Rental growth coming off the boil in all sectors - Capital Economics
US Commercial Property

Rental growth coming off the boil in all sectors

US Commercial Property Chart Book
Written by Kiran Raichura
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Economic indicators have improved recently, but remain at low levels, meaning that the recovery in GDP growth is likely to be gradual. As a result, occupier demand is likely to continue to slow, keeping upward pressure on vacancy rates and causing rental growth to slow further. But slow growth is moderately positive for capital values, as the low level of Treasury yields keeps property yields on a downward course.

  • Economic indicators have improved recently, but remain at low levels, meaning that the recovery in GDP growth is likely to be gradual. As a result, occupier demand is likely to continue to slow, keeping upward pressure on vacancy rates and causing rental growth to slow further. But slow growth is moderately positive for capital values, as the low level of Treasury yields keeps property yields on a downward course.
  • Economic Indicators point to an improvement over the last few months, albeit only a limited one. The ISM activity indices rebounded, while payrolls strengthened. A gradual recovery in GDP growth will support occupier demand as the year progresses. Strengthening activity means that, despite subdued core CPI inflation, the Fed is set to keep interest rates at current levels.
  • Occupier Market Indicators showed a softening in most sectors, with vacancy rates rising in the apartment, retail and industrial sectors. The office sector bucked the trend, with Q4 2019 net absorption hitting its highest level since Q3 2007 and vacancy stabilising.
  • Office vacancy fell in three of our top six cities this quarter – Boston, Chicago and DC. But this did not prevent a further slowdown in DC asking rents, where growth fell to 0.7% y/y. Boston and NYC also saw slower asking rent growth, whereas LA and San Francisco rents continued to grow at a decent clip.
  • Investment Market Indicators showed a lower level of Q4 activity than in 2018, meaning that annual investment fell slightly. While retail activity weakened, much of the slack was taken up by the industrial and apartment sectors, which continue to attract investor attention. Yield falls in industrial and rises in retail kept capital values growing and falling respectively. (See Chart 1.)
  • Economic Data and Forecast Summary

Chart 1: Capital Value Growth by Sector (% q/q)

Source: MSCI


Economic Indicators

  • Both the manufacturing and non-manufacturing ISM indices strengthened in January, with the former rising to a six-month high of 50.9 and back into expansionary territory (2). Furthermore, while consumer spending and retail sales have been weak, the Conference Board measure of consumer confidence rose in both December and January and is well above its long-term average, suggesting that an improvement is on the horizon. Accordingly, with the risks of a domestic epidemic from the coronavirus well contained, we expect economic growth to gradually accelerate over the course of 2020 (3).
  • Payrolls surprised on the upside in January with a gain of 225,000, which pushed the six-month average back up to 206,000, its highest since July 2018 (4). Average earnings rose by a steady 2.9% annualised in the three months to January, with the annual growth rate slowing from 3.3% to 3.1% in the same period (5). But with the labour market regaining some momentum, we see wage growth improving in 2020.
  • Headline CPI inflation rose again in January, to 2.5% y/y, but core CPI inflation was unchanged at 2.3% y/y and has, if anything, softened in recent months, suggesting that underlying price pressures are subdued (6). We therefore see little pressure on the Fed to raise interest rates even as economic growth gradually accelerates this year. This will also keep Treasury yields close to current levels (7).

Chart 2: ISM Activity Indices

Chart 3: Real GDP Growth (% q/q Ann.)

Chart 4: Change in Payroll Employment (000s)

Chart 5: Average Hourly Earnings (%)

Chart 6: CPI (% y/y)

Chart 7: Interest Rates (%)

Sources: Refinitiv, Capital Economics


Office Market Indicators

  • The usually strong fourth quarter did not disappoint in 2019, with absorption reaching 13m sq ft, the highest quarterly volume since Q3 2007. This drove an uptick in what had been fairly stable numbers since early 2018 (8). One factor enabling this high level of absorption was the strong end to the year for new supply. At 13.7m sq ft, after Q4 2018 this was the highest since Q2 2009 (9). We expect 2020 to be another year of strong supply.
  • Those numbers meant that new supply exceeded demand for the third consecutive year in 2019, nudging the national vacancy rate higher, albeit by just 10 bps (10). The reverse was true in our top six cities, where vacancy fell by 20 bps. This reflected annual falls in five of the six cities – DC was the only exception (11).
  • Despite differences in vacancy changes in 2019, growth in asking rents reached 2.6% y/y at a national level and in our weighted measure of the top six cities (12). That said, we expect a slightly larger rise in vacancy this year, which we think will dampen rental growth. The strongest rental growth amongst our six cities last year was in LA and San Francisco, which we expect to outperform again in 2020 (13).

Chart 8: Office Net Absorption (m sq ft)

Chart 9: Office Completions (m sq ft)

Chart 10: Office Demand and Supply Indicators

Chart 11: Change in City Vacancy Rates (bps)

Chart 12: Asking Rents (% y/y)

Chart 13: Asking Rents in the Major Cities (% y/y)

Sources: Refinitiv, REIS, Capital Economics


Apartment Market Indicators

  • The HVS survey shows that household formation was strong in 2019, at 1.43m (14). Coupled with a record low number of homes for sale, this has kept absorption of apartments strong and rental vacancy rates low. At 7.8% in the fourth quarter, the Census Bureau measure of the rental vacancy rate in buildings with five or more units was at a four-year low. Admittedly, this differs from the small uptick in the REIS measure, from 4.6% to 4.7% (15). But respondents to the NMHC survey have reported a gradual tightening in apartment market conditions over the year, as have developers (16).
  • What’s more, there was a downturn in apartments completed over 2019, with the total of 184,000 the lowest since 2013. That said, with the Census Bureau reporting a steady number of rental apartment starts over the past 18 months, completions look set to recover in 2020 (17).
  • Nevertheless, the small upward trend in vacancy in recent quarters is set to continue, dampening rental growth somewhat (18). However, the pick-up that we expect in earnings growth later this year will provide support to rental values going into 2021 (19).

Chart 14: Annual Household Formation (Millions)

Chart 15: Apartment Vacancy Rates (%)

Chart 16: Surveys of Apt. Market Tightness

Chart 17: Apt. Comps. & Starts for Rent (4-Qt Tot., 000s)

Chart 18: Apartment Vacancy Rate & Asking Rents

Chart 19: Rent & Earnings Growth (% y/y)

Sources: Census Bureau, Refinitiv, REIS, Capital Economics


Retail and Industrial Market Indicators

  • Net absorption of neighbourhood and community (N&C) centre space was essentially zero in Q4, causing the rolling four-quarter average to drop back for a second consecutive quarter (20). This meant that vacancy ticked up marginally, from 10.1% to 10.2%. This contrasted with regional and super-regional malls, where vacancy jumped by 30 bps in Q4 and a total of 70 bps for the year. The closing of the vacancy rate gap between these retail sub-sectors likely reflects department store closures in recent years (21).
  • Rental growth for N&C centres slowed to 0.1% q/q in Q4, the weakest growth since Q4 2012. The year-on-year growth rate fell to 1.2% as a result and is likely to soften further in 2020. No change in regional mall rents in Q4 meant that annual growth in that sub-sector reached only 0.4% y/y (22).
  • Warehousing absorption fell back in 2019, with each of the four quarters seeing lower expansionary activity than in 2018 (23). Completions of new stock also fell back, but a quarterly average of 24.4m over 2019 far outstripped absorption (24). This pushed vacancy up from 9.4% to 9.9% over the course of the year, meaning that rental growth dropped back from 2.8% y/y in Q4 2018 to 2.2% y/y in Q4 2019 (25). That trend of rising vacancy and slowing rental growth is likely to continue into 2020.

Chart 20: N&C Net Absorption (million sq ft)

Chart 21: Vacancy Rate (%)

Chart 22: Retail Asking Rents (% y/y)

Chart 23: Industrial Net Absorption (m sq ft)

Chart 24: Industrial Completions (m sq ft)

Chart 25: Vacancy and Asking Rents

Sources: REIS, Capital Economics


Investment Market Indicators

  • Investment activity reached $163bn in Q4, down 6.5% y/y. This contributed to a continuation of the gradual softening in the four-quarter moving average (26). On an annual basis, there was a 25% drop in retail investment, although this was mostly made up for by an increase of 14% in industrial transactions and an 8% increase in apartment deals (27).
  • The changing patterns of investor demand continue to be reflected in pricing, with retail yields rising and industrial yields falling. Retail yields have now risen by 25 bps since Q3 2018 (28). We are expecting a further rise of around 15 bps in 2020, although N&C centres should hold up better. Along with the rental growth trends noted earlier, these yield shifts mean that retail capital values fell again in Q4. This took the year-on-year decline for the sector to 6% (29).
  • All-property total returns slowed to 5.9% y/y, but the 1.4% q/q outturn was the same as the two previous quarters, suggesting the slowdown has come to an end (30). Indeed, we are forecasting a total return of 7.2% for 2020. At a sector level, retail returns were negative on both a quarterly and an annual basis (31).

Chart 26: Real Estate Investment Activity ($bn)

Chart 27: Investment Activity by Sector ($bn)

Chart 28: NOI Yields by Sector (%)

Chart 29: Capital Value Growth by Sector (% q/q)

Chart 30: All-Property Total Returns (% y/y)

Chart 31: Total Returns by Sector (%, Q4 2019)

Sources: MSCI, Newmark Knight Frank, Capital Economics


Data and Forecast Summary

Main Economic & Market Forecasts

%q/q ann. (%y/y) unless stated

Q3 2019

Q4 2019

Q1 2020

Q2 2020

Q3 2020

Q4 2020

2019

2020

2021

GDP

(+2.1)

(+2.1)

(+2.0)

(+2.0)

(+2.3)

(+2.4)

(+2.3)

(+2.0)

(+2.4)

CPI Inflation

(+1.8)

(+2.0)

(+2.2)

(+1.9)

(+1.9)

(+1.8)

(+1.8)

(+1.9)

(+1.9)

Core CPI Inflation

(+2.3)

(+2.3)

(+2.1)

(+2.1)

(+1.8)

(+1.9)

(+2.2)

(+2.0)

(+2.0)

Unemp. Rate (%), Period Ave.

3.6

3.5

3.6

3.6

3.6

3.6

3.7

3.6

3.5

Household Spending

(+2.9)

(+2.0)

(+2.5)

(+2.6)

(+2.7)

(+2.5)

(+2.6)

(+2.6)

(+2.6)

Earnings Growth/Labour Costs

(+3.2)

(+3.1)

(+3.2)

(+3.3)

(+3.2)

(+3.2)

(+3.2)

(+3.2)

(+3.4)

Case-Shiller House Prices

(+3.2)

(+3.0)

(+2.9)

(+2.6)

(+2.4)

(+2.0)

(+3.0)

(+2.0)

(+3.0)

Fed Funds Rate, End Period (%)

1.75-2.00

1.50-1.75

1.50-1.75

1.50-1.75

1.50-1.75

1.50-1.75

1.50-1.75

1.50-1.75

1.50-1.75

10y Treas. Yld., End Period (%)

1.67

1.92

2.00

2.00

2.00

2.00

1.92

2.00

2.00

3-month LIBOR (%)

0.76

0.79

0.80

0.80

0.90

0.90

0.79

0.90

1.20

5-year Swap Rate, End Period (%)

1.5

1.7

S&P 500, End Period

2977

3231

3300

3300

3300

3300

3231

3300

3500

$/€, End Period

1.10

1.12

1.08

1.06

1.05

1.05

1.12

1.05

1.05

¥/$, End Period

108

109

110

110

110

110

109

110

110

Sources: Refinitiv, Capital Economics


Andrew Burrell, Chief Property Economist, +44 20 7811 3909, andrew.burrell@capitaleconomics.com
Kiran Raichura, Senior Property Economist, +44 20 7811 3917, kiran.raichura@capitaleconomics.com