Q1 2020 COMMERCIAL REAL ESTATE OUTLOOK …...The fundamental economic landscape has soured somewhat over the past 18 months, with year-over-year GDP growth in the U.S. falling from

Q1 2020 COMMERCIAL REAL ESTATE OUTLOOK

Mirroring the broader economy Strong labor markets, solid consumption growth and low interest rates continue to support the market. Like the broader U.S. economy, the dispersion between sectors has grown wider.

Matt MaloneManaging Director

Matt is Managing Director of Real Estate at FS Investments, where he focuses on the growth and management of our real estate platform. His experience as a securities lawyer and Head of Due Diligence informs his unique perspective on the industry. Matt serves as Chair of the Board of Directors of the CFA Society of Washington, DC, and on the Board of Directors of ADISA.

FS Investment Solutions, LLC 201 Rouse Boulevard, Philadelphia, PA 19112 www.fsinvestmentsolutions.com 877-628-8575 Member FINRA/SIPC© 2020 FS Investments www.fsinvestments.com

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

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Investment Research FS Investments 1

Mirroring the broader economy

Executive summary The commercial real estate (CRE) market heads into 2020 looking like a mirror image of the broader economy – still healthy but moderating, with wider dispersion between sectors becoming apparent. Our outlook for Q1 2020 calls for a continuation of this trajectory, with property price growth resuming its moderation after receiving a momentary shot in the arm from lower interest rates.

Macro backdrop: not that bad is good The fundamental economic landscape has soured somewhat over the past 18 months, with year-over-year GDP growth in the U.S. falling from a peak of 3.2% to 2.1% currently. We expect growth to continue on this path and settle in around 1.7% in 2020, a slowdown that would be uncomfortable but not catastrophic. Globally, activity has declined more sharply, with the U.K. and Germany posting negative growth in Q2 and China continuing to slow.

In the U.S., property demand is buttressed by a strong labor market, which continues to support steady consumption growth. Historically low unemployment and rising wages have helped push national vacancy rates to multidecade lows, while strong personal consumption continues to drive healthy rent growth. Business investment represents the other side of the growth coin. Weakness in structures investment has been particularly apparent, which has helped keep property supply moderate and supported price growth.

Capital markets: owing a debt of gratitude Transaction volume in 2019 is on pace to finish 10% lower than 2018, as a dearth of larger entity-level deals has impacted headline numbers. However, underlying demand for individual properties remains robust and has kept up with new supply. Property prices have received a boost from lower interest rates and rose 8.7% year-over-year through November.1 Lower rates have also reduced upward pressure on cap rates, as spreads between the 10-year Treasury and property yields have closed in on cycle averages. We expect price appreciation to continue to be driven by rent growth, with little to no contribution from cap rate compression.

CRE debt markets continue to promote strong demand for property by offering attractive financing. Mortgage rates hit a cycle low of 3.9% as of October 31, widening the spread between cost of debt and property yields, a measure that has historically been positively correlated to overall transaction volume. CMBS issuance hit a post-crisis high in 2019, driven by strong apartment volume, and CRE CLOs continued to gain traction. Debt markets remain open, robust and competitive, with alternative lenders continuing to gain market share. However, metrics still show a disciplined market, with lenders willing to compete on pricing rather than structure.

1 Real Capital Analytics.



Property types: going their separate ways As the current real estate cycle enters its second decade, a performance disparity has grown between different property types. As valuations have reached higher and higher, fundamentals of individual sectors are becoming increasingly important to investors. The delta between the best-performing and worst-performing property types averaged 5% from 2010 through 2017; today that gap is over 12%, the highest since 2005.2 Differences within sectors have also become apparent, including between commercial business district (CBD) and suburban offices. While elevated dispersion has at times signaled a downturn for the space, we see it as more representative of diverging secular trends.

The increased dispersion initially coincided with the tightening of monetary policy, which started in late 2015. Monetary stimulus tends to act as a “rising tide that lifts all ships,” and that is precisely what we saw during the first half of the last decade. Indeed, as the Fed cut rates three times in 2019, a similar effect can be seen: price growth increased across the board going into year-end. With the Fed now (allegedly) on hold, we would expect dispersion to remain and for individual sector fundamentals to drive returns once again.

Macro trends have favored the industrial sector, which has broken away from other property types over the past three years. The market for industrial assets remains strong, driven by the rapid growth of e-commerce and the associated demand for distribution and logistics centers. Meanwhile, although the retail sector faces a challenging structural backdrop and continues to trail other major sectors, it has seen a healthy uptick in price growth over the past few months.

2 Macrobond; NCREIF Property Index.



Macro view: Consumer in the driver’s seatKEY TAKEAWAYS

• The U.S. economic expansion is set to continue.

• The consumer is the engine, and business investment the brakes.

• Policy uncertainty lingers heading into 2020.

The U.S. economy has continued to show impressive

resiliency, even as certain areas such as business

investment and manufacturing have weakened.

Q3 GDP growth of 2.1% surpassed most estimates,

though we expect growth to continue to moderate in

2020. Risks to the outlook remain prominent, including

2020 elections, U.S.-China relations and concerns

around corporate earnings. Central bank easing in

2019 could leave policymakers ill-equipped to deal

with a potential downside shock going forward.

The macroeconomy continues to be supported by

strong personal consumption, which has outpaced

total economic growth in 17 of the past 20 quarters.3

The solid labor market, embodied by a 50-year low

unemployment rate and rising wages, and healthy

household financials have kept U.S. consumers

confident even as uncertainties have crept in.4

Consumption has in turn supported CRE rent levels,

while the tight labor market has helped push vacancy

rates in many sectors to near-decade lows.

While the consumer has been the engine of the

economy, business investment continues to act as the

3 Bureau of Economic Analysis.

brakes. Slowing global growth has dented companies’

appetite to invest in long-term projects. The impact has

been skewed toward the manufacturing sector, where

the ISM Manufacturing PMI has been toiling in

contraction territory since the second half of 2019. One

area of particular weakness has been in nonresidential

structures, where investment has fallen 8.1% year-

over-year. While this can be partially attributed to a

decline in energy production (wells, rigs), softness has

persisted across most sectors. The relative dearth of

new supply has helped keep property prices growing

at a solid clip.4

Heading into 2020, we see three major categories of

risk that could impact markets: the macro, the political,

and the policy. On the macro front, the global economy

continues to show weakness. Slower growth could

impact foreign CRE investment in the U.S., which has

already started to slow. Politically, the 2020

presidential election will be top of mind. The wide

disparity in candidates’ proposals could lead to intense

uncertainty for businesses leading into November.

Finally, policy risks remain. Despite headlines, trade

and Brexit remain far from resolved. Additionally,

monetary and fiscal policy across the globe will be

items to watch heading into next year.

While cyclical risks certainly remain, we continue to

view the domestic macro backdrop as accommodative

for the CRE space.

4 Bureau of Labor Statistics.

$350

$375

$400

$425

$450

$50

$75

$100

$125

$150

$175

$200

2014 2015 2016 2017 2018 2019

NONRESIDENTIAL STRUCTURES INVESTMENT$B, quarterly

Mining exploration, shafts & wells (lhs)

All other (rhs)

Source: Bureau of Economic Analysis.

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

2009 2011 2013 2015 2017 2019

LABOR MARKET

Unemployment rate (lhs)

Average hourly earnings, % y/y (rhs)

Source: Bureau of Labor Statistics.



CRE equity markets: Investors getting pickier KEY TAKEAWAYS

• Price growth ticked up, though return disparity between sectors remains.

• Weak foreign demand has dented volume.

• Flat cap rates imply higher equity risk premium.

CRE property prices continue to grow at a solid clip,

with price growth accelerating somewhat during Q4.

While there is unlikely to be an extended bounce in

price growth, it is a welcome sign that property

demand remains steady. Return dispersion between

sectors continues to grow, with industrial leading the

way and the retail sector lagging.

While total transaction volume in 2019 ran slightly

below last year’s pace, underlying property demand is

solid. Much of the decline can be attributed to an 85%

pro forma decline in entity-level deals, which were

skewed in 2018 by three megadeals that totaled $42B.

In fact, individual asset transaction volume is largely

unchanged from a year ago.1

The dearth of entity-level deals has coincided with a

decline in activity of foreign investors, who tend to

access the U.S. CRE market via larger transactions.

Through Q3, property dispositions have outnumbered

acquisitions by more than $18B, which would

represent by far the lowest annual net activity in the

past decade. Investment from Canada, which

represents about 41% of cross-border volume, has

declined by nearly 25% year-over-year. We will be

watching to see whether global uncertainty continues

to weigh on foreign investment, which during this cycle

has made up 10%–20% of total annual volume.1

Cap rates have declined somewhat recently, but

continue to trend sideways, with each major sector

within 20 bps of levels from a year ago.1 The 10-year

Treasury yield fell 77 bps in 2019 to 1.92%, widening

the cap rate spread to around its long-term average.

We do not expect lower rates to drive significant cap

rate compression, as the increased equity premium

appears warranted given the uncertainties that have

led to the decline in interest rates. Consequently,

income will likely continue to drive the majority of CRE

equity returns.

w

0%

2%

4%

6%

8%

10%

12%

14%

2011 2012 2013 2014 2015 2016 2017 2018

YEAR-OVER-YEAR PRICE GROWTHBy property type

MultifamilyOfficeRetailIndustrial

Source: Real Capital Analytics.

5%

6%

7%

8%

9%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

CRE CAP RATESBy property type, rolling 4-qtr average

Multifamily

Office

Retail

Industrial


-$80

-$60

-$40

-$20

$0

$20

$40

$60

$80

$100

$120

2012 2013 2014 2015 2016 2017 2018 2019(ytd)

FOREIGN INVESTOR ACTIVITY IN U.S. CRE $B

Acquisitions

Dispositions

Net

Source: Real Capital Analytics, as of Q3 2019.



CRE debt markets: Disciplined and supportiveKEY TAKEAWAYS

• Despite low rates, debt growth remains moderate.

• Banks are starting to see higher demand for loans.

• Metrics imply a disciplined lending environment.

CRE debt markets continue to facilitate steady

property transaction volumes. Moderate demand for

financing and attractively low interest rates have

combined to create a debt market that is extremely

functional but not overheated. Year-over-year growth

in outstanding commercial mortgages is running

around 5%, well below levels seen during the latter

part of the past two market cycles.5 Additionally,

underwriting remains disciplined, exemplified by strong

coverage metrics.

As slower economic growth has tested investor

appetites, lower interest rates have acted as a shot of

espresso for transaction volumes. Banks are starting

to see demand for CRE loans pick up (see chart

below) as mortgage rates have fallen about 150 bps

over the past 12 months to a cycle-low 3.9%.1 The

Federal Reserve, which lowered the target Fed Funds

Rate 75 bps in 2019, has now signaled that it expects

to hold rates steady for the foreseeable future. We

expect interest rates to remain low, keeping debt

financing attractive as property yields hold steady.

The CMBS market, which represents the third-largest

source of capital for borrowers after banks and

government-sponsored enterprises (GSEs), depicts a

positive picture for CRE debt. Delinquency rates on

CMBS loans recently reached a post-crisis low of

2.34%, and spreads on AAA rated tranches have

declined below long-term averages, signaling strong

investor demand. Additionally, CMBS issuance is on

pace to finish 2019 consistent with levels seen over

the past six years, reinforcing the notion that debt

markets are functional but not excessive.6

Metrics for the entire CRE debt market remain

constructive. Loan-to-value (LTV) ratios, declining for

much of the current cycle, have risen somewhat in

recent months, but currently sit at 62%, below the

long-term average of 64%. Market debt yield, which is

a ratio of a property’s net operating income to its total

debt, recently hit 11% for the first time since 2013, a

sign both of healthy rent growth and prudent capital

structures. Finally, debt service coverage remains a

bright spot at nearly 2.0x.1

We see debt capital as readily available but not

indiscriminate, as total debt continues to grow at a

modest pace and metrics appear healthy. Low rates

should continue to support transaction volumes into

2020.

w

5 U.S. Federal Reserve. 6 Bloomberg Finance, L.P.

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

2013 2014 2015 2016 2017 2018 2019

DEMAND FOR CRE LOANSNet % of banks reporting stronger demand

Source: Federal Reserve Senior Loan Officer Opinion Survery.

1.4x

1.5x

1.6x

1.7x

1.8x

1.9x

2.0x

2.1x

2.2x

2.3x

2011 2012 2013 2014 2015 2016 2017 2018 2019

DEBT SERVICE COVERAGE RATIO (DSCR)




Retail: Consumption remains key support KEY TAKEAWAYS

• Pace of retail growth trails other sectors.

• Modest price growth despite challenging backdrop.

• Transition away from stand-alone stores to mixed-use spaces will continue.

Retail prices have experienced the slowest growth of

all major CRE sectors in 2019, rising approximately

3.3% year to date.1 The sector continues to face

structural challenges, with department stores and mid-

priced apparel retailers feeling the brunt of the

industry’s slowdown. Cushman & Wakefield notes

more than 25 retailers have filed for bankruptcy

through Q3, with more on the watchlist.7 Against this

backdrop, it is notable that prices on retail properties

have, in fact, continued to grow in 2019.

The sector was supported by a solid macro tailwind

throughout 2019. Specifically, the labor market

continues to be strong heading into 2020 – the

unemployment rate reached a 50-year low in Q4 2019

– while consumer sentiment remained near its 20-year

7 Cushman & Wakefield MarketBeat: U.S. Shopping Center, Q3 2019.

high. Consumer spending was lower in 2019 than a

year earlier but continued to be relatively firm. At the

same time, the sector has also benefited from a

considerable consolidation over the past several

years. As the chart highlights, retail deliveries reached

a post-crisis peak of approximately 26M square feet in

2015 but have declined each year since. Through Q3,

deliveries totaled only 11.3M square feet, a significant

decline from last year and far below the 10-year

average of approximately 25M square feet.8

Economic projections remain relatively sanguine

heading into 2020, which should likely help prolong

retail’s slow momentum into the new year. We also

look for the sector to continue its longer-term evolution

away from stand-alone stores, with the majority of new

development in 2020 and beyond likely focusing on

experiential and mixed-use projects that include

housing, office or entertainment elements. There is

currently more than 345M square feet of major, new

mixed-use retail projects in the works, with the recently

completed American Dream mall in Northern New

Jersey as an example.8

8 JLL Research Report Retail Outlook, Q2 2019.

0

10

20

30

40

50

60

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

RETAIL DELIVERIES REACH A NEW LOWMSF

Source: Cushman & Wakefield Research, as of Q3 2019.



Industrial: Demand keeps sector on top KEY TAKEAWAYS

• The consumer shift to e-commerce continues to provide a tailwind.

• Industrial sector leads CRE in activity and returns.

• Supply may be coming more in line with demand.

Spurred on by e-commerce’s rapid growth over the

past decade, the industrial sector continued to drive

overall activity within the commercial real estate

market. Though final numbers have not yet been

released, the U.S. industrial market was set to absorb

more than 200M square feet of space in 2019 for the

sixth consecutive year, which would make it the

longest period of sustained demand ever.9 Transaction

volume spiked in Q3 2019, largely a result of one large

(nearly $19B) industrial transaction. Against this

backdrop, price returns in 2019 have significantly

eclipsed those of the previous year, helping industrial

buck the broader trend of moderating returns across

other parts of the CRE market.1

9 Cushman & Wakefield MarketBeat: U.S. Industrial, Q3 2019.

Driven by vacancy rates of approximately 2% or below

within major markets including Savannah, GA, Los

Angeles and Orange Counties, CA, and Central New

Jersey, the national industrial vacancy rate remained

at an all-time low of just 4.8% through both Q2 and Q3

2019. Such tight market conditions have helped

continue to drive up asking rents across the sector and

particularly within the warehouse/distribution segment,

which saw Q3 rents rise more than 8% from a year

earlier.11

After years of new construction, supply could slightly

outpace demand in 2020 (by about 0.2%) for the first

time since the financial crisis.10 The potential

imbalance shouldn’t notably disrupt rent growth,

however, as CBRE forecasts rent growth to rise 5% in

2020.3 E-commerce suppliers will likely continue to

focus on higher-quality and smaller warehouse space

in populated areas as they increasingly work toward

same-day delivery. As the chart shows, this transition

began in earnest in 2019, which saw a significant

increase in leasing activity for warehouses below 100K

square feet and virtually no leasing activity for spaces

over 1M square feet.10

10 JLL Industrial Outlook, Q3 2019.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

10K-50K 50K-99K 500K-749K 750K-999K Over 1msf

2019 LEASES FOCUSED ON SMALLER SPACES

2018

2019

Source: Jones Lang LaSalle Research, as of Q3 2019. Square footage of industrial leases



Office: Vacancies low in changing sector KEY TAKEAWAYS

• The vacancy rate hits a cycle low.

• Fundamentals remain sound; price growth ticks up.

• Asking rents trend upward, led by technology and co-working projects.

Transaction volume within the office sector has been

split in recent months between solid year-over-year

gains for offices in central business districts (CBD) and

significant declines (20% or greater) within suburban

office spaces. Altogether, transaction volume across

the entire sector averaged a small year-over-year

decline of approximately 5% versus a year earlier.1

The decline could reflect the broader trend of slow

growth among office-using jobs as work becomes

increasingly flexible. Annual growth in office-using

employment through November 2019, for example,

was just 1.6% and is expected to slow to just 0.3%

next year despite a still-healthy employment picture in

the U.S.11

Despite the significant bifurcation in transaction

volume across suburban and CBD offices, the sector

remains fundamentally healthy. At 12.9%, the national

office vacancy rate is at its lowest point since late 2007

and the number of individual markets that experienced

11 Moody’s Analytics; CBRE, 2020 U.S. Real Estate Market Outlook.

an increase in vacancies was at its smallest in three

years.12 Technology companies accounted for

approximately 31% of all leases signed nationally

during Q3. During the year, however, the trio of

technology, co-working spaces and finance together

dominated office leasing activity, representing nearly

44% of all office leases nationally.13 As the chart

highlights, co-working has grown rapidly in recent

years – from just 1.3% of all office leases signed in

2014 to nearly 13% in 2019.14 Co-working’s share of

office leases slowed late in 2019 and could decline

somewhat further in 2020 given the well-publicized

concerns surrounding WeWork.

With vacancy rates at cycle lows across the sector,

asking rents continued to rise at a steady 4% clip from

a year earlier.9 Rent growth remains strongest in tech-

oriented markets, with asking rents in Silicon Valley,

Austin and San Francisco climbing more than 15%.

Such significant rent growth is difficult to maintain,

however, and Cushman & Wakefield looks for it to

slow in 2020 in both tech-oriented markets and

nationally.

12 Cushman & Wakefield MarketBeat: U.S. Office, Q3 2019. 13 JLL Office Outlook, Q3 2019.

19.3%13.6%

7.3%

4.1%

51.0%

52.5%

21.0%

17.3%

1.3%12.5%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2014 2019

RAPID GROWTH IN CO-WORKING CHANGES OFFICE CREShare of leasing activity

Finance

Law firms

Other

Technology

Co-working

Source: Jones Lang LaSalle Research.



Multifamily: Renter demand drives growth KEY TAKEAWAYS

• Price growth ticks upward.

• The national vacancy rate reaches a cycle low.

• Rent controls regulations are a potential headwind.

Year-over-year price growth within the multifamily

market began to slow in June 2018, declining from a

recent peak of nearly 13% to 7.5% by July 2019. In

recent months, it has picked up modestly, eclipsing 9%

by November 2019.1 Through Q3 2019, price growth

has been driven by activity in nonmajor (secondary

and tertiary) markets, which saw 10% growth, whereas

major markets saw weaker growth of about 4%.14

Despite the more moderate pace of price growth

compared to 2017 and 2018, demand for multifamily

housing remains healthy. The national vacancy rate of

just 3.7% reached its lowest point since 2001, a

decline that can be partially attributed to discipline

among developers. Year to date deliveries of 190,000

units, for example, represented an 8.4% decrease

from the same period in 2018. As has been the case

14 Cushman & Wakefield MarketBeat: U.S. Multifamily Market, Q3 2019.

through the past several years, growth in transaction

activity was generally highest within sunbelt cities

(Phoenix, Tampa and Las Vegas, for example) as well

as those that feature a significant tech presence (San

Francisco, Boston, Seattle and San Diego).14

While home ownership has become more affordable

over the past 18 months as mortgage rates declined in

2019 near their long-term lows, housing prices remain

a significant issue for first-time homebuyers compared

to earlier in the decade.15 Though housing affordability

(or lack thereof) represents a larger macro concern, it

may continue to act as a tailwind for the multifamily

sector, adding to the size of the pool of potential

renters. Alternatively, new rent control regulations,

which are either scheduled for debate in 2020 across

several states or have been recently enacted, could

serve as a headwind in 2020, potentially stifling new

multifamily development.

15 National Association of Realtors, Housing Affordability Index.

6%

7%

8%

9%

10%

11%

12%

13%

14%

Jan-18 May-18 Sep-18 Jan-19 May-19 Sep-19

MULTIFAMILY PRICE GROWTH RECOVERSYear-over-year price growth


Documents

Q1 2020 COMMERCIAL REAL ESTATE OUTLOOK …...The fundamental economic landscape has soured somewhat over the past 18 months, with year-over-year GDP growth in the U.S. falling from