As we approach 2020, real estate fundamentals continue to be strong. However, it’s likely we are approaching the end of the positive run of the current commercial real estate cycle. The state of the economy at large has economists locked in a debate over many warning signs. Trade wars, recent inversions of the yield curve, impeachment talks and worsening global economic forecasts fuel speculation about a possible market downturn in 2020 or 2021, although projections, timing and beliefs over which variables pose the most serious threat vary significantly. Regardless of the possible market decline or recession, opportunities still exist in the real estate and debt sectors. These areas are worth watching as we move into a new year.
High Financing Demand for Affordable & Workforce Housing
The U.S. has a severe housing shortage, particularly in the affordable and workforce space. The majority of multifamily product built over the past 10 years are Class A; this leaves the affordable and workforce market supply extremely constrained. According to the National Low-Income Housing Coalition’s 2019 “Out of Reach” report, the private market has lost more than 2.5 million low-cost rental units since 1990, leaving a shortage of seven million affordable homes to adequately serve the country’s 11 million families with the lowest incomes.
Rising construction costs contribute to this problem, as does a lack of government incentives for new supply. This is why the financing of existing affordable housing is critical. A potential downturn will only continue to drive demand for this product type, as people will have an even greater need for lower cost housing as unemployment rises and the market takes a hit.
Buyers and owners can benefit from extremely low rates. The Federal Reserve’s multiple interest rate cuts in 2019 are driving high loan demand and ample opportunities for commercial real estate borrowers. It’s unknown how long rates will remain this low, so now is the time for borrowers seeking debt for affordable rental properties to lock in lower long-term rates.
Increased Activity in Secondary/Tertiary Markets
Primary markets such as Los Angeles, New York City and San Francisco are often top-of-mind when thinking about the affordable and workforce housing crisis. However, the affordable housing issue also confounds secondary and tertiary markets such as Charleston, South Carolina, Raleigh, North Carolina and Austin, Texas. According to Yardi Matrix, secondary and tertiary markets such as Pensacola, Florida; Wilmington, North Carolina; Midland-Odessa, Texas; Las Vegas and Phoenix led the way in national year-over-year rent growth.
This creates an opportunity for multifamily owners and buyers to help fill this gap, while reaping a strong return on investment on their investment. Secondary and tertiary markets offer cap rates that are 150 to 200 basis points higher than their primary market counterparts, creating stronger cash flow. Buyers and owners should always conduct due diligence. There is a somewhat greater risk of tenant turnover in less populated markets, particularly in a downturn, but vacancy rates across markets of all sizes continue to be at record lows.
Opportunities in Distressed Debt
Should the real estate market slide, defaults of bridge and other commercial real estate loans will inevitably rise, and the institutions holding these assets on their balance sheets will seek to offload them. Banks, likely with the help of the Federal Deposit Insurance Corp., will seek to dispose of nonperforming loans in bulk, providing incredible upside for sophisticated investors with the ability and infrastructure to work out troubled assets. Opportunities such as these showcase why debt remains one of the best investments throughout the real estate cycle, from the peak through recession.
As we enter 2020 with increased economic uncertainty, it’s clear that ample opportunity remains in the workforce and affordable multifamily space, including in secondary and tertiary markets. If a market decline does occur, it will present increased opportunities in distressed debt. Buyers, owners, investors and lenders who are nimble enough to seize opportunity amidst shifting market dynamics are likely to fare well in the face of a downturn.
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