returns moving forward, versus value or price appreciation. This is especially true of the gateway cities and involves major core assets.
It has taken longer for the economy and financial markets to recover from the scale and severity of the global financial crisis, which was structurally different from previous economic downturns and mostly compared to the Great Depression. GDP growth has been slow and steady during this expansion, averaging 2.3 percent. For comparison, GDP growth ranged from 2.9 percent to 7.0 percent (averaging 4.6 percent) across all other recovery cycles since the aftermath of World War II. Historically, slower economic growth has been associated with longer expansion periods. The tax cuts passed last year gave the economy an extra boost—to the tune of 4.2 percent GDP growth in the second quarter of 2018, the highest rate in almost four years.
At 3.9 percent, the August 2018 unemployment rate is at an 18-year low. However, it took the jobless rate, which peaked at 10 percent in October 2009, more than seven years to reach the trough of the previous cycle, and wage growth has been unusually stagnant. According to the Federal Reserve Bank of Atlanta’s calculations, three-month smoothed wage growth was 3.2 percent in the second quarter of 2018, but it has averaged 2.6 percent during this recovery. Going back to 1983, the earliest time period for which data is available, wage growth averaged 4.6 percent during previous recovery periods. Despite the falling unemployment rate, the labor force participation rate (LFPR) remains lower than it was before the global financial crisis: The average LFPR was 62.8 percent in 2018 compared to 66 percent in 2008. In past expansions, beginning in the 1970s—after women began entering the workforce in large numbers—the LFPR average was 64.2 percent.
Moreover, according to the Congressional Budget Office, the output gap—the difference between the economy’s actual performance and its potential—for the U.S. economy has stayed wider and more negative since the global financial crisis as compared to prior recessions. The output gap has remained negative for the past 35 quarters since the global financial crisis. Comparatively, the output gap was negative for 17 quarters after the 2001 recession and 22 quarters after the 1991 recession.
What lies ahead
With this rather unusual economic backdrop in mind, we will have to wait and see how the commercial real estate market shakes out. Investors are expecting income to be the major component of future total returns, and they will either need to learn to be satisfied with in-place income or find other ways to strengthen their NOIs and earn value or price gains. This is especially true of core properties in the major markets. The gains in smaller markets and industrial are helping propel overall price gains to almost 4.0 percent year-to-date . Space market fundamentals remain strong for many property types, but the across-the-board gains created by cap rate compression, which favored all property types without regard to quality and location, are over.
The good news is that despite its length, the economic recovery seems far from over, and recent economic indicators suggest growth ahead. This means we likely have more room to run before we hit the next bust, and commercial real estate is positioned to continue to provide a strong case for investment.