Interest Rates, Political Unrest Threaten to Jeopardize Health of Commercial Real Estate, Says Economist
The U.S. economic expansion continues on, extending its long streak of slow but steady growth. The economy has benefitted from years of stability in both the political and monetary realms, but massive paradigm shifts are underway. These changes are breeding uncertainty, which threaten both overall economic expansion and the commercial real estate industry in a way not seen in years.
On the monetary front, years of low and declining interest rates supporting credit markets and asset prices are giving way to a new environment. Rates have risen noticeably since the fall and the Fed is overseeing a tightening cycle. Rising interest rates pose a new challenge to credit conditions and valuations, which has already been reflected in the significant decline in investment volume reported in January by Real Capital Analytics. The sharp rise in interest rates has scuttled the closing of some deals, protracted the closing of others and thrown financing terms for a loop across the board.
The larger uncertainty and concern, however, is emanating from the political realm. The new administration has proposed radical policy shifts to immigration, trade, regulations and taxes. Both the amount of proposed policy changes and their severity are resulting in an uptick in uncertainty.
For example, tariff proposals are a threat to global trade, and their implementation would slow both global and domestic economic growth. The proposed tariffs would have the potential to adversely affect the real estate space by constraining demand for industrial property, especially in markets near large ports or the country’s southern border.
Immigration crackdowns threaten the demographic underpinning of robust growth in many metros, and these crackdowns could result in dramatically higher labor costs for construction across all property segments. Reduced taxes and regulations could be a boon for businesses, but proposals in this realm have been vague at best, and outside of some very narrow financial regulations, do not seem to be one of the administration’s priorities.
While the U.S. economy remains in expansion thanks to a robust labor market, a continuation of this political volatility amid a less supportive monetary environment increases the threat of recession. Payroll gains remain solid, having averaged a gain of just under 189,000 jobs per month over the last six months, while the unemployment rate continues to improve, most recently measuring 4.7 percent. The reduction of slack in the labor market continues to spur wage growth, which is critical at this point in the cycle. Wage growth is a key to continued expansion in multifamily rents and home prices, as affordability has eroded in recent years.
Housing remains a ballast of growth for the economy, with a strong labor market and rising wages combining to fuel gains. Home sales have been trending higher since the recession, and existing home sales recently reached their highest pace of the cycle, surpassing their tax credit peak. (While new home sales dipped at year-end, they had been trending steadily higher until that one month of data.)
Despite the strong sales figures, this cycle of home sales growth has actually been constrained by historically low inventory levels, which have combined with low and declining mortgage rates to push home prices up to peak levels. These low inventory levels could linger for some time, as immigration crackdowns will remove a sizable portion of the home construction labor force, driving up construction costs and constraining the supply side of the market.
Even though mortgage rates are at extremely low levels historically, the Fed has initiated a tightening cycle that in the coming years will raise interest rates, and mortgage rates along with them. Some sources indicate that the current administration is considering some reform to Fannie Mae and Freddie Mac. While no concrete plans have been disseminated, any changes to the GSEs will result in changes in mortgage availability, greatly affecting the housing market.
The industrial side of the economy appears to be stabilizing as well. Oil prices remain well below their heights from a few years ago, and their recent stabilization has reduced a headwind on the U.S. economy, one that was felt most acutely in the Southwest. Capital goods orders appear to have troughed and are seeing modest growth, though they remain below their range from 2012 to 2015. The energy and industrial sectors are not considered growth drivers quite yet, but they are no longer impeding growth.
The robust labor market has resulted in a strong consumer sector as well, and consumer spending continues to reach new heights month after month. This has helped drive the expansion onwards and upwards, but has done nothing to help the retail property sector, as a growing percentage of spending is captured by e-commerce retailers. Retailers have also been outspoken about the rumored border tax, claiming it would drive up costs to consumers by nearly 25 percent and dramatically harm their businesses.
Currently, the economy remains healthy and on solid ground, but for the first time since the U.S. debt ceiling and European debt worries of 2011, the outlook is muddied. Financial markets remain placid and tranquil, but the interest rate and political regimes have completely changed. The current administration has proposed numerous radical shifts to U.S. policy and has been erratic and volatile in its communications and actions in its brief time in office.
This is exacerbated by uncertainty in Europe over Brexit and upcoming elections in France, Italy and Germany, which further threaten the EU’s stability. While there is time for clarity to return, it is hard to imagine the commercial real estate cycle continuing to enjoy its uninterrupted rise amid rising political volatility and rising interest rates.
— By Peter Muoio, chief economist of Ten-X, formerly Auction.com. This article originally appeared in the March issue of Southeast Real Estate Business.