CRE Fundamentals Solid, But Rising Prices Present Risk

Wells Fargo Securities, Charlotte, N.C., said commercial real estate fundamentals remain on solid ground more than a decade into the expansion, but noted increasing property prices present a clear downside risk.

The U.S. economy marked its 120th month of growth in July, making the current economic expansion the longest on record. Wells Fargo Securities’ Commercial Real Estate Chartbook said the economy remains in decent shape as solid employment growth boosts household income, which sustains consumer spending. But economic growth is clearly “moderating,” the report noted.

“Commercial real estate fundamentals have largely mirrored this trend, with demand softening a bit and new development cooling across most property types,” said the report. “Even with the downshift, property prices remain at or near all-time highs, which is drawing increasing attention from policymakers worried that commercial real estate may be a potential source of contagion that would amplify a slowing in the economy and potentially deepen any subsequent recession.”

Wells Fargo Securities noted the Federal Reserve has cut interest rate 50 basis points since July, and the firm predicted the Fed will cut an additional 50 basis points before and during first quarter 2020. “These cuts will likely lift property valuations even further,” the Chartbook said. “Ascendant property prices are understandable given rents are rising across the board and demand remains generally solid.”

But the report called the contrast between the rise in property prices and slowing economic growth concerning, citing the apartment market as an example. “For much of the expansion, multifamily construction has remained strong and apartment property prices have trended higher as developers have taken advantage of the seismic shift away from homeownership towards renting,” Wells Fargo Securities said. “Undergirding the demand for apartments has been a strong job market, but hiring has lost momentum in recent months, reflecting growing caution in trade-related industries such as manufacturing and logistics.”

While employment has held up relatively well over recent years, some high-profile initial public offerings including Uber, Peloton and office-sharing firm WeWork have run into trouble, which could indicate tougher times to come in the venture capital and private funding markets. “As venture capital becomes dearer, tech firms are likely to become more cautious, which would slow hiring and leasing,” the report said.

The office market is also vulnerable. Some observers including Boston Federal Reserve president Eric Rosengren have expressed concern about the co-working office space in particular. Rosengren said the rise of co-working space “is creating a new type of potential financial stability risk in commercial real estate.”

Wells Fargo Securities said it believes the risks from growing co-working space are somewhat overblown. “We doubt the growing share of co-working leases presents an outsized risk for commercial real estate or the financial system more broadly,” the report said, noting co-working space makes up less than 2 percent of overall office inventory. “…Even in the largest and fastest growing flex markets, which tend to have a heavy presence of creative and knowledge-based industries such as tech, media, R&D and professional services, the ratio of co-working space to total inventory remains relatively low,” the Chartbook said. “Furthermore, it does not appear that U.S. banks are overly exposed to commercial mortgages, and thus the fallout from a potential downswing would likely be contained to the office market.”