Presented at CREW Miami’s Luncheon Meeting, January 24, 2018
Guest Speaker: Hugh Kelly, Ph.D, CRE, Special Advisor to Fordham University Real Estate Institute, and Principal, Hugh F. Kelly Real Estate Economics
Economist Hugh Kelly opened his 21st annual presentation to CREW Miami by describing today’s economy as “on a long glide to a soft landing, and soft landings are rare.” That extended duration is a positive, because the modest pace of expansion during the rebound from the Global Financial Crisis has reduced the risk of a deep correction. For 2018, Kelly expects steady economic growth of about 2.5%, but not the 5% that optimists might wish to see. Here is why:
Productivity is limited. The availability of human capital is a major constraint on the economy’s ability to grow. With unemployment at 4.1% and likely to go lower by year’s end, a tight labor market will put pressure on employers, who will have to pay workers more. And there aren’t enough labor force entrants–either young or displaced workers–to achieve employment growth of more than1.5%.
With the gap between short and long term interest rates narrowing, the yield curve is flattening, and that’s usually a precursor to recession. Fixed income markets suggest the economy will slow down in the next few years. “Now is the time for businesses to adapt to contracting economic conditions,” he cautioned. The availability of human capital will shortly match that of physical or financial capital in importance. Kelly recommends that businesses pay close attention now to economic change, plan to carry out disciplined execution of their business plans, and adopt a clear-eyed view toward the end of expansion and a likely recession before 2020.
Supporting Kelly’s forecast were details about insurance costs, capital flow, slipping confidence in the dollar, and analyses of the major real estate market sectors.
The frequency of major natural catastrophes has roughly doubled since 1980; the insurance industry now calculates an average of 82 events per year. The 2017 events cost insurers $306 billion in direct losses, and will result in premium rises for everyone, not only those directly affected by storms, wildfires, flood, or drought. He urges businesses to have contingency plans in place to deal with sudden interruptions, whether of natural or human origin, and to anticipate higher insurance bills.
We should expect US acquisition trends to ease slightly in 2018. Asset pricing shows a risk of correction, which will affect savings accounts, retirees, and businesses that rely on equity The world’s broad money supply is immense, yet real estate transaction volume has slowed in the last few years. He considers that restraint a sign of discipline among investors, who are disinclined to seek yield regardless of risk. There is a continuing need for balance between investment capital and development (debt).
World confidence in the trade-value of the US dollar has been slipping, reflecting concerns about our governance, our debt, and our economic outlook. While we have been euphoric (at least in the equities markets), the world has been more critical. That makes this a time for real estate businesses to plan defense and risk-management strategies on operational and financial fronts.
Office investor preferences are putting some CBD markets in competition with their suburbs. Downtown investment is still 24-hour-city oriented, but of the roughly $112 billion in office investment in 2017, $70 billion was spent on suburban acquisitions. In the past two years, office investor interest has shifted from CBD-only to markets in more-economically-priced suburbs with amenities like walkability, transit access, restaurants and shopping, and proximity to desirable residential areas. Office investors are buying now to hold for later moves; few are selling due to lack of appropriate reinvestment options, thus limiting the number of transactions.
Retail. Department stores are being deconstructed and outlet malls are competing with Amazon. With five times the selling space of Europe, US retail is overbuilt. Prices have been driven down by fast fashion, short runs, and fast turnover, and demand has fallen as millennial buyers consume fewer clothes and household goods. Technology is where retailers must adapt or die, yet tech expenditures erode the bottom line. Kelly sees 2018 as a year of capitulation/acceptance (rather than unconditional surrender) in retail. Rising expenses and lower margins in apparel and other purchases have altered the mix of stores for shopping centers, entertainment and lifestyle centers are doing well.
Industrial is real estate’s feel-good sector, and Miami is in Emerging Trends’ top ten in this sector. Warehouses and fulfillment centers are in demand, as the growth of non-store retailing (ecommerce and mail order houses) has ratcheted up the demand for warehouse space. Just-in-time demand has morphed from the supply chain of producers to last-mile delivery to consumers. This is leading to a rise in construction costs for industrials, as property quality and tech sophistication are replacing tilt-up boxes.
Residential is bifurcated, and that’s a negative. We build on the high end but policies call for more low-end housing. He predicts that the new tax consequences will drag down residential sales. Areas like New York and San Francisco that have both high home values and high local taxation are likely to see downward pressure on home values, putting stress on the financial system and on the economy as a whole. Even before passage of the tax act in December 2017, multifamily housing production was beginning to slow down. That could spur rent bumps–good for apartment building owners, but an added pressure on affordability just when the single family housing sector for the middle class is facing pressures of its own. The US residential market is $27 trillion, while commercial is less than $6 trillion, so any dip in residential activity is significant.
Hospitality is reaching a plateau following a good five-to-six-year run. This is not a disaster, simply a sign of little growth. RevPar is expected to rise by 2%, given that demand is up 1.8%, and supply is up by 1.9%. This sector’s lack of frothiness signals consolidation, with projections approached conservatively, and expectation of gains lower.
On the outlook for multifamily, Kelly said it is part of the housing solution, long term. A third of the US population is looking to rent–it’s part of the affordability equation. For investors, multifamily is less volatile than other sectors because rents can easily be adjusted to market changes. Rentals also have great liquidity on the back end, allowing both small entrepreneurs and big investors to participate in this sector.
On the effects the recent tax cuts: A tax cut is a stimulus, so some of that stimulus will filter to GDP. It might grow by a quarter point. For investors, will their gains be distributed to shareholders or go into Treasuries? Effect on export/import will be positive, while productivity and employment growth will be flat. But lowering taxes means the government will have less to spend. Kelly recommends that governments spend on infrastructure now, while interest is low,