Expectations and market realities in real estate 2020

Analysis

Real estate market trends

Expectations and market realities in real estate for 2020

As we enter a new decade, will the outlook for the commercial real estate (CRE) market be more positive than in years past? Learn how economic growth, low unemployment, and declining interest rates will affect CRE investors in 2020.

Our predictions for the 2020 real estate market

This new decade brings unique challenges and opportunities for commercial real estate investors. The United States is well into its longest economic expansion, and the US economy, financial markets, and capital markets are forging ahead in 2020.

Forging ahead can either mean “moving slowly and steadily” or “moving with a sudden burst of speed.” And while the formed definition reflects current economic conditions and CRE market fundamentals, overall CRE transaction volume and secular changes affecting the CRE market are more aligned with the latter.

Our economic and CRE outlooks are optimistic, in contrast to what the industry expected at the beginning of 2019. This brighter outlook is being driven by advances in trade negotiations, a more accommodative monetary policy, record-low unemployment, and steady economic indicators.

Download our full report to learn more about our real estate market predictions for 2020.

Expectations and market realities in real estate 2020

CRE forges ahead as a preferred asset class

Since the global financial crisis, commercial real estate has been a preferred asset class, offering investors solid risk-adjusted returns. CRE is a tangible asset, offering relative safety during a downturn in the form of income returns, as well as higher yields compared to bonds. As we continue into the long expansion cycle, we expect that uncertainty will continue to play a primary role in investment decisions. Investors are likely to keep a risk-off approach, backing away from high-risk assets such as stocks to retreat to safe-harbor investments.

The relative performance of CRE compared to benchmark low-risk investments will drive investment activity moving forward. With 10-year Treasury yields falling quarter-on-quarter (QoQ) and cap and discount rates flat, spreads widened in Q3 2019, according to analysis from Real Estate Research Corporation (RERC), as they have for three consecutive quarters, to reach the largest in three years.

This means that CRE investors are getting a higher risk premium despite no perceived risk increases in CRE. Cap rate spreads over the 10-year Treasury are now above the three-year, five-year, and 10-year averages. Moody’s BAA and AAA yield rates also declined QOQ in 3Q 2019, pushing cap rate spreads higher. Cap rate spreads over both Moody’s BAA and AAA have increased for three consecutive quarters and are at the widest in almost seven years. Cap rate spreads over both these bond rates exceed the three-year, five-year, and 10-year averages.

The interest rate environment

The US economy has appeared to reach the “Goldilocks” zone, where the economy has been growing and the unemployment rate dropping without kindling any appreciable increase in the inflation rate. In July 2019, the Federal Open Market Committee (FOMC) decreased the target rate range for the first time since 2008 in an attempt to keep the economy humming and followed up with identical quarter-point cuts in September and October. The rate cuts undoubtedly helped the overall economy, while the inflation rate remained in the 2.0 percent range for the year. An accommodative FOMC will likely continue to keep short-term interest rates low in 2020 in hopes of staving off a recession.

The 10-year Treasury rate was volatile in 2019. After sharply declining through August 2019, the 10-year yield reversed course and increased 45 basis points (bps) by the end of the year. This followed advancements in trade negotiations and solid economic data, which pushed investors into riskier positions. Despite the upward trend in yield late in the year, the 10-year Treasury rate had declined 79 bps between December 31, 2018, and December 31, 2019.

The impact of interest rates on CRE depends on economic growth and spreads between cap and discount rates and interest rates. RERC data shows that cap rate compression has stalled over the past couple of years but remains at historically low levels, despite market participants’ concerns about a long-in-the-tooth expansion. Assuming economic fundamentals remain positive over the year, the low interest rates could kick-start cap rate compression again.

As capital flows continue to intensify due to declining interest rates, CRE pricing will likely increase; this makes rational underwriting standards even more important. Remember that a 50 bps decline in the cap rate translates to a 10 percent increase in price. Historically low short- and long-term interest rates have driven a substantial across-the-board increase in property prices in nominal and real (inflation-adjusted) terms.

But as long as fundamentals are strong, underlying values will support high prices. However, we are seeing an increasing bid-ask gap at such high prices. Sellers are often taking deals off the market and instead refinancing at ultra-low rates. This has left buyers with few high-quality options.

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