The October 2018 University of St. Thomas / Minnesota Commercial Real Estate Survey is continuing to show to show changes in the sentiment of our panelists as they look out over the next two years. The biannual survey projects a two-year ahead outlook for Minnesota’s commercial real estate industry and forecasts potential opportunities and challenges affecting all commercial real estate sectors.
As was done with all fifteen of our previous surveys, the same group of 50 commercial real estate industry leaders involved in development, finance, and investment were polled regarding their expectations of near-term, future commercial real estate activity. The decisions that these industry leaders are making today will determine what the CRE markets will look like two years from now.
Fall 2018 Results
Observations from October 2018 have recorded several notable changes in the panel’s expectations that were observed in the last survey conducted in December 2017. “There is some concern that we are near the top of the cycle and that overbuilding and increased vacancies may occur in some product types and submarkets.” says Herb Tousley, Director of the Real Estate Programs at the University of St Thomas. “While the forecast for 2020 has become slightly less optimistic, there is no expectation of a major downturn in the commercial real estate market in the Twin Cities. The increase in online shopping, higher interest rates, changes in housing trends and the continued redefinition of the office environment will remain major factors in the performance of commercial real estate in the coming two years.”
Our panelists seem to be most concerned about the expected increase in the cost of building materials and the impact of rising interest rates on values and expected returns for developers and investors. The panel has changed to a more pessimistic outlook on all categories (see the chart at the end of the report). While our respondents are not expecting a major downturn, they are more concerned about future prospects than they have been in our previous surveys.
The composite index of all the other indices the survey continues to indicate a slightly less than neutral expectation looking ahead two years to late 2020. The composite index was recorded at 42. This is slightly less optimistic than the 43 that was recorded a year ago. Index values greater than 50 represent a more optimistic view of the market over the next two years, with values of less than 50 indicating a more pessimistic view. More detailed information about each of the individual indices may be found below.
The individual indexes are detailed below:
The outlook for rental rates has become less optimistic. Market conditions expected in late 2020 are best described by the price for space (rental rates) and the supply of space (occupancy levels). The index for rental rates was 62 compared to 67 one year ago. This means the panel now has a lower expectation of the rate rents will increase for all property types over the next two years. The panel’s sentiment is that the economy will continue to grow and that business conditions will continue improve at slower pace, creating less competition for commercial space.
The outlook for occupancy levels has changed significantly moving from slightly optimistic 52 to more pessimistic 43. This indicates the panelist’s belief that occupancy levels and space absorption may not remain at current levels during the next two years. As a great deal of new product has been delivered the panel is beginning to be concerned about the market’s ability to absorb the new space. This is especially noticeable in the multi-family, office and industrial segments. It is a continuation of a general trend that began 4 years ago. Businesses will continue to grow but they are concentrating on reducing their cost of occupancy by doing more with less space.
Land Price Expectations
The rate of increase in land prices is expected moderate. The land price index has increased (become less pessimistic) in the current survey moving from 38 last in December 2107 to 46 this fall. The lowest point for the index was recorded at 31 in the fall 2013 survey. This index has become somewhat less pessimistic. Although land prices are expected to continue to increase during the next two years, any moderation in the rate of increase would help to keep total project costs in check. Higher land prices are a hindrance to new development, making it more difficult to obtain financing and adequate returns for investors.
Building Material Price Expectations
There is a continued expectation that increases in the price of building materials will continue to accelerate. The index for the price of building supplies remains strongly negative, moving from 24 in December 2017 to 27 in October 2018. The panel believes that commodity prices for lumber, concrete, steel and many of the other materials used in construction will continue to increase due to shortages and newly imposed tariffs. Since building materials are a major cost component of any development project any increases in prices will make it difficult to provide adequate returns on future developments.
Return on Investment Expectations
Our panel expects that investors return on investment expectations will increase. The index for investor’s return expectations has become more pessimistic moving from 42 to 39. This indicates that investors will be expecting to achieve higher returns. The consensus among survey respondents indicates that investors will be seeking higher returns due to their expectation of increasing interest rates and concern about market fundamentals over the next two years. Investors will continue to seek out quality investments but they will be much more diligent about how they price risk and evaluate return when considering their investment options.
Equity and loan to value requirements are expected to remain essentially unchanged. The index for the amount of equity required by lenders has decreased slightly, moving from 42 to 41 in December 2017 to 42 in October 2018. Although interest rates have increased somewhat since our last survey, the panel’s belief that is even if interest rates continue to increase moderately credit will still be available for good projects. However, they expect lenders will continue be more risk adverse by tightening their underwriting criteria in the coming two years.