Commercial Real Estate Chartbook

Over a decade into the expansion, commercial real estate fundamentals remain on solid footing, although ascendant property prices present a clear downside risk.

The U.S. economy passed an important milestone earlier this summer. July marked the 120th month since the recession ended, making the current expansion the longest on record. Ten years in, the economy remains in decent shape, as solid employment growth continues to bolster household income and sustain consumer spending. While household fianances are solid, economic growth is clearly moderating, reflecting the trade war, slower growth abroad and a persistent cloud of policy uncertainty weighing on business investment and manufacturing.

Commercial real estate fundamentals have largely mirrored this trend, with demand softening a bit and new development cooling across most property types. 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. The Fed has cut interest rate 50 bps since July, and we expect an additional 50 bps of cuts, likely in Q4 and Q1-2020. These cuts will likely lift property valuations even further. Over the past 10 years the Commercial Property Price Index has risen more than 87%, and it rose 6.7% over the year through August. Ascendant property prices are understandable given rents are rising across the board and demand remains generally solid. The contrast between the rise in property prices and downshift in economic growth is nevertheless concerning.

The apartment market serves as a clear 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. Since 2007, the apartment property price index has risen faster than any other major property type and is 76% above its prior peak. Lofty valuations are arguably justified, given a modern-era low in apartment vacancies. New construction has also been skewed toward higher end urban/lifestyle projects, while suburban apartment development and workforce housing have generally lagged.

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. The slowdown has not been quite as apparent in the creative and knowledge-based industries, such as finance, tech and professional services, which we in part attribute to a still fairly robust pipeline of venture capital. These industries tend to cluster in the large gateway and secondary markets where there is an ample supply of highly educated labor, whose apartment markets have outperformed as a result.

The Bay Area, Boston and Austin have been clear benefactors, with apartment rents continuing to climb alongside a seemingly endless stream of venture capital funding, which supports many of the fastest growing industries in these markets. While employment has held up relatively well, some high profile Initial Public Offerings have run into trouble, which might be a harbinger of tougher times 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 office market is similarly vulnerable, particularly co-working office space, which has benefited from these same trends. Observers have already begun to express concern, most notably Boston Federal Reserve president Eric Rosengren, who recently noted that the rise of co-working space is "creating a new type of potential financial stability risk in commercial real estate." The wellpublicized trials and tribulations surrounding a potential public offering for WeWork, the largest co-working company in the United States, has reignited the debate surrounding the long-term durability of the flexible office space model. The risks are pretty straightforward, although we believe they are somewhat overblown. Co-working firms, which typically take on long-term leases with property owners and re-lease the space on a short term basis, would likely be especially vulnerable to falling occupancy and declining rents that typically occur during a downturn. As tenants fail to renew the short-term leases, the loss of lease payments would also likely lead to a higher incidence of loan defaults.

We doubt the growing share of co-working leases presents an outsized risk for commercial real estate or the financial system more broadly. While flexible office space represents roughly one-third of all new office leases over the past 18 months and total square footage has more than doubled since 2015, occupied co-working space is estimated to be just under 2% of overall inventory. Coworking companies have their largest footprints in San Francisco, Manhattan and Los Angeles, but are expanding rapidly in up-and-coming secondary markets such as Austin, Denver, and Raleigh- Durham. But 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. Moreover, not all the firms leasing co-working space are small and thinly capitalized businesses. Many are divisions of large companies or satellite R&D facilities that are looking to quickly ramp up. Co-working space makes this fairly easy. 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. Today, commercial mortgages amount to nearly 11% of the total financial assets of the U.S. banking system, which is not out of line in a historical context.

Even though there is less exposure than widely thought, the next recession may not be particularly kind to the co-working space model. During the prior two recessions, employment in "office-using" sectors fell relatively further than overall employment, reflecting the deep cutbacks in the tech sector following the long 1990s expansion and massive job losses in financial services following the housing bust (Figure 6). Co-working tenants predominantly include categories of workers which tend to feel the negative impacts of a recession early, such as startups, freelancers and entrepreneurs. A downturn would also halt the vast amount of venture capital flowing into startups, which would evaporate the primary wellspring of funding on which they depend.

Still, even if the flex office model bends during the next recession, it likely will not break. While WeWork and Regus rank as two of the largest co-working companies, there are over 200 other small and mid-sized operators such as Impact Hub, Convene and Knotel. Co-working space provides just-in-time office space, which enables both new and established firms to gain efficiencies by acquiring work stations and meeting rooms on an as-needed basis. Additionally, the average space per chair in a flex office is estimated to be 60 sq. ft., considerably smaller than the 194 sq. ft. in the traditional office layout. A more open and collaborative working environment with streamlined technological and business services only adds to the potential productivity gains.

By offering a suite of amenities such as beverage service and access to gyms, restaurants and retail, flex offices also provide creative ways to attract and retain younger workers, a segment growing in importance as more Baby Boomers exit the labor force. Moreover, even large organizations such as Microsoft, KPMG and IBM are beginning to see the benefits of the flex office model, which allows firms to gradually expand into new markets without making long-term commitments. This may serve to limit the downside risks of a downturn. Mitsubishi UFJ Financial Group recently leased enough WeWork space for 300 fintech employees in Charlotte, which allows it to immediately focus on hiring and more quickly ramp up its operations.

The efficiencies achieved through co-working may have tempered the real estate cycle. As with apartments, much of the growth in the office market has taken place in the Central Business District or next largest employment center in a handful of rapidly growing metropolitan areas. There have been relatively few spec office towers developed during this cycle, although co-working space is providing much of the flexibility that spec space did in the past. Overall office vacancy rates remain relatively low, particularly relative to the latter period of past business cycles.

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