I’ve always believed it’s better to have an opinion and later be found wrong than to be a person who has either no convictions or doesn’t have the courage to express them. So I respectfully disagree with the saying, “It is better to remain silent and be thought a fool than to open your mouth and remove all doubt.”
So where are we headed in 2016? Before I give you my thoughts on this topic, let me start by saying that some of the most important events in 2015 were not anticipated. No one:
- Expected the continuing collapse of oil prices and commodities in general. The average price of gas nationally is currently $1.90 per gallon which is the lowest price since 2009.
- Predicted the flight of millions of refugees from the Middle East, principally from Syria and Iraq, to invade Europe.
- Guessed that Donald Trump would strongly influence the 2016 presidential race.
And I’m confident there will be other important events throughout 2016 that no one, not even the most seasoned prognosticators, will have anticipated. That said, there are really two questions that need to be answered in order to make reasonable predictions about commercial real estate in 2016.
- What is the health of the U.S. economy?
- Where are we currently on the real estate cycle?
Answering those two questions will go a long way in predicting the health of the commercial real estate market in the Pacific Northwest and beyond.
Even though the US economy is still growing at a modest pace there are four adverse factors influencing it:
- A strong US Dollar. The U.S. dollar index is up 9% in 2015 after gaining 13% in 2014. A strong dollar has a dramatic adverse impact on earnings of companies that do a significant amount of business outside the US.
- Depressed Energy Prices. Though we consumers like lower gas prices it is devastating to petro-dependent economies around the world including some US states.
- Rising Interest Rates. The reaction so far has been negligible. However many economist believe there may be several more interest rate hikes coming our way this year.
- China Contagion. We live in an interconnected world. China is our number one trading partner. It appears that they are having significant economic problems. If so it will have a significant impact on the world economy and ours as well.
I believe Tim Duy, economics professor at the University of Oregon, says it best: “One of two things is going to happen. Either the US economy is or will soon be slowing on the back of already tighter financial conditions, or the US economy will soon be slowing on the back of future tighter conditions as directed by the Federal Reserve.”
Last year I coined the phrase, the Silly-Stupid Phase to describe where we are currently at in the real estate cycle. Why silly-stupid? Because investors are buying properties at silly-stupid prices thinking that this phase in the real estate cycle is going to last forever. A useful tool called the Cycle of Market Emotions helps us understand how market phases are interconnected to prevailing moods like optimism, excitement, fear, panic and hope. The market phases look a lot like an emotional roller coaster.
We are presently at the very top of the real estate cycle characterized by euphoria, and for good reason. Rental rates have zoomed up in recent years, vacancies have been curbed, interest rates have are hovering around historic lows. Life has been very, very good for real estate investors. So what could change the rosy picture for real estate in the foreseeable future? I believe a downturn in the economy will eventually impact commercial real estate.
So here are my predictions for 2016:
- This year, 2016, will be the year of transition from a slow but steady economy to one that loses steam and goes into recession. 2016 will be the last good year of economic growth. Before the new president takes office in January 2017, the US economy will be headed toward recession.
- Even though the Federal Reserve is strongly suggesting future interest rate hikes, I believe interest rates for the 5 and 10 year U.S. treasuries will only increase modestly in 2016, maybe 50 basis points, no more. With the economy slowing the Federal Reserve will be hard pressed to raise rates.
- Rental increases will be much more modest than they have been for the past few years. But make no mistake, rents will go up some this year.
- Vacancy rates should remain steady except for possibly Class A apartments. The supply and demand of the upper end of the market may hit equilibrium this year in some submarkets.
- The commercial real estate market will continue being a seller’s market with limited supply of properties for sale causing a further compression of cap rates.
Assuming these five predictions are true, how should those of us in commercial real estate respond? This scenario of one more good year before things begin to turn reminds me of the story of the ant and the grasshopper. The ant prepared for winter during the summer months while the grasshopper relaxed and enjoyed himself. Do you have an “ant” or a “grasshopper” perspective?
I think those of us in commercial real estate, both real estate professionals and investors, need to avoid the dangers of groupthink. Yes, it has been a wonderful ride these past few years. Investors in commercial real estate have made a lot of money since the Great Recession.
But the lemming mentality, “This time is different” is really dangerous. I’ve been told that successful poker players when they’re winning put aside their original stake and then only bet on “house money.” If their luck eventually takes a turn for the worse, they can still walk away from the table without having lost a dime.
That should also be the mentality of those of us in commercial real estate. We need to understand that this phase in the real estate cycle at some point in time is going to come to an end. It’s not a matter of if it will happen, it is only a matter of when. And when it does, we should not be caught with our pants down. On the contrary, we should be preparing ourselves to hunker down for one or possibly two years until the market changes again.
So specifically how do we prepare for what is beyond the Silly-Stupid phase of the real estate cycle?
- Don’t buy properties that don’t make economic sense. If you have a game plan to turn a property around, fine. But if you’re buying a stabilized property with no real issues, don’t expect sharp rent increases to bail you out for buying overpriced properties. Because this time around, it might not happen.
- If you haven’t already taken advantage of low interest rates now is the time. But don’t overleverage your properties. Do whatever you can do to optimize your property’s cash flow.
- Now is the time to be accumulating a rainy day fund. If you’re an investor who is planning to refinance a property, take some of the cash proceeds and put it in the bank. And I mean the bank or money market fund, not the stock market. The equity market is poised for a substantial sell off this year. If you’re a real estate professional whose compensation is based on commissions, now is the time to sock away some of those lucrative commissions you’ve earned instead of spending it on the next expensive man toy. How much should you save? At the very least it should be the equivalent of one year’s worth of personal expenses, probably more.
Forewarned is forearmed. Consider yourself warned.