Western Real Estate Business

SEP 2018

Western Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Western United States.

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56 • September 2018 • Western Real Estate Business www.REBusinessOnline.com CHANGE ON THE HORIZON An overview of the economy and its impact on California's commercial real estate market. By Elliot M. Shirwo C ommercial real estate is intrinsi- cally linked to the economy at national, regional and local lev- els. That's a good thing today and for the immediate term ahead as econom- ic strength continues to benefit almost all major asset classes. Looking longer term, however, a combination of evolving economic, geo-political and industry-driven fac- tors — along with rising interest rates, an expanding trade war, and potential overheating in key markets and seg- ments — indicate a slowdown on the horizon within the next few years. Today, Things Look Good Contributing to the current hawk- ish view at the national level is real GDP growth, which forecasters put at a healthy 3 percent for 2018. At the Fed's June 13th meeting, Chairman Jerome Powell proclaimed the U.S. economy was in "great shape," rais- ing the institution's projections for economic growth and lowering its projections for unemployment. Citing solid economic growth, a strong labor market and inflation close to its 2 percent target, the Fed- eral Reserve raised its benchmark federal funds rate by 25 basis points to the 1.75 percent to 2 percent range, with two more increases expected be- fore year-end. What does all that mean for our cor- ner of the world…commercial real es- tate in California? First, it has translated into commer- cial construction near pre-recession territory. For example, according to Colliers International, new construc- tion totaling 5.2 million square feet is underway in the Los Angeles basin office market alone, three quarters of which will deliver in 2018. However, for a second year in a row, commercial real estate transaction volumes declined in 2017, with the total value of office, industrial, retail and apartment transactions decreas- ing by 13 percent year-over-year. All asset types experienced slower mar- ket activity, except industrial, which increased by 8 percent. Prices continue to increase despite the slowdown in volumes. The Man- ulife Asset Management U.S. Com- mercial Real Estate Outlook for 2018 indicated that apartment, industrial, office and retail average prices were up year-over-year by 10.2 percent, 9.8 percent, 4.1 percent and 3.7 percent, respectively. The view from the Golden State has been quite auspicious as well. Cali- fornia has benefitted from national growth, as well as from domestic ex- pansion within the state itself. This has recently led California to become the world's fifth-largest economy, sur- passing the United Kingdom. Irena Asmundson, the California Department of Finance Chief Econo- mist, also recently noted that all eco- nomic sectors except agriculture con- tributed to California's higher GDP, with financial services and real estate leading the pack. Property Type Snapshots: • Office: According to Marcus & Mil- lichap, almost all major metropolitan areas in California are experiencing office vacancy levels below the nation- al rate of 13.7 percent, with the sole ex- ception of Los Angeles at 14.1 percent. Office vacancy in Los Angeles County rose to 15.6 percent in the first quarter of 2018 with Greater Los Angeles ris- ing to 14.9 percent, Colliers notes. • Industrial: Construction in Cali- fornia has been completed on more than 37 million square feet of indus- trial product over the past four quar- ters. While the Inland Empire and Los Angeles typically garner the most at- tention, the industrial boom is also moving south, with lending sources showing increasing interest in multi- tenant properties in the San Diego submarkets. • Multifamily: The multifamily seg- ment is experiencing a high level of demand. California's average effec- tive rent on multifamily properties rose 4.9 percent over the past year, slightly outpacing the national rate of increase, which is around 4.6 percent, per Marcus & Millichap. • Retail: Recent headlines of big box closures — partially promulgated by online shopping — have contributed to a slightly more pessimistic outlook in the retail sector. But despite the neg- ative headlines, many developers and owners are using the empty boxes as an opportunity to make adjustments, try new concepts and provide what the market is demanding. As a result, some regions are prospering. We'll see what happens to this segment in Cali- fornia, but in an era of fewer available sites for development, re-using empty big box stores provides an opportuni- ty for developers and investors in all markets. Why Things May Change Nothing stays the same forever. Per- haps with a realistic risk of throwing a wrench into the current rosy sce- nario, there are multiple challenging forces at play. This includes a tighten- ing labor market, higher interest rates and inflation and the emerging global trade war. UCLA Anderson's forecast, issued in June, proposed that the markets are signaling higher inflation and interest rates, a shift from slow growth and low interest rates. All things remain- ing the same, the forecast projects a 3-2-1 scenario, with expected growth in 2018 of 3 percent; 2 percent in 2019; and 1 percent in 2020, moving toward a potential recession. USC's Lusk Center for Real Estate looks toward a potential trade war and concluded it could have a signifi- cant negative impact on the value of industrial real estate. This may de- pend on the economic impact of tar- iffs, along with a slowing of construc- tion due to the increased costs for materials, which is where this impact is likely to be felt first. The combination of higher interest rates, potentially overheating proper- ty markets (including oversupply and overvaluation) and evolving demand requirements — coupled with tariffs on exports and imports on a broad va- riety of raw and manufactured goods — will no doubt impact both the sup- ply and demand side of the equation. This could affect a spectrum of prop- erty types. Higher interest rates will impact the cost of capital and borrowing costs for everyone from developers to consum- ers, affecting both lending and new Value of U.S. Commercial Construction Put in Place from 2002 to 2017 (in billion U.S. dollars) Source: Statista 2018 Transaction Volume, Trailing 4Qtr Source: Real Capital Analytics, Manulife Asset Management, as of Dec. 31, 2017 continued next page

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