Is the US market reaching a cyclical turning point?

The US's eight-year economic expansion is maturing. What are the growth prospects in the economy and real estate? 

16th December 2016

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The US economy emerged from the Great Financial Crisis (GFC) in mid-2009. Already the third-longest recovery since WWII, its eight-year expansion is clearly maturing, and the growth outlook has implications for the real estate sector. This article outlines our thinking on the current position and likely near-term path for both the US economy and core real estate sectors.

Economic Overview

Real GDP has been very uneven since the US emerged from recession (Chart 1). It has struggled to maintain a modest 2.0% average rate of growth; far below its normal post-recession trajectory of 3.5% - 4.0% p.a. Despite its lack of strong momentum, there is less slack in the economy than is generally recognised.

Labour force slack is diminishing.  Unemployment is already a low 4.9%, and job growth has slowed as firms struggle to locate qualified workers.  Although job openings are at an all-time high, employment gains have fallen from 229,000 per month in 2015 to 180,000 per month thus far in 2016.  Labour force participation will continue to move up and underemployment to fall.  Wage and salary income has begun to accelerate meaningfully in response to tightening labour market conditions.  

Inflation is not as quiescent as it appears.  Core CPI (excluding volatile energy and food components) has been steady at 2.2% for many months, just above the Fed’s 2.0% target. Headline inflation has already risen from 1.1% in August to 1.6% in October and is expected to rise further as last year’s oil price declines and US dollar appreciation drop out of the year-on-year comparisons, converging to core inflation.

There is a growing disconnect between corporate operating performance, which has deteriorated on a year-on-year basis for five consecutive quarters and the general stock market, which continues to reach new highs. Consumer, investor, and business confidence is good but very fragile, yielding considerable volatility when events fail to unfold as expected.

Although growth will continue to be positive in the near term, we believe the Fed will raise interest rates more quickly than the consensus currently projects as signs of overheating develop.  The economy will slow in response. We believe that the probability of a recession in the next five years is high, and assume it will start by 2019; ten years after recovery began.

Unlike the last US downturn, which significantly impacted all geographic regions and all sectors of the economy, this should be a more “normal” cyclical recession, i.e. three – four quarters long; real GDP decline of 1.75% - 2.0%; loss of ~3.0 million jobs; unemployment rate rising from 4.5% -7.5%; impact focused in one or more economic sector(s) and geographic region(s). The economy will return to positive growth thereafter and expand through mid-decade. 


The Real Estate Environment

Apartment softening:  First and fastest to recover from the 2008-09 downturn, the apartment sector has passed its peak and begun to soften.  Multifamily construction is both significant and widespread across markets.  Since mid-2015, quarterly completions have exceeded rental demand and in 2016 less than 80% of new units being delivered have been absorbed.  Pittsburgh, San Francisco, and Philadelphia stand out for the size of their apartment pipelines; expected completions in all three will be four to five times their respective long-term average, despite rising vacancy.  Although still low at 4.5%, US apartment vacancy has been gradually rising (Chart 2).  Average effective rent growth still exceeds inflation but has been progressively easing. However demographic trends are becoming less favorable for the sector as the key rental cohort of 20-34 year olds will add fewer than 0.3 million in each of the next ten years, after expanding by 0.8 million annually since 2007.


Office stabilising:  The office sector made substantial progress during the past two years with vacancy rates falling 180 bps. Although fundamentals continue to improve, progress is decelerating as demand/supply fundamentals approach balance.  Office construction pipelines are expanding.  Although activity has begun broadening to include more metro areas, development remains fairly concentrated: two-thirds of the ~100 million square feet currently underway are in ten metros, including New York, Chicago (financial); San Francisco, San Jose, Boston (Tech); Dallas and Houston (energy). Meanwhile half of the 63 markets tracked by CBRE-EA report little or no new rental product underway. Vacancy rates in the top ten metros range from a low of 6.5% (San Francisco) to a high of 17.5% (both Dallas and Houston).

Demand for office space continues to exceed new supply.  Vacancy has declined only 10 bps, to 13.0% in 2016 (Chart 3).  The nation’s downtown markets – where most office construction is taking place – led the recovery but are now beginning to cool.  By contrast, suburban submarkets continue to improve (although at 14.3% Q3 suburban vacancy is still 360 bps above the CBD average).  Office rent growth has also slowed significantly this year, from a robust 4.3% yoy rate in Q1 2016 to 1.4% yoy by Q3 2016.  Slowing job growth will constrain further office sector improvement, even if construction stabilises near its current level. Because of the sector’s strong cyclicality and the wide divergence in conditions across individual markets, office trends will most appropriately be evaluated on a metro-by-metro basis.

Retail uneven: Retail real estate has been contending with significant structural change as well as lingering impacts from the severe 2008-09 downturn. Post-recession retail sales growth has been dominated by non-store retailers (Amazon). Consequently demand for bricks and mortar space has been weak and inconsistent, which has suppressed new supply in many US metros. As a result, vacancy has fallen very slowly from its mid-2011 peak.  Effective retail rent only turned positive in 2014, but is gathering pace, rising 2.4% (yoy) in Q3 2016. Although consumer spending is strengthening, retail sector improvement will continue to be uneven as retailers struggle to integrate online and store-based offerings into a profitable omni-channel operation. 

Returns moderating: Quarterly return for NCREIF’s benchmark all-sector index (NPI) peaked at 3.6% in Q1 2015, and has declined steadily to 2.0% in Q3 2016. After posting six consecutive years of double-digit returns (2010-2015), the NPI was 9.2% above its year-ago level in Q3 2016.  Deceleration has focused in its appreciation component, as is typical in a maturing expansion.        


We are no longer in a “rising tide lifts all boats” environment.  As the cycle continues to turn, a solid understanding of individual metro economies and markets and of real estate sector characteristics become critical in order to optimize investment and portfolio management decisions.  With a Trump administration entering office in January 2017, our contention that inflation and interest rates will rise more sharply and quickly has greater plausibility.  If implemented, the president-elect’s campaign promise of ample fiscal stimulus in the form of spending expansion and tax reduction would bolster near-term growth, although lower trade flows could be a potential offset. Economists continue to parse the tea leaves about his plans and priorities  


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