Since the Great Recession of 2008/2009, the U.S. economy has slowly but steadily improved. This continued to be the case in 2016. For most of the year, the yield on the 10-year treasury remained at historic lows, the economy continued to add jobs, unemployment dropped below 5 percent, real gross domestic product growth settled in at about 2 percent, energy prices remained exceptionally low, and the stock market reached historic highs. Despite all of these positive factors, commercial real estate continues to face some hurdles.
The wild card for the economy at large and for commercial real estate is what will be referred to in this Article as the “Trump Factor.” On the one hand, the Trump Factor could be very positive for the economy: he has plans for significant infrastructure spending, tax reform (including significant tax cuts for corporations, which could result in off-shore jobs returning to the U.S.) and the rolling back of regulations that impede lending and business growth. However, on the other hand, the Trump Factor could “spook” business as a result of the President’s unpredictability and increasing evidence of a tendency to “flip-flop” on policy. As of this writing, it appears that business generally views the Trump Factor positively, as evidenced by the way the stock market has reacted since the election. Another interesting development since the election is the run-up in the 10-year treasury rate of about 1 percent. Although most experts predicted that the Federal Reserve would increase the federal funds rate by one quarter of a point in December (which they did), very few expected such a significant increase in the 10-year treasury rate since the election.
Despite many dire predictions for retail sales and shopping centers in 2016 due to the prolific rise of internet shopping, mostly through Amazon, retailers and retail developers continue to evolve quickly to attract customers. Retail developers are adding largely Amazon-proof uses to their shopping centers. For example, restaurants and fast casual dining have replaced many of the shop tenants that traditionally dominated at shopping centers. In addition, movie theaters have made a major comeback since the Great Recession, and many of them now offer enhanced amenities such as fully reclining seats and high-end food and alcohol offerings. “Experiential” is the buzz-word for retail developers: create an enhanced experience at the shopping center to attract consumers away from their homes. For the most part, even with high-speed internet and large-screen high definition TV in their homes, people still crave interaction in communal environments that provide entertainment and unique shopping experiences.
Since the Great Recession, high end retail and off-price retail have done extremely well. It is everything in the middle that has suffered, most particularly big box category killers (whose offerings can be found as easily or more easily on Amazon) and non-high-end department stores such as Macy’s, Kohl’s and Sears. However, many of these retailers have started making significant strides to attract consumers to their stores or their internet portals. Those that have been successful in their efforts have down-sized, matched Amazon prices, offered better in-store experiences and service, and provided omni-channel options between their own internet sites and stores, with in-store or fast home deliveries.
Taking into account all of the above factors, we predict 2017 will be another good year for most sectors of the retail real estate market, and we expect capital will continue to be available for retail investment sales and borrowing, albeit at a slightly higher cost above the historic lows of the last few years. However, new shopping center construction likely will continue to be largely stagnant in 2017 due to anemic new home building in undeveloped and suburban markets. Retail development likely will continue to be driven mostly by the re-positioning of poorly-performing regional malls, the renovation of existing retail centers, new in-fill development (often paired with a multi-family component), and some new ground-up construction in robust economic pockets such as Silicon Valley.
We also expect that foreign investment will rank as the highest source of available capital for real estate in 2017. The demand for U.S. real estate among foreign capital providers stems largely from geopolitical uncertainties, including the economic downturns in Greece and China and the recent Brexit vote. Many foreign investors still view U.S. investment as the best opportunity for safe growth, as do many domestic investors struggling to obtain returns comparable to the rates of return on commercial real estate. Because of cap rate compression and demand, much of this capital is now flowing into secondary and tertiary markets with the expectation of higher returns.
Although the Dodd-Frank and Bassel III regulatory regimes impose a constraining factor on the growth rate of debt capital, we believe this is not necessarily bad for real estate. In fact, most experts express the view that these regulatory regimes help protect against dislocation between supply and demand, thus diminishing the risk in the near term that the banks and the CMBS industry will repeat the same mistakes they made in the run-up to the Great Recession. Despite the tightening of underwriting standards, we believe the volume of acquisition and refinancing debt capital is in good balance relative to market conditions, with the exception of the continuing undersupply of debt funding for new development. As a result, we expect another year of improving occupancy at retail centers. In addition, because of this continuing conservative placement of capital, we see no clear red flags indicating a real estate recession is imminent.
We expect commercial bank lending for retail projects to continue to be constrained in 2017, much the same as it was in 2016. Loan-to-value ratios for bank permanent loans likely will range from 50% to 70%. Terms likely will be short – typically in the 5 to 10 year range with amortization over 30 years, and interest rates in the vicinity of 2 to 3 basis points over the 10 year Treasury yield (as opposed to 1.5 to 2 basis points over the 10 year Treasury yield in 2015/2016). Banks are expected to continue to show a strong preference for preferred sponsors with development deals in primary and select secondary markets. As has been the case since the Great Recession, significant pre-leasing will be required. These construction loans likely will be short term (i.e., 3 to 5 years), require significant equity (20 to 40%), be recourse obligations of the borrower, and have interest rates in the vicinity of LIBOR plus 3% to 4%, with a “floor” in the neighborhood of 5% to 6%.
As has been the case over the last few years, life insurance companies in 2016 benefitted from the regulatory and other pressures felt by banks, and continued to be a very important source of debt financing for retail buyers and developers. As noted in 2017 Emerging Trends in Real Estate (published by the Urban Land Institute and the accounting and consulting firm pwc) (“Emerging Trends”), “life insurance companies are navigating today’s tricky lending environment with typical care. On the one hand, as the real estate value recovery has reached a mature stage, investment committees still demand strict underwriting as they manage deal flow. On the other hand, the demand for debt capital exceeds available supply and so the insurers can direct funds into assets that they have not traditionally acquired.”
According to Federal Reserve data on loans outstanding, the life insurance industry had $335.8 billion in commercial real estate loans on its books as of the first quarter of 2016. This represented a 13.3 percent market share, a significant increase from their 12.7 percent share in 2015. Although life insurance companies remain the most disciplined real estate lenders, we have seen indications that they will now consider providing construction loans on projects meeting their strict underwriting standards, with the intent of rolling such loans into permanent loans upon project completion and stabilization.
With the exception of the construction lending referenced above, life companies will continue to stick to permanent loan lending, with terms likely to be between 5 and 10 years and loan-to-value ratios likely to be in the vicinity of 65%. We expect most life company permanent loans to be non-recourse loans with fixed interest rates between 5% and 7%, and with amortizations between 25 to 30 years. However, considering the current minor volatility in 10-year treasury yields, life companies may begin to make floating interest rate loans. It is anticipated that life companies will continue to confine the vast majority of their lending to Class A assets.
According to Emerging Trends, “[t]he CMBS market displayed more surprises and plot twist than a Hollywood potboiler in 2016. Last year, Emerging Trends reported specialists expecting volume to hit or exceed $100 billion during the year; it now looks like year-end 2016 volume will be about half of that. Beyond 2017, analysts expect the public debt markets to rebound, filling gaps in bank and life company lending. CMBS turns out to be very good at intermediating credit risk and, at volumes less than half of the bubble’s peak, there is time to underwrite issue with less rush. The quality of the collateral is of paramount importance. If, as appears to be the case, real estate industry fundamentals stay sound, CMBS should be returning to its seat at the table with all the capital needed to be a significant player later in the decade.”
For years, commentators speculated about the stress on the U.S. lending markets once the glut of CMBS loans originated prior to the Great Recession reached maturity. We are currently right in the middle of that so-called “wall of maturities”, but, to the great relief of borrowers, a recovery in values and a deep lineup of debt sources has facilitated sales or refinances at maturity without the long-feared glut of defaults and foreclosures.
Additional players in the debt market are Mortgage REITs and “shadow banks,” although the level of funding from these two sources is small compared to the more traditional debt from banks, life companies and CMBS.
In the equity sector, as leverage has been de-emphasized in the post-financial-crisis environment, the weight accorded to equity increases. Risk may seem to increase as more equity capital is demanded, but lower leverage actually helps reduce the level of equity risk as well, since lower loan to value ratios make the survival of equity a higher probability in a market downturn. As yields get tighter, equity investors see more opportunity through the better yields they receive for providing the additional capital needed to keep the overall debt/equity ratio at a level that makes debt financing viable. A significant number of private equity providers are seeking value-add and opportunistic investments, which means greater investment in secondary and tertiary U.S. markets.
The role of crowdfunding in retail development finance remains small. Crowdfunding is still in its infancy, and is generally viewed as a novel and untested means for raising capital. As a result, crowdfunding is unlikely to grow in the near future to the point where it represents a meaningful competitor to more traditional funding sources.
Despite the uncertainty of the Trump Factor, the U.S. continues to remain the “gold standard” for real estate investment. Considering the expectation of continuation of a low interest rate environment (even with the prospect of gradual increases), low unemployment, low energy prices and a robust U.S. stock market, over the short term we continue to believe that the U.S. economy will outperform other developed markets, thereby continuing to provide an environment for significant capital to find its way to retail real estate investors and borrowers in 2017.