U.S. WILL REMAIN A HAVEN FOR INVESTMENT
Expectations for slower economic growth will shape U.S. capital markets conditions in 2020. While investors are increasingly cautious and focused on an investment’s potential for downturn protection, investment capital remains abundant. With global bond yields expected to remain extremely low and equity markets likely weaker and more volatile, the stable, solid returns of U.S. commercial real estate will be even more attractive.
Foreign investment should also rebound next year after significant pullback in 2019, as a substantial decrease in hedging costs for many major investor countries (spurred by falling U.S. interest rates) drives more foreign investors to compete for U.S. assets, particularly in “safe haven” core markets. Although U.S. interest rates are expected to remain low, periods of volatility could occur, causing short-term disruptions in the capital markets. This could include fluctuations and short-term increases in currency hedging costs, potentially impacting foreign investment activity in U.S. commercial real estate.
HIGH LIQUIDITY TO CONTINUE
Domestically, low interest rates have fueled demand for debt financing, particularly as low cap rates prompt the use of leverage by some investors to boost returns. Lenders are largely keeping pace with this demand. Increased lending by debt funds, mortgage REITs and other alternative lenders should continue in 2020. Although underwriting was slightly more conservative as of late 2019, lending momentum should remain healthy next year.
Multifamily lending activity is projected to rise due to an expected increase in financing opportunities. Given recent increases to their lending caps, Fannie Mae and Freddie Mac likely will maintain their market share. Other lenders are expected to increase their multifamily volumes as well due to the increase in lending opportunities.
On the equity side, there was nearly $210 billion of available capital focused on North American real estate as of September 2019, according to Preqin. Much of this capital must be deployed in 2020 to meet deadlines promised to investors. Moreover, several major institutional investors, including risk-averse pension funds and insurance companies, plan to increase allocations to real estate next year.
INVESTORS EXERCISE CAUTION
Given this considerable liquidity and a global search for yield, investor interest in U.S. commercial real estate will remain strong in 2020. Nevertheless, investment volume is expected to decrease by between 5% and 10% from 2019 levels as greater investor caution and selectivity coupled with very high asset prices increase the time required to close deals.
A pause in transaction activity could occur ahead of the November 2020 presidential election, which would temper volume in H2 2020. Nonetheless, the approximately $478 billion to $502 billion of investment volume expected in 2020 would be one of the highest annual totals this cycle, on par with 2018 and 2019 levels.
Although appetite for risk generally is decreasing at this late stage in the cycle, some investors continue to look for higher yields given the low cost of capital. As a result, certain fast-growing secondary and tertiary markets, as well as alternative asset types (see alternatives section for more information), likely will see increased investment next year.
FIGURE 5: ABUNDANCE OF CAPITAL TO DRIVE INVESTMENT VOLUMES IN 2020
Note: Historical and forecasted volumes exclude entity-level deals.
Source: CBRE Research, Real Capital Analytics, October 2019.
CAP RATES TO EDGE HIGHER BUT INCOME RETURNS WILL REMAIN SOLID
Some property owners will begin to accept lower prices in order to close deals more quickly, but, in aggregate, we anticipate property values will be largely stable next year. However, because NOI is expected to increase faster than property values, cap rates likely will edge up slightly. The minimal increase in the 10-Year Treasury yield anticipated for 2020 will help limit cap rate increases and keep the spread about 200 to 300 bps above the risk-free rate next year.
We expect industrial and office cap rates to increase by 10 bps in 2020 and retail to increase by 20 bps. Multifamily cap rates should decrease by 10 bps, as a period of slower economic growth sustains strong investor interest in rental housing, supporting high valuations but limiting landlords’ ability to hike rents and tapering NOI growth. Increased property taxes levied by underfunded municipalities are also putting additional pressure on NOI.
As appreciation in property values slows, total returns should be lower in 2020 than in recent years. However, income returns will remain steady, making U.S. commercial real estate an attractive, reliable option for both domestic and foreign investors to fortify their portfolios at the outset of a year that is guaranteed to have at least some level of geopolitical and economic turbulence.
FIGURE 6: CAP RATE SPREAD OVER RISK-FREE RATE HAS WIDENED
Source: CBRE Research, U.S. Federal Reserve Board, CBRE Econometric Advisors, October 2019.
U.S. Outlook by Sector
U.S. GDP growth will slow to between 1.5% and 2% in 2020, down from an average of 2.5% over past five years.
U.S. GDP growth will slow notably next year as various issues create higher levels of uncertainty, including the ongoing U.S.-China trade conflict, slowing global growth and a presidential election. Barring any unforeseen risks, we assess that a recession will be avoided, thanks in large part to the stimulatory effects of the Fed’s rate cuts in 2019. Slow growth will continue in 2020, broadly supporting already strong property market fundamentals.
Investment volume in 2020 should total between $478 billion and $502 billion, making it one of the strongest years on record.
Amid slower economic growth and global uncertainty, U.S. commercial real estate will remain a haven for investment in 2020. Greater investor caution and buyer-seller disconnects on pricing could moderately reduce volume from 2019 levels. Cap rates should be broadly stable, with slight compression for multifamily assets and slight increases for the other major sectors for an average spread of about 260 bps over 10-year Treasury yields next year. Investors should not count on significant appreciation returns, but income returns will remain steady.
Demand for office space will remain strong in 2020. Flexible space inventory will continue to increase, but at a slower pace.
Despite continued positive absorption of office space in 2020, rent growth will slow and vacancy will increase. Leasing activity will remain driven by tech tenants, benefiting markets like San Jose, Austin and Salt Lake City. Flexible office providers will strategically expand their footprint but a drawback by WeWork will significantly slow expansion from previous years. CBRE’s forecast is for 51.1 million sq. ft. in completions, a 70-bps increase in vacancy and 1.6% rent growth.
Absorption gains will be limited in 2020, with available supply outpacing demand. Nevertheless, rents will rise by 5%.
Despite some softening in the industrial & logistics (I&L) market, overall fundamentals will remain strong due to continued e-commerce penetration and demand for logistics space. Rent growth will be driven by newly constructed facilities and infill properties. Although there are potential trade-related risks, resilient consumer spending will buoy the I&L market and mitigate any tariff effects on major hubs relying on port activity.
Total U.S. retail sales increased by 3.5% year-over-year in Q3 2019 to $1.57 trillion, however more modest growth is expected in 2020 to $1.55 trillion.
Total U.S. retail sales growth is expected to slow in 2020, as consumers become more cautious. Positive net absorption and rent growth in most U.S. markets will be spurred by a lack of new supply and thousands of retail store openings. Malls are benefiting from the refreshing influence of Generation Zers, who prefer to shop in stores and are driving traffic back to brick-and-mortar retail. Many retail assets will convert to mixed uses, creating communities and thriving town centers.
The multifamily vacancy rate will edge up by 20 basis points to 4.5% in 2020, remaining under its long-term average of 5.1%.
Multifamily is positioned for continued favorable performance in 2020 but will experience some cooling due to new supply outpacing demand. Completions will match peak levels of recent years. New and potential rent control legislation will remain an industry concern. The best opportunities are in suburban markets, smaller metros and metro leaders, including Austin, Atlanta, Phoenix and Boston.
Interest in specialty sectors will continue, with alternatives accounting for more than 12% of all commercial real estate investment in 2019.
Investment in alternative or specialty sectors has risen steadily in recent years and will continue to attract high levels of investor interest and capital in 2020. Total investment in 2020 will come close to the annual average of $59 billion since 2014 and represent 12% of all commercial real estate investment, up from only 6% at the peak of the last cycle. Alternatives acquisition volume in 2020 likely will match this level.
New deliveries will increase the primary data center markets’ total inventory by 17.3% in 2019, increasing the competition between certain markets in 2020.
The wholesale data center sector continues to evolve as flexibility and agility within IT and real estate strategies drive decisions. Transaction volume remains driven by the adoption of Hybrid IT/multi-cloud access strategies by users. Adding momentum headed into 2020, network connectivity should remain a critical component of overall IT and real estate decisions. Demand will continue as users right-size and adapt their portfolios to handle current and future technologies, such as high-performance computing (HPC) and 5G.
