CRE N Illinois

Forecasting three corners of commercial real estate for 2019

Forecasting three corners of commercial real estate for 2019,ph1

All throughout 2018, the real estate market was once again buoyed by a virile U.S. economy. There may new challenges in 2019 in the forms of rising interest rates, tightening credit and lingering uncertainty over the geopolitical climate, yet many commercial real estate professionals remain bullish on the market going into the new year.

Three experts weighed in on how the real estate market will fare in 2019 in the face of these challenges. Jeff Berta, Steven “Sonny” Ginsberg and Steven Weinstock immersed themselves in interest rates, ruminated on retail and opined on opportunity zones. For more insight into the 2019 market, join them, dozens of other speakers and hundreds of attendees at the 17th annual Commercial Real Estate Forecast, to be held January 8th at the Hyatt Regency Chicago.

Interest rate introspection

With three interest rate increases so far in 2018 and another expected by year’s end, industry experts already are looking ahead to 2019, when several more hikes are expected. Whether the Federal Reserve will follow through on its plan remains to be seen, but investors are mindful of the trend and, in many cases, have already begun structuring deals accordingly.

“Interest rate movement will be front and center in 2019,” said Weinstock, first vice president and regional manager of Marcus & Millichap’s Chicago Oak Brook office and national director of the company’s national land group. “As interest rates go up, we will see some cap rate decompression, particularly for income-producing properties locked into long-term leases without adequate rent bumps to keep pace with inflation and the rising cost of capital.”

Some owners have opted to lock in long-term rates as soon as assets qualify. There has also been a renewed focus on provisions that future buyers might find favorable if they assumed in-place debt, such as transfer and secondary financing rights. Obtaining a good rate now with the right structure can add a lot of value, especially if interest rates increase as expected.

Faced with greater risk today than even a couple of years ago, some developers are getting into the lending and preferred equity business, said Ginsberg, co-founder of Chicago-based real estate law firm Ginsberg Jacobs LLC, whose expertise includes structuring complex debt and equity vehicles.

“Developers can stay in their ‘lane’—be it geographically or through asset class—while shielding themselves from part of the risk,” Ginsberg said. “Because they’ve done similar projects before, they understand the developments better than anyone, and if needed, can step in and see the project through as the developer.”

Ginsberg believes, though, that despite real estate being a cyclical business, the situation now is far healthier and less risky than it was a decade ago. And while there may be a slowdown, he doesn’t expect a crash similar to 2008 thanks to more discretion on both sides of today’s deals.

“Lenders and borrowers who were burned the last time around are putting safeguards in place to ensure the same mistakes aren’t repeated,” said Ginsberg. “In the case of developers and investors, this means making more conservative projections in terms of rent or price growth.”

Time for a retail revival?

Dramatic changes in retail are making some owners and developers re-envision entire shopping centers. According to Berta, senior director of real estate for Chicago-based Structured Development, people continue to go to stores to get the kinds of experiences they can’t get online. Earlier this year, Structured secured a lease with climbing gym Planet Granite at The Shops at Big Deahl, a 500,000-square-foot mixed-use center in Chicago’s Lincoln Park neighborhood that’s scheduled to break ground in spring 2019.

In addition, the firm was recently chosen to develop the remaining parcels in a larger 27-acre master plan in Orland Park, Illinois. Working in collaboration with village officials, the firm envisions a pedestrian-friendly, urban-inspired live/work/play district with residential and commercial uses, including retail.

“We are not focused on big-box retailers as our project is a pedestrian-friendly, downtown-inspired, mixed-use project with smaller-footprint shops,” said Berta. In other words, a return to the type of shopping experience many people had before the big-box era.

Big-box retail may be on life support, but retail as a whole is not dying; in fact, it’s not even ill. With the exception of automobiles, gas stations and restaurants, retail sales have grown year-over-year in all but one month since the beginning of 2010, according to the National Retail Federation, which revised its 2018 sales forecast upward, to a growth rate of 4.5 percent. Moreover, a report from global research and advisory firm IHL Group found that for every retailer closing stores in 2018, two are opening locations, resulting in net growth of over 2,000.

“Many online retailers are moving into brick-and-mortar, which shows how it’s not an either/or decision for many brands; instead, they want both,” said Weinstock. “Amazon’s expansion into traditional storefronts with cutting-edge technology is an example of how the old model is being modified rather than replaced. But the basic fundamentals of real estate, including location, remain largely unchanged.”

When e-tailers do establish a brick-and-mortar presence, many are looking at smaller locations that function primarily as showrooms. Purchases are then shipped to the customer’s home using regular distribution channels, reducing the need for in-store inventory. Most of these spaces are small and focused more about promoting the brand than selling a specific product. As a strong, popular brand can drive foot traffic, many of these tenants are able to negotiate concessions, such as the buildout of their space.

Looking into the Opportunity Zone oracle

The next two years may be the golden era of Opportunity Zones. The program, created by the 2017 Tax Cuts and Jobs Act to leverage private capital to improve distressed areas across the U.S., hopes to tap into investors’ unrealized capital gains—a figure projected to top $6 trillion.

Opportunity Zones have the potential to pump equity into distressed communities with less risk than existed before the funds were created. There are approximately 8,700 Opportunity Zones around the country but with so much capital sitting on the sidelines, some experts question whether there are enough deals available within the designated areas.

“On the surface, Opportunity Zones look like a no-brainer,” said Ginsberg. “The question is, will there be enough opportunity to utilize all the money being raised in a wise manner? And if not, what will the funds do with leftover capital? Investors expecting a gain deferral until 2026 will not want returned funds in 2019 and 2020, and the regs are not yet clear as to whether investors can reinvest returned capital into another Opportunity Zone should any funds be returned.”

There remains some uncertainty for the target communities in terms of the potential for gentrification. Investors, too, have reservations about the program nearly a year after it was introduced.

“I think a lot of people are going to flock to Opportunity Zones in 2019—and there are already investment funds established with billions of dollars—but the picture is much less clear than everybody wants it to be,” Weinstock said. “Recently released guidelines from the IRS and Treasury Department have given investors a better understanding of the program, but many questions still remain. Simply, does the Opportunity Zone, factoring in the initial acquisition cost, additional funds required and potential capital gains savings, produce a desirable return such that investors will move their money into these areas?”

In 2003 REJournals launched what has now become the largest, longest-running commercial real estate forecast event in Chicago, the Midwest and perhaps the U.S. The event brings together the brightest minds and the best dealmakers in the industry to benchmark the industry, and set the tone for the upcoming year. Be sure to register for the 17th annual Commercial Real Estate Forecast on January 8th to hear more from these and many more CRE experts.