A Look at 2018: A Year of Leasing Highs, Retail Lows and Stock Market Flux
New York City’s real estate scene appeared to have, at first, a meandering, take-it-or-leave-it kind of year.
Yes, it saw a strong business cycle persist into a 10th trip around the sun, strong office leasing citywide and easier-than-ever access to financing. To be sure, there were affordability concerns, infrastructure woes and retail hand-wringing, but that all seemed on track for a relatively unremarkable year.
Key word: seemed. Everything changed last month. On the year’s 317th day, a certain tenant you may have heard of blew into Queens like a new-economy deus ex machina.
“I don’t think many of us saw Amazon coming, but it was a very pleasant surprise,” Michael Cohen, Colliers International’s president for the tri-state region, enthused. “I’d gotten so accustomed to the idea that big companies leave New York that it never occurred to me that a big company would move to New York.”
Though the announcement that Long Island City would be one of Amazon’s two new headquarters (the other is in Virginia) was met by protests from some of the NIMBY crowd, the city’s real estate pooh-bahs sided firmly with the Seattle-based internet giant.
“I think Amazon is a huge, huge positive for our city and for our state,” said William Rudin, the CEO of Rudin Management Company and the chairman of the Real Estate Board of New York. “It’s a game-changer for, obviously, Long Island City, but also for the mayor’s efforts to diversify our economy.”
“We have been actively engaged with the Long Island City community about the future of this site and look forward to our continued work together to create a great project for all,” said Jake Elghanayan, a principal of TF Cornerstone.
Minding the Store
If the enthusiasm around Amazon’s national sweepstakes emphasized the sustained momentum of everything e-tail (a representative for Amazon did not respond to an inquiry for this story) it also set in stark contrast the existential uncertainty surrounding the economy’s old way of selling things.
“This is a moment in time when retail rents are in freefall,” Cohen said.
Sears, the old-as-the-hills home-goods mainstay that revolutionized retail when it introduced catalogs in the 19th century, surrendered to creditors in October—taking down Kmart, a subsidiary, with it. Toys “R” Us, which declared bankruptcy last year, shuttered nearly 800 stores in 2018. Mattress Firm, insolvent as of October, nixed 700 shops.
But in New York City, at least, Rudin observed some sunlight poking through the clouds.
“I’m definitely more optimistic [than I was last year],” Rudin said of the outlook for the city’s storefronts and eateries. “We’re seeing in our portfolio deals and activity in spaces that had not seen activity, including seeing a lot of fast-casual restaurants coming on the scene.”
He noted that Target announced it will open new stores in Astoria, Queens on Staten Island and on the Upper East Side, and added that he’s also seeing the business plans of experiential retailers putting shops to new and creative uses. (Target’s new locations, for instance, are early entries in its new roster of small-format stores.)
Adam Roman, the COO of Stellar Management, noted that while legacy retail institutions may be in full retreat, there’s a crop of modest but nimble businesses finding smart uses for New York storefronts.
“Our view on retail this year was that it’s not as doom and gloom as is often seen in the markets,” Roman noted. “If you can meet the markets on rents, there’s still plenty of demand from small businesses and medium-sized businesses.”
Food halls have offered some of the best opportunities for retail tenants to make new ideas work, with two opening last month in Brooklyn—Japanese Village in Industry City and Hill Country Food Park opening in Downtown Brooklyn.
The only true trouble spots, in Roman’s view, have been “certain pockets of the retail market where the owners [have] needed to hit underwritten rents.”
For asset classes like office space and industrial warehouses, whose fortunes are cast more by the ups and downs of the economy writ large, the year was mostly smooth sailing. Industrial rent growth nationwide continued at the healthy clip it’s maintained since 2012 or so, appearing on track to land in the 6 percent range year-over-year, according to a mid-year report from JLL. And in Manhattan, office leasing eclipsed the 30-million-square-foot mark, blowing past 2017’s annual total in just this year’s first 10 months, per Rudin.
Good business fundamentals helped those trends along. Despite an ever-more volatile political climate, Americans continued to feel hopeful about their economy. Even as President Donald Trump’s tariffs policy threatens to raise the prices of steel, aluminum and goods from China, the University of Michigan’s consumer sentiment survey, a benchmark measure of economic optimism, reached a new post-recession high in March, and has barely budged from that level since. (An abrupt stock market slide might yet weigh on the readings for October and November, which have not yet been tallied.) One source for all that cheer was a consistently rosy employment picture. In each of the last 12 months the economy has added at least 100,000 new jobs, and the monthly gain surpassed 250,000 four times this year.
True, a trio of interest-rate hikes from the Federal Reserve—with a fourth widely expected later this month—put upward pressure on benchmark borrowing costs for real estate investors. But steeper prices for debt could reflect a well-functioning real estate sector, Jay Sugarman, the CEO of iStar, observed.
“If rates are rising because economy is strong, real estate over long periods of time represents an asset class that tends to grow in value,” Sugarman said. “If the driver of higher rates is economic growth, what you’ve really done is raise the replacement cost of all real estate”—good news for owners of existing properties, he pointed out.
But there were also some signs that the economic expansion could be cooling. Despite initial projections for several more Fed rate increases next year, consensus forecasts have retreated. And after a third quarter in 2018 that saw Gross domesitc product growth push into the 3- to 4-percent range, some economists think a more modest pace is in store next year.
At the investment bank’s annual conference in Midtown last week, Steven Ricchiuto, the chief economist at Mizuho Securities USA, predicted a slightly slower economic advance in 2019, pinning up a 2.2 percent estimate for 2019’s GDP growth rate.
“[The next recession] is still probably three years out,” he said, but warned that the current flattish yield curve—a schematic showing the difference between long-term and short-term interest rates—could reflect reduced enthusiasm for where the economy is headed.
As long as the going is good, however, plum New York City real estate has a good chance of supporting a strong investment sales climate, David Amsterdam, Colliers’ president for leasing, investments and the eastern region said in an email. He pointed to industrial distributions centers as an especial bright spot.
“As investor demand wanes from traditional retail, last-mile distribution is essentially filling that gap as the demand is ultimately coming from the end-user: the retail consumer,” Amsterdam wrote. “With very little of that product available in New York City, investors are looking for opportunities to convert existing industrial buildings into viable last-mile facilities.”
Despite an iffy start, office buildings also managed to charm equity investors once the strength of the year’s leasing numbers began to hit home.
“As the year progressed and rental rates were seeing strength, investors turned their attention back to office,” Amsterdam said. “Just recently DivcoWest, a California-based investor, purchased an asset on the Far West Side of Manhattan that has a significant WeWork presence. We are not seeing as much value compression due to co-working tenants as we once were.”
Part of the city real estate industry’s sustained genius is finding new uses for outdated digs—another factor that keeps property values strong.
“One of the things that’s been going on for a long time is that buildings that go obsolete as office buildings regularly get converted to residential,” Michael May, the president of Silverstein Properties’ new lending venture, said, citing Lower Manhattan as one hotbed for such repositionings.
Lend Me Your Year
At first glance, the current trend towards higher interest rates would look to be a direct burden on landlords forced to pay more to lend against their portfolios. But on the frontiers of real estate finance, an ever-more-competitive landscape created a whipsaw effect, squeezing lenders’ margins to keep debt affordable for borrowers.
“We have seen that while borrowers have been cautious, the investment-sales market has not really adjusted much, [even] with the impact of the [higher] base treasury rate,” Warren de Haan, a co-founder of ACORE Capital, said.
On the other hand, he added, if the Fed keeps ratcheting monetary policy tighter, the story could be different next year.
“I would say that at ACORE, we are very concerned about the continual rising-rate environment and its impact on real estate,” de Haan continued. “We haven’t felt or seen the direct impact yet, but we think 2019 will be more reflective of the tighter interest-rate environment.”
Specifically, he noted, the myriad new debt funds that have appeared could start to bifurcate into winners—that is, those that have the wherewithal to take on tough deals that come with wider spreads—and losers.
Doug Mazer, the head of real estate capital markets at Wells Fargo, agreed with that assessment, and especially so when it comes to the commercial mortgage-backed securities sector. Wells is one of the most prolific issuers in the space. If higher benchmark rates continue to erode spreads, Mazer said, smaller competitors could find themselves cornered next year.
“Your best hedge, in CMBS, is issuance: regular issuance. We’re in the moving business, not the storage business.” Mazer said. “The best way [to do that] is to make sure you have critical mass, and it’s easier for larger players to generate critical mass faster. [Smaller CMBS lenders] may be caught flat-footed when spreads widen out.”
But while traditional lenders like Wells Fargo have as firm a spot as ever at the base of the capital stack, the year brought breakout runs for higher-leverage executions that shook up the way less-stabilized assets are funded. Mezzanine debt volumes hit levels they hadn’t matched since before the financial crisis. And collateralized loan obligations—instruments that securitize transitional debt—doubled their 2017 showing.
Lender creativity has also blossomed in the construction financing space, because, subject to harsher capital controls since the financial crisis, big banks have cooled their heels on those loans, Carlton Group CEO Michael Campbell observed. (See page 28 for a Q&A with Campbell.)
“One thing that’s been more difficult to find is construction financing from traditional sources,” he noted. “This year, a lot of debt funds have come in to fill that gap a bit.”
Many Renters Still Priced Out
Upstart construction lenders aren’t the only industry players who found themselves enlisted to fill a vacuum this year. In New York City, getting enough affordable housing online remained a pressing challenge, creating a near-endless range of opportunities for developers skilled at navigating the treacherous waters of city and state agencies that grant incentives to affordable developers.
“Obviously the demand is always going to be extraordinary,” said Jeffrey Levine, the founder and chairman of Douglaston Development, which emphasizes affordable housing work. “There are lots more people living at or near the poverty line than there are in the top 1 percent.”
Stellar’s Roman concurred that with an ever growing, high-paying tech sector, grappling with affordability in the year ahead must be the city’s top priority.
“I think overall, the variety of different levers that are out there are being pushed and pulled, and it seems to be gaining positive momentum,” he said.
Chris Varjan, an investment sales specialist at Lee & Associates, on the other hand, was a bit more guarded about where things stand for tackling the challenge.
“Programs like 70-30 [market-rate-and- affordable buildings] and the rezoning [in Inwood] are headed in the right direction, but I just don’t know that there’s enough scale out there to move mountains,” Varjan said. “There’s a reason these questions come up all the time, and I think it’s because no one’s found the perfect answer yet. We’re not curing cancer yet, but we’re on our way.”
We’re Getting There
Rudin, meanwhile, had his own prescriptions for what the city has to get right in the new year to continue its decade-long roll.
“We have to deal with our infrastructure and the [Metropolitan Transportation Authority],” Rudin said. “We need to really make sure we have a vibrant and functioning transportation system.”
Nor are local politics the only civic questions that look to bear on what sort of year real estate has when the calendar turns. Voters delivered a sharp rebuke to Trump and his Republican allies in November, setting up a split Congress that in January will surely struggle to find common cause on crucial economic questions like health care policy and an ever-expanding national debt. Things have grown so divisive, former Senate Banking Committee Chairman Chris Dodd said last week, that were another financial crisis to crop up, it’d be a miracle of leaders could reach across the aisle to get a relief package passed.
Asked what he makes of the Washington scene, Douglaston’s Levine took a deep breath and said plaintively that he wished that political leaders would do the same.
“We have the far left and the far right on the rise, and they are diametrically opposed,” Levine sighed. “They seem to be the tail wagging the dog. You need the moderates on both sides of the political spectrum to sit down and plan a course for the country.”