Challenges and Opportunities for Commercial Real Estate in 2015

The outlook for commercial real estate markets and REITs has continued to evolve as the overall macroeconomic recovery matures. It is important to keep in mind just how much the momentum has changed. Two years ago, for example, the consensus outlook among the economists surveyed by the Wall Street Journal anticipated job growth averaging 160,000 per month. In January 2015, this panel expected job growth of 230,000 per month. It is certainly good news that after several years of disappointments, the economy finally appears to be hitting its stride.

There are both challenges and opportunities for commercial real estate in this new macroeconomic environment. The most significant risk would be if the recovery would falter and economic growth fails to maintain its current trajectory. Indeed, concerns about weakness in Europe and our other trading partners have recently clouded the outlook. Adverse developments abroad, however, appear unlikely to derail the U.S. economy, particularly as job growth, consumer confidence and spending have continued to improve.

The rise in construction activity could also crimp the outlook for commercial real estate. Data from the U.S. Census Bureau show that total construction spending on commercial buildings in late 2014 was at an annual rate of nearly $400 billion, up more than 60 percent from its low point in 2011. Yet, despite these sizable increases, construction activity remains well below the peak reached prior to the financial crisis. While one should remain wary of future increases in building activity, construction to date has lagged far behind the growth of the overall economy. Following such a long period with little new activity, most markets still have some catching up to do.

Rounding out the list of potential major challenges is the prospect of increases in interest rates in the year ahead.  Officials at the Federal Reserve have indicated that they anticipate raising short-term interest rates at some point during 2015, and uncertainty about the timing and pace of such moves has at times led to heightened volatility in the stock market. Yet, history has shown that real estate markets often perform well when interest rates rise in the context of accelerating economic activity, as stronger demand for real estate tends to boost occupancy and rent growth.

Still, the current economic landscape holds many positive factors, most importantly that stronger growth in jobs and incomes is boosting demand for all types of real estate.  Office markets receive a direct effect due to the need for space for a larger workforce. Other markets benefit as well, as larger paychecks allow consumers to spend more at the mall, and Millennials who are joining or returning to the work force may be more likely to sign a lease for a new apartment. Stronger economic momentum tends to generate higher absorption and rising occupancy rates across all property types.

Rent growth is likely to pick up as lower vacancy rates give landlords more pricing power. Rent increases were sluggish during the early stages of this economic recovery, as the slow growth of absorption did little to reduce the high vacancy rates in most markets. This is likely to change, however, in an economy with monthly job growth of 230,000 or higher, and the resulting demand for space will likely outpace the increases in new construction.

The financing environment is also supportive of commercial real estate. Real estate markets need adequate financing in order to thrive, and access to capital has improved steadily. Bank loans for commercial real estate rose 6.7 percent in 2014, nearly three times the pace from the year before. Issuance in the CMBS market climbed higher in 2014, though it remains less than half of its pre-crisis peak. REITs raised $64.6 billion in capital in 2014, a bit off the pace of the prior two years, mostly due to a decline in equity issuance. There are several IPOs for REITs reportedly in the works, however, and the robust gains in REIT share prices bode well for seasoned equity issuance in the months ahead.

The recovery in commercial real estate markets, like the economy as a whole, continues to mature without signs of overheating. Further improvements in the economic fundamentals are likely to keep the sector in a solid position to weather the inevitable bumps along the way.

The Market Commentary blog on reit.com presents analysis of the macro- and micro-economic fundamentals impacting the REIT and commercial real estate industry. The Nareit economics team offers their commentary on the state of the market, the outlook for commercial real estate and breaking macroeconomic news. The opinions set forth here are solely those of its author(s), and do not necessarily reflect the views of the Nareit or its membership. For more, see our Terms of Use.