Market Volatility and Real Estate: What the 2018 1st Quarter Looks Like

I bet you want to know more about what’s going with real estate, specifically as it relates to the properties your own, right now. Well, I see 3 things at work:

1 – the overall market and economy
2 – the interpretation by the experts and media
3 – what actual property owners like yourself are doing

When it comes to the economy, GDP expected to grow by 2.5%. Unemployment is incredibly low at 4.1%. The Fed is expected to increase rates 3 times this year, and Jay Powell said on Monday “The next couple of years look quite strong. I would expect the next two years to be good years for the economy.” The volatility index is still below risk levels. Generally a level below 20 is a stable market and over 30 is a market that is probably close to a turning point. On February 28th it closed at 19.85.

Now let’s look at the interpretation by the experts and the media. Last month I attended the annual forecast meeting of the Society for Chartered Financial Analysts. It was set in the Biltmore Hotel in downtown LA, with a beautiful dinner reception and an open bar – and it looked like anyone who was anyone wanted to be there. Not for the open bar, mind you. But to pick the brains of other people in the industry. The overall consensus was that times are good and will be good for a while longer. The market, today, is hot, it is a bull market. We have had 3 corrections since 2009, 20% in 2011, 15 in 2015/16, and 10 in 2018. Many economists put us at year 9 of an 18 year on average secular bull market. At the same time, there is not all good news, since interest rates are rising and likely to go above 3% this year. What is that going to do to cap rates? What is that going to do to where investors decide to invest? Should they even be investing now? There is a lot of uncertainty.

And there should be. Leaving the dinner, my wife and I were waiting in the valet line to get our car. Accidentally, we ended up standing right behind the host of the event – Jane Wells from CNBC. Do you guys recognize the name? She is a well known for financial programming. Anyway, as we were standing right behind her, she started talking to her acquaintance about WebVan. Does anyone remember WebVan? You see, I remember WebVan. I went big into WebVan. I invested most of my savings and was buying on margin. Jane Wells also did the same. In 1999 WebVan was a dotcom darling with a huge IPO. Everyone thought it was the next best thing. Until it went belly up in 2001. The market turned and all that we were left with were worthless stock certificates. Jane told us she had her framed as a reminder of the changing cycles.

The moral of this story is that it’s only hindsight that’s 20/20. What seemed like a great idea in 1999 turned out to be a total flop in 2001. The market can turn very quickly. Since we don’t have a crystal ball to look into, the best we can do is understand how the economy is effecting the market we are in.

Lets look at our market – I am specifically referring to office and retail properties between Encino and Thousand Oaks, and between 5,000 and 150,000 square feet, since that’s where most of you own properties. Even if you own something not described by these, it is the understanding of the trends that matter more than any specific datum.

So in our market, office sales volume was up 50% in 2017 to 329M. Retail sales volume was down 77% to 53.44M. This could be due to a number of factors including people waiting to see what was going to happen with tax reform. What we have seen a lot of too, is a lot of sellers wanting to sell, but not knowing what they would exchange into, so they sit on the sidelines. For office, maybe people were responding to the low unemployment figures.

According the Costar, the average asking office rent is $2.35 psf, The average asking retail rent is $2.73 psf, Two things are interesting in this graph. First, it looks like the slope of the rental rate curve for office has become less steep, that rents may not be increasing more. Second, that retail rents have risen above their peak at the end of 2007.

Occupancy has been leveling out since 2015 and is at 88.2% for office and retail has been pretty steady and is at 95%.

Office cap rates are low at an average of 5.95% for office and 4.67% for retail. Office appears to be leveling off.

Integra Realty Resources puts our suburban office market in stage 3 of the recovery cycle. In their model of the cycles though, to hit the expansion stage we should still see moderate new construction – which we aren’t seeing, high absorption – which we aren’t seeing, employment growth – which may be present, but growth unlikely as unemployment is already below the natural rate, and rental rate growth – which looks like it has flattened out. So the conclusion here is that it could be a stage 3 of recovery cycle, or we could bypass the expansion and hypersupply stages all together and go right into the down cycle.

The actual property owners we are talking to, seem to be more skeptical of state of the economy. Everyone seems to be asking the same question – how do we capitalize on the current market and how do we secure our position if the market does turn? With rents being high and CAP rates reaching such lows, many owners do see this as a good time to sell and to shift into more passive and less volatile properties like NNN. Depending on their holding period goals, some find more security in taking advantage of the high prices now, then waiting for the next growth cycle. Office and retail sellers are in a power position right now, since the apartment cap rates are totally cost prohibitive, leaving buyers more hungry for office and retail.

In conclusion, the positive indicators in the economy are also facing the increasing interest rates, which could lead to the shift in the current environment. Our best advise to you is stay informed, review your goals and decide what’s a more appealing strategy for you situation – a switch for a more conservative portfolio or a long term hold.