The most gratifying and surprising economic news from the first quarter of 2019 had to be the strong stock market recovery after a market-battering fourth quarter that many saw as a harbinger of the next recession. The S&P 500 index rose 13.07%, which is its best first quarter performance since 1998. If you were told at the beginning of January that the market was going to be up 13% for the year, you would have been thrilled.
As the stock market has risen over the last few years, money has poured into real estate funds. The amount of dry powder looking for commercial real estate investments when compared to the annual transaction volume is the highest it has been in years. There is also ample capital for real estate lending with an increasing demand for higher leverage. On the equity side, funds are raising less capital for core investments and more capital for value-add opportunities in search of higher returns. Typically, at the latter stages of the cycle institutional investors get more conservative and purchase more core investments for the stable cash flow. Investors reduce their allocations to the riskier value-add properties where a larger portion of the return is imbedded in appreciation. This psychology is not evident in the current environment which may mean that investors view this market as having more upside or that the threat of recession is not imminent. Whether or not this is a rational decision by the market at large, the amount of capital on the sidelines today has put continued upward pressure on real estate prices as cap rates remain low and, in some cases, are still falling.
As the first quarter ended, the longest government shutdown in history seemed like a distant bad dream and the Washington DC real estate community got back to business. Our market is notable for having the second highest amount of office space in the country under construction and an apartment construction boom that continues to absorb units at a record pace. While job growth in the region is in the middle of the pack of US cities in terms of percentage growth, regional optimism runs high with Amazon’s presence at National Landing taking shape, continued growth of tech and creative office in the region, and an increasing defense budget. The future seems bright and the accompanying chart on Northern Virginia office absorption from Cushman and Wakefield may explain why.
After experiencing the negative effects of the sequester and a lackluster recovery, Northern Virginia has seen strong positive absorption of space and rental rate growth over the last six quarters. The number of tenants currently in the market suggests this trend will continue. While activity in DC proper is also robust, the near-term delivery of significant amounts of new supply creates a different dynamic than in Northern Virginia, i.e. a rising vacancy rate instead of a falling one. DC will be a tenant’s market in the near term. Look for the landlord share of tenant fit out costs in DC to continue rising to some pretty eye-popping numbers.
On the worry list is a growing concern both nationally and in this region about the burgeoning labor shortage. This is reflected in the large number of unfilled tech jobs which is the headline news, but equally critical for the real estate industry is the labor shortage in the construction industry. We all know and welcome the current low unemployment rate, but there are certain trades where young people are not replacing older workers as they retire. For instance, the average age of a welder in the US is 56 and a licensed electrician 55. At the same time, we are making it more difficult for immigrants to fill these jobs. All of this leads to higher costs for new construction and tenant build-outs. A recent research publication from JLL stated “the average cost of an office fit out increased by 12% in 2018.” This trend is affecting everyone in the business. If the cost of construction continues to rise, it may challenge the wisdom of building new buildings vs. buying existing ones.