Trends in Commercial Real Estate Services

Friday, October 26, 2018

The commercial real estate (CRE) services industry is growing relatively quickly and represents a broad variety of services provided to property managers, investors, and tenants/occupiers of commercial real estate. According to Cushman & Wakefield, total annual spending on global commercial real estate should grow 5% annually over the next four years (reaching $4 trillion), which is slightly above the IMF's projection for GDP growth of roughly 3.8%-3.9% globally from 2018 to 2020.

Secular Growth Drivers in the CRE Industry

Global services analyst Stephen Sheldon believes there are three fundamental secular growth drivers in the CRE industry that are likely to drive more industry consolidation to the benefit of the larger players (the top five CRE firms are estimated to generate only roughly one-fifth of total CRE services spend). These trends have been discussed by many of the larger CRE service providers and thus are fairly well-known across the industry.

  1. Clients consolidating vendor lists. "We believe that many users/owners of CRE assets are consolidating vendor lists," stated Sheldon, "which mainly benefits the larger players that can provide a comprehensive suite of solutions in the CRE industry across a variety of regions." Using fewer vendors allows clients to spend less time on vendor management, creates greater cost efficiencies, and typically allows for more consistent service delivery across regions. It is also likely viewed as less risky from a client's perspective to use one larger provider than using a range of smaller ones. However, the consolidation trend appears to be in the early stages, as most CRE clients still use a variety of CRE service providers.
     
  2. Increasing propensity to outsource commercial real estate services. Owners and occupiers of real estate assets have been increasingly prone to purchasing outsourced solutions from CRE firms. Many of the firms that provide outsourced CRE services have seen strong growth in these areas. There are multiple positive factors from firms increasing their percentage of outsourcing, including more sustainability/visibility into the revenue base (typically operate under multiyear contracts), more defensibility in a market downturn (more so than the capital markets and leasing businesses), and cross-selling opportunities, particularly within the leasing businesses.
     
  3. Institutional ownership of CRE assets increasing. Overall ownership of CRE assets by institutions has trended higher over the last 10 years. While it is difficult to quantify this trend (i.e., the actual institutional versus non-institutional ownership across all CRE assets), it has been discussed by many industry participants and is likely providing a positive tailwind, since institutions typically transact more frequently (boost to the capital markets and leasing businesses) and are more prone to outsourcing. One of the ways to monitor this trend is the overall investment allocation by portfolio managers to the real estate asset class. "We believe that many PMs now view real estate allocations separately from the broader 'alternative asset' allocation," said Sheldon. According to the 2017 Institutional Real Estate Allocations Monitor report (surveyed 244 institutional investors across 28 countries), the average allocation to real estate assets surpassed the 10% level for the first time in 2017 (10.1%) and was expected to trend up another 20 basis points in 2018 (to 10.3%). This higher allocation has led to an inflow of new capital and increased activity in the CRE sector.
     

Sheldon views the current conditions in the CRE industry as relatively stable. The tightening monetary policy in the United States could be a slight headwind for the industry over the next few years given that rising interest rates can have a negative impact on asset values and increase the cost of capital. However, interest rates (specifically the 10-year Treasury yield) are still forecast to be low relative to historical levels, and the headwind from rising rates could arguably be offset by the potential economic impact of lower tax rates and a generally more positive GDP growth outlook. Capitalization rates in the U.S. CRE sector have trended down over the last few years, mainly because of increasing asset prices. However, the average yield spread (capitalization rate against the 10-year Treasury) is currently at about 3.9%, which is slightly below the historical average of about 4.5%. "We believe there would have to be either significant increases in interest rates or unexpected volatility to make a meaningful difference in underlying activity in the CRE sector—the spread compression indicates that firms are taking more risk," Sheldon stated. Therefore, if macroeconomic conditions remain stable over the next few years, he believes it would support underlying activity.

Vacancy rates for CRE assets in the United States have trended down since 2010, with demand outpacing the level of new supply in most asset classes. With vacancy rates trending down, rental prices have steadily increased since reaching a bottom between 2010 and 2013; however, the pace of rental growth has started to decelerate across most asset classes, with growth now in the low single digits in the U.S., down from the midsingle digits in 2014 and 2015. Sheldon believes that rental growth has slowed as new supply has entered the market. Generally, the moderately low vacancy rates and growing rental rates should continue to attract healthy levels of investment in commercial real estate assets in the near term (barring any significant change in the macroeconomic environment).

Cyclicality and Performance in the Prior Recession

The commercial real estate industry faced significant challenges during the last recession (2007 to 2009). Given these challenges, we believe that many investors continue to debate the way in which CRE firms would be affected by another economic downturn. Sheldon analyzes the cyclicality of these businesses based on both industry data and the trends at some of the large CRE players during the last recession. At the highest level, the capital markets businesses (mainly investment sales and debt placement) were severely affected from 2007 to 2009 (overall volumes down close to 80%), while leasing also saw some modest declines (much less pronounced than capital markets). However, the outsourcing businesses for the larger CRE firms held up well. Beyond lower levels of leverage across the industry relative to 10 years ago, Sheldon believes that the growth and stability of the outsourcing businesses should provide support to the larger CRE service providers in the event of a broader market downturn. Therefore, he does not believe a market downturn in this cycle is likely to be nearly as pronounced for the CRE service providers as it was during the last recession. Sheldon analyzes the trends in the three larger service lines for the larger CRE service providers and the overall exposure to these service lines, and believes the growing percentage of revenue and profit generated from the more stable outsourcing businesses is underappreciated by investors.

First, Sheldon believes the most cyclical service line by far is the capital markets business for CRE firms. According to data from CoStar, U.S. investment sales volume declined from roughly $460 billion in 2007 to $111 billion in 2009 (a decline of roughly 76% from peak to trough). The peak-to-trough decline according to Real Capital Analytics was more pronounced at roughly 88% from 2007 to 2009. Therefore, overall investment sales volume in the United States declined significantly in the last recession, although volumes subsequently increased steadily from 2010 to 2015.

Second, the leasing service line appeared to hold up better for CRE firms, but it also displayed some level of cyclicality. According to data from CoStar, the volume of square footage leased in the U.S. during the last recession was down roughly 7% peak to trough (2007 to 2009). Sheldon views this business line as somewhat recurring; "leasing activity can be delayed in certain periods, but the activity usually still happens at some point." Overall, the leasing businesses displayed some cyclicality in the last recession, but to a much lesser degree than seen in the capital markets businesses.

Third, the outsourcing businesses (which include property management, facilities management, and project management) appeared to hold up well in the last recession for the big players. These businesses are usually provided under multiyear contracts with some fixed-pricing components, which can provide underlying stability even when market conditions weaken. Most CRE service providers have seen a growing percentage of their revenue and profit come from the outsourcing businesses.

This report initiated coverage of Cushman & Wakefield plc. For more information on this or other companies from Stephen Sheldon's coverage list, please contact your William Blair sales representative.

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