These are heady times for commercial real estate. Fueled by cheap money, low levels of new construction (except for apartments), and modestly improving demand, commercial real estate values have more than doubled from their financial-crisis lows of 2009.

Nevertheless, prices are leveling off as investors have become concerned that the period of extraordinarily low interest rates may soon be coming to an end. In addition, job growth—the source of much real estate demand—will inevitably slow as the economy approaches full employment. At the same time, supply will pick up as more construction is completed in 2017 and 2018.

Thus, the overall environment for commercial real estate will become less favorable over the next few years. Further affecting the sector will be technological disruption from e-commerce and reduced square footage of office space per worker.

Continuing Shift toward E-Commerce

A report by Green Street Advisors shows that about 800 department stores—about 20 percent of all anchor space in U.S. malls—will likely close over the next few years, and many malls will close with them. Mall problems are not limited to the anchor department stores: in the first quarter, Simon Property Group, the largest owner of regional U.S. malls, once again reported that same-store sales for in-line shops were down on a year-over-year basis.

It is not that overall retail sales have been declining; to the contrary, retail sales have been increasing at a modest pace. However, a decided shift toward e-commerce has taken place. For example, in April on a year-over-year basis, department store sales declined by 1.7 percent and clothing store sales rose 1.3 percent while nonstore retail (e-commerce) surged by 10.2 percent. Indeed, since 2000 the e-commerce share of retail sales advanced from just under 1 percent to about 8 percent for the first quarter of this year.


However, the data understate the impact of e-commerce on retail sales: with retail sectors not amenable to e-commerce (automobiles, gasoline, food, and restaurants) removed from the calculation, the e-commerce share of sales rises to 14 percent. Moreover, e-commerce since 2000 has accounted for about 30 percent of the growth in retail sales excluding the categories cited above. For just the past five years through April, the e-commerce share of sales growth has increased to 44 percent. Indeed, it would not be surprising in the coming decade to see significant e-commerce penetration in the grocery sector, which currently is not included in the 44 percent share.           

In an effort to stay competitive, major mall operators have ramped up capital spending to make their assets more attractive to consumers, adding restaurants and experiential activities not subject to internet competition. Examples of the high level of capital spending include two competing malls in west Los Angeles—Westfield’s Century City, with an $800 million program, and Taubman’s Beverly Center, with a $500 million program.

Thus far, grocery-oriented shopping centers have been immune to the impact of e-commerce, but with Amazon moving into the private-label grocery business and attempting same-day deliveries, convenience-oriented retail may soon be disrupted as well. Indeed, the still-prized Whole Foods Market anchor is now suffering from increased competition in the organic food space.

Two years ago, it was noted that the bright spot in retail real estate was street-level retail in dense urban centers with significant tourist components. That proved true until very recently, when a strong dollar and weakness in much of the global economy diminished international tourism. As a result, asking rents are beginning to drop in Manhattan, for example, which has been a major beneficiary of luxury tourism.

Industrial: A Beneficiary of E-Commerce

What has been bad for retail real estate has been good for industrial real estate. E-commerce is warehouse intensive, and as the need to shorten delivery times has increased, the demand for close-in modern warehouses in major population centers has soared. Overall warehouse rents have been growing at a 5 percent clip. And in markets such as Los Angeles, East Bay San Francisco, and northern New Jersey, rents have increased at a double-digit pace over last year.

Office: In a Late-Cycle Recovery

After seven years of slow economic recovery, the national office vacancy rate has barely come down—from about 18 percent to 16 percent. New construction has been very sluggish until recently, and demand has been far more muted than in past cycles.

Technological disruption is obviating the need for physical file space and reference rooms, and a shift to open floor plans is reducing the square footage needed per employee. Instead of allowing for 200 square feet (19 sq m) of space per employee, planners are now allowing for 150 square feet (14 sq m). This trend is far from running its course.

One truly bright spot for office demand has been in the technology sector, including computer-systems design and related services, where 120,000 jobs were added in 2015. However, as the venture-capital tech startups wane, employment growth has slowed to 80,000 per year. This slowdown has raised worries about the sustainability of office demand in tech hubs.

Multifamily Housing: Running Out of High-Income Renters

Multifamily residential housing has seen a sustained boom since 2011. Despite a surge in new supply—starts are on track to reach 400,000 units this year—rents continue to climb much faster than the Consumer Price Index (CPI). According to official CPI data, residential rents were up 3.7 percent year-over-year in April, but because of quirks in the data, the true increase in market rents tops 4 percent—and in more than a few markets, the increase is twice that. The rise in rents is supported by a dramatic decline in the apartment vacancy rate, which of late has leveled off at a very low 4.5 percent.

A powerful factor affecting rental demand has been the long decline in homeownership. This partly reflects a preference for a more urban lifestyle and a delay in such life-cycle events as marriage and childbirth. But with the gradual rise in single-family home starts, we believe that the long decline in the homeownership rate has about run its course. Apartment owners may soon discover there might not be enough tenants to support $3,500-a-month rent for one-bedroom units. The apartment business now appears to be in transition from great to good.


The combination of a less favorable financial environment with weakening fundamentals arising from increased supply and reduced demand will likely bring to an end the seven-year bull market in commercial real estate. To be sure, we are in no way forecasting a crash, but rather an extended period of sideways to down prices. Simply put, financial conditions will move from being extraordinarily easy to just plain easy, making it unlikely for us to witness a repetition of the events of 2007–2009.