April 24, 2018

Commercial real estate investors look to the coming year with increased optimism thanks in large part to the approval of new tax legislation.

Details are still unfolding on some of the finer points of the recently passed Tax Cuts & Jobs Act.

The country is still waiting for guidance from the IRS and the Treasury Department on exactly how the new rules will be applied in a variety of situations. “There are still a lot of pieces that have to be defined,” says John Chang, national director of research services at Marcus & Millichap. “But investors have a basic framework of the new rules, which is giving them more confidence in the economy and the performance of commercial real estate.” Exclusive research from the first half NREI/Marcus & Millichap Investor Sentiment Survey shows that the Investor Sentiment Index climbed to 163.  The move marks a significant change in course for the Index that had been on a downward trend since early 2016. Sentiment started slipping as uncertainty surrounding the presidential election began to take hold, and the trend continued through 2017 as the direction of federal fiscal, tax and monetary policies came into question. “There were a lot of new conversations that emerged after the election about tax reform, infrastructure spending, economic growth and the new administration’s approach to fiscal policy,” Chang says.

“The Sentiment Index didn’t collapse, but it did move gradually lower as investors became more cautious.”

The approval of the new tax law has provided more clarity and is giving investors renewed confidence in their ability to make informed decisions. “That alleviation of uncertainty is reflected in the boost in the Sentiment Index,” Chang adds. Sixty-eight percent of respondents expect the economy to grow faster as a result of the new tax law, while 71 percent believe tax reform will have a favorable impact on commercial real estate. Survey respondents also are more bullish about their plans to increase their commercial real estate investment in the coming 12 months when compared with the third quarter survey. Two-thirds of respondents (67 percent) plan to increase their commercial real estate investment compared with 59 percent who felt the same in the third quarter last year. Among respondents who expect to grow their real estate holdings, an average increase of 23 percent is predicted. Economy Could Gain Momentum Tax reform could act as a stimulus to the economy on a variety of fronts, such as boosting consumer spending and fueling job growth. Ninety-four percent expect that job growth will be the same or better in 2018 compared with 2017. That optimism continues into 2019 with 83 percent who expect job growth to be the same or better than 2017. “We believe that companies will have increased staffing needs, but they will be battling the particularly tight employment market to acquire talent,” says William E. Hughes, senior vice president of Marcus & Millichap Capital Corp. “The byproduct of that will likely be accelerating. wage growth, and, potentially, inflation risk as we go forward.” Yet respondents do not view inflation as their top concern in the year ahead. Investors rated rising interest rates and unforeseen shocks to the economy as more significant issues at 69 percent and 48 percent, respectively, while inflation was noted as a concern by 29 percent of respondents [Figure 2].

 

Although most respondents (92 percent) anticipate that interest rates will move higher in the coming 12 months, opinions vary on how much rates will rise.

Thirty-nine percent predict an increase of less than 50 basis points; 41 percent expect hikes of 50 to 99 basis points and 12 percent believe 100-plus basis points is more likely. However, those expectations also come on top of rate increases that have already occurred. Based on the survey closing date of Feb. 14, the 10-year Treasury had already increased by 45 basis points this year. “The new tax law will likely have a stimulative effect on the economy, and the Federal Reserve is very cautious about rapidly accelerating inflation. So, they will be tapping the brakes on the economy using the tools at their disposal, including putting upward pressure on interest rates,” Hughes says. Sixty-four percent of respondents cited Fed action as the main factor driving interest rates higher, while 49 percent also predict that rates will rise on expectations of higher inflation

 

Reform Strengthens CRE

In addition, stronger economic growth created by the tax law changes has the potential to accelerate demand for all types of real estate. When asked how the tax law will influence demand for space across specific property types, more respondents said industrial and apartments will benefit the most at 58 percent and 53 percent, respectively. A reduction in tax obligations should boost discretionary spending, which will benefit the entire logistics supply chain. In addition, the significantly higher standard deduction for taxpayers tips the scales slightly in favor of renting versus home ownership, Hughes says. Industrial Engine Remains Strong Investors signaled a modest boost in optimism that real estate values will rise over the next 12 months. However, they are most bullish on industrial with 71 percent of respondents anticipating that values will move higher. Apartment investors followed with 64 percent anticipating gains and 52 percent of mixed-use investors expect values to rise [Figure 5]. Industrial investors also believe this sector will realize the biggest percentage value gain compared with other sectors, with 6 percent appreciation expected. Apartments followed with a 5 percent increase and a 4 percent gain is anticipated for hotels [Figure 6]. E-commerce continues to provide a strong tailwind for industrial. “We have seen vacancies fall to their lowest level on record, and that has occurred even as construction accelerated,” says Alan L. Pontius, senior vice president, national director specialty divisions of Marcus & Millichap. Despite the 240 million square feet of new space that was completed in 2017 and another 190 million square feet planned for 2018, Marcus & Millichap predicts that vacancies will decline from 5.1 percent to 4.9 percent by the end of this year. “Investors see the positive big picture related to the secular shift in industrial, and they also see positive supply and demand dynamics at the local level. So, investors are very optimistic about where industrial is going,” Pontius adds. Industrial investors remain consistent in their views on whether it is a good time to buy, hold or sell. About half (51 percent) of industrial investors consider now the time to buy, while 37 percent consider it a better time to hold and 12 percent prefer to sell.

Retail Perception Swayed by Headlines

Retail is having a tough time shaking negative sentiment. “Retail is still living under the media-driven cloud of e-commerce and a perception that brick and mortar retail will face dramatic challenges,” says Scott Holmes, senior vice president, national director of the National Retail Group and Net Leased Properties Group of Marcus & Millichap. Forty-three percent of retail owners think it is a better time to hold properties compared with 24 percent who want to buy more and 33 percent who prefer to sell. Although nearly half of investors believe retail values will remain unchanged, the overall prediction is for a slight decline in values by 0.3 percent. “People think that if e-commerce is winning, then traditional retail centers must be losing, and that is not the case,” Holmes says. E-commerce and traditional retail centers are becoming more intertwined as online sellers like Amazon expand their real-world footprint, and traditional retailers enhance their online presence. Retail vacancies reached 5.1 percent at the end of last year, their lowest level in more than 17 years. Rents grew by 4.0 percent last year and have returned to parity with pre-recession levels that there is a lot of reinvention occurring in the space with new brands and concepts emerging, such as experience-related stays and hotels that cater to millennials, Nichols adds. “So, investors are looking at hotels with a little bit of rejuvenated optimism,” he says. Marcus & Millichap is predicting that occupancies will rise 30 basis points to an average of 66.3 percent this year, while ADR and RevPAR growth will remain positive with growth of 2.5 percent and 2.8 percent, respectively.