We invest in commercial real estate because there are fewer surprises. Private real estate pricing moves more slowly than the public equity markets because it is illiquid. But it does move in important ways. As we enter a new decade, investors will want to stay ahead of the curve and adjust their private equity real estate strategy for 2020 in light of new threats and opportunities.
Our predictions for 2020 come with a spoiler alert. The property market is a slow ship to turn around, so the terrain will look familiar. We’re on the record forecasting market trends in this article a year ago. While total accuracy is unlikely (even Fed chairman Jerome Powell said he expected rates to rise at least twice in 2019, which never happened), transparency is one of Origin’s core values. That’s why we’re not only sharing our predictions for the coming year based on our assessment of market conditions, but also we’ve prepared a scorecard on our 2019 predictions.
Fortunately, we called 90% of 2019’s real estate market developments correctly, and our correct assumptions have worked in our investors’ favor. So, as we chart our course for a new decade, consider this year’s top 10 list an exercise in accountability; we’ll weigh in with a scorecard at the end of 2020. For now, here’s a countdown of the most impactful 2020 real estate market trends:
10. Private capital will buoy commercial real estate.
Private capital for real estate investment set a new fundraising record in 2019, Preqin research indicates. Meanwhile, the money supply has grown in the past year as the Federal Reserve, rather than raising short-term interest rates, cut them three times. Last year, we mentioned private equity real estate funds, banks and insurance companies will step in to fill the void—and as predicted, property owners have all three sources competing for their loan business today.
9. Margins will tighten for property owners.
Commercial real estate prices reached record highs last year, and right now there are few bargains to be found in multifamily. And with the Federal Reserve standing pat on rates, capital remains economical and properties often sell at top dollar. But this is making it harder to earn high yields because neither salaries nor family incomes are growing fast enough to afford big rent increases. For that reason, extended low rates pave the way for preferred equity investments, which offer robust dividend payments and diminished risk to investors.
8. Rent increases will slow across property types.
In a low inflation, low growth environment, real estate can’t sustain the rising revenue pace of the past few years. Industrial and technology oriented properties such as data centers have seen strong growth in the past 12 months and multifamily rent increases have moderated, as we predicted last year. However, rent rates should moderate in the future even for tech-focused properties and Class A multifamily, although Class B will not slow. Instead, it will continue to go up driven by tenants need for affordability and competition for economical options. Rent increases have been slowest in retail, followed by office and multifamily housing. Demand is still there and valuations are solid, but real estate can’t avoid the impact of the economic slowdown we’ve anticipated in our assumptions.
7. Artificial intelligence will disrupt office space.
Today, well-located urban infill and creative loft spaces are bought and sold at lower cap rates, making them potentially more profitable, while cap rates are rising for generic suburban office buildings, indicating they are riskier properties to purchase. What does this have to do with artificial intelligence? Midlevel office jobs are more vulnerable to being replaced by automation, and this is reflected in the softening prices of those generic suburban office properties built for midlevel bankers, lawyers and accountants. AI resides in data centers, which remains the more popular growth investing option as we predicted. But innovative technology companies will keep demand for creative office space strong as well.
6. Money will flow to multifamily housing and value-add will be overvalued.
Fannie Mae and Freddie Mac provide a liquidity edge for multifamily housing. In the first nine months of 2019, Fannie Mae provided $52.1 billion in multifamily financing, an 18% boost from the year before. This liquidity makes multifamily property pricing more stable and predictable. Investors also continued to favor value-add and opportunistic real estate strategies in 2019, Preqin noted in its Q3 update. For 2020, we believe value-add real estate will be overvalued relative to core and core plus.
5. Residents’ demand for rental housing will remain strong.
Multifamily housing demand will remain strong, as we predicted last year, for two reasons. First, affordability is an issue for many consumers. Second, many young people are still reluctant to put down roots—even when they can afford to do so. Only three out of eight householders under 35 in the Census Bureau’s latest estimate are owners, a slow increase over five years, and three-in-five between 35 and 44 own, which remains statistically unchanged. As Gen Z, the largest cohort to ever live, enters the rental market and downsizing Boomers return, the multifamily housing market will continue to stay strong for now. However since income growth has not kept up with rent growth, rent raises will slow in Class A but not in Class B, as mentioned above.
4. Affordability is the differentiator.
Secondary markets keep growing, but returns are not automatically higher—Austin or Houston multifamily properties have comparable cap rates to those in San Francisco or San Jose, as measured by CBRE. The new growth driver is affordability– PwC’s top markets to watch for 2020 are largely lower cost-of-living cities like Austin, Raleigh-Durham, Nashville and Charlotte. So despite comparable cap rates to high priced markets or gateway cities, these markets are still affordable. This means that rents are low enough to withstand raises, making them good investments.
3. Opportunity zones hit reset.
Politicians may be getting buyer’s remorse over tax breaks for low-income neighborhood investment, and that may be reflected in future reporting requirements. But the program will stay in place despite concerns over who will benefit. Incentives aren’t worth anything unless there’s some opportunity for profit—which suggests that the biggest winners will be in properties on the periphery of population growth, or in growth segments like data centers. But there are a limited number of quality assets in opportunity zones, and fund managers need to move quickly to secure them; the scarce resource is the deal itself. In all of our QOZ deals, we use the same underwriting in opportunity zones as everywhere else to ensure all the investment properties we buy have strong fundamentals and room for healthy IRRs and multiples on investment. Nevertheless, by congressional design the after-tax benefits are long-term and won’t be fully realized for another decade.
2. Destination neighborhoods go a little flat.
With salary increases still lagging, hot urban neighborhoods will grow less affordable and landlords won’t have the same ability to raise rents. Developers will respond with the microflat–600 square feet or less of very efficient convertible space. But high costs might also revive the idea of co-living spaces—basically student housing for working adults, with shared kitchens and lounges.
1. Welcome to hipsturbia.
“Millennials will discover suburbia,” we noted last year, and indeed they have—specifically those that have thriving downtowns with transit hubs, retail, restaurants and cultural offerings that exude urban vibes and promote walkability. Urban Land Institute’s 2020 Emerging Trends in Real Estate report called these vibrant suburban pockets “hipsturbias.” They tend to be about 30% cheaper than urban areas, and millennials are choosing to pay less rent but live here. While affordability will draw these growing families farther from the central city, urban jobs and nightlife will keep them to a short commute. Take West Nashville, 10 minutes from the City’s main “on Main St.” attractions, and maybe an $11 Uber ride. Millennials will make that tradeoff, and in all our markets Origin is developing in affordable multifamily offerings with gyms, coffeeshops and the other experiential shops young renters expect.
Opportunities for growth investing are still available in private real estate this year—as long as we understand changing real estate market trends and use our observations to enforce rigorous underwriting.