A Lingering Financial Crisis Hangover Keeps CRE Humming Through The Longest U.S. Economic Cycle
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A strong jobs report, the stock market performing at record highs and low interest rates continue to fuel U.S. commercial real estate’s prolonged growth cycle. But overall economic growth has fallen as the year progresses, raising commercial real estate’s favorite question: How much longer can it all last?
The Dow and Nasdaq both closed Tuesday at record-high levels, buoyed by investor optimism at a potential pause on the U.S.-China trade war — which has negatively impacted CRE sectors like retail and industrial. October’s 128,000 jobs increase was the 109th straight month of U.S. employment gains, and the U.S. Federal Reserve has worked to extend the economy’s life span, already the longest growth cycle in U.S. history, by cutting interest rates.
One of the most common pastimes in commercial real estate is to speculate over how much life the economy has left in it this cycle. Things are slowing down — gross domestic product growth went from 3.1% in Q1 to 1.9% in Q3, according to the U.S. Bureau of Economic Analysis. But CRE’s play-it-safe attitude this cycle may keep the industry humming along, even in an economic slowdown.
“There’s nothing out there that says just because we’re in year eight, nine or 10 means we now go backward,” Walker & Dunlop Chairman and CEO Willy Walker said. “Just because past cycles have lasted for a certain period of time has zero relevance for this cycle.”
The commercial real estate industry has broken its performance mold this cycle due to slower-than-average growth accompanying the longevity of the expansion. GDP growth usually runs between 3% and 4% following a recession — leading to overbuilding, oversupply, stretched financing and, finally, “the whole thing blows apart,” Walker said.
U.S. GDP growth has been above 3% in the years before every recession since the Great Depression apart from the 1981-1982 recession, according to GDP data from the U.S. Bureau of Economic Analysis. But GDP growth on an annual average has hovered below 3% during this cycle, and there hasn’t been the same glut of building supply that has accompanied past cycles. Lending also continues to be restrained, Walker said.
Walker & Dunlop averaged a 68% loan-to-value ratio in its Q3 deals, he said. Prior to the recession, there were some banks offering as high as 90% LTVs. But post-recession, banks have stuck to lower levels and maintained it for the duration of the current expansion.
“I still, to this moment, don’t get it, other than there’s still a significant hangover from the financial crisis,” he said. “You’d think people would stretch lending standards, but they haven’t.”
Monetary policy, coupled with lending and construction restraint, is also helping the industry.
The Federal Reserve has cut interest rates three times in 2019, and it may take months for CRE to see any material impact, as there is typically a lag between monetary policy and its impact on the overall economy, according to CBRE Global Chief Economist Richard Barkham.
But while economists debate how much CRE will respond to the rate cuts, Barkham is optimistic and says he has already tracked early signs the field is poised to throttle ahead.
“The signs for the economy are quite good and have substantially improved since Q1,” Barkham said. “It’s been an almost perfect monetary policy response.”
There hasn’t been a data set that definitively says the U.S. economy has managed to skip a downturn, but Barkham likes how existing home sales in the U.S. have performed. It isn’t a perfect metric, as sales were down a little more than 2% in September. But sales a month earlier were at a 17-month high, and followed a general upward swing since the spring.
“We’ve seen this happen after the ’08-’09 collapse,” Barkham said. “The first thing to flicker back into light was the housing sector.”
While he notes a slowdown that doesn’t actually turn into a downturn and instead re-accelerates is “a strange scenario,” Barkham also sees why it is working in the U.S. economy’s favor this cycle.
There have been three demand shocks this cycle that each could have sparked a recession on their own, according to the economist:
- The Eurozone crisis led by Brexit, although that has been delayed until December at the earliest.
- The U.S.-China trade war.
- A global manufacturing downturn thanks to slowdowns in the automobile sector, trade war and even Boeing’s crisis following two crashes on its 737 MAX airliner.
While each had the potential to induce the major correction CRE experts have been deliberating for years, the demand shocks were offset by two supply effects, per Barkham: low oil prices and the rise of the sharing economy.
Oil prices today hover between $50 and $60 per barrel, which is well below prices before the Great Recession. Prices eclipsed $140 per barrel in June 2008. In addition, the rise of the sharing economy through services like Airbnb have managed to add new supply to markets without the added cost of constructing a new building.
“The negative demand and positive supply point to what we’ve got: a low-inflation, low-growth elongated cycle, which, as it turns out, has been an extremely good condition for real estate,” Barkham said.
That said, optimism isn't ubiquitous when discussing the economy. While there have been signs the U.S. and China are showing signs of making a new trade deal, an overall deal will arrive in phases, if one ever materializes. GDP growth has beat analyst expectations for the year but have continued to fall, from 3.1% in Q1 to 1.9% in Q3.
“I think undoubtedly we’re closer to the end of the business cycle than to the beginning,” JLL Chief Economist Ryan Severino said. “One way or the other, the economy is slowing. The question is does it slow down enough to tip us into a recession or does it just slow temporarily and has the proverbial soft landing before we skip back up.”
GDP growth dipped below 2% in 2011, 2013 and 2016 this cycle before bouncing back. If a recession were to occur, Severino said the risk is more in the 2020 to 2021 timeline when weaknesses on the corporate side, like manufacturing, would have had time to spill over into the consumer side of business.
“We haven’t seen any indication of that yet, but, the longer this goes on, the more we’ll have to see if there’s any of this spillover effect going on,” he said.