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The US economic recovery, it has been said, has been on a steady but uneven journey since the devastating financial crash of 2008. While the big picture story is a positive one—growth is here, fundamentals are strong and the future looks solid—the mercurial path of this growth forces commercial real estate firms to play a mental game of chess as they try to anticipate these twists and turns.

Consider Preston Despenas, co-founder and senior partner of Chicago-based Growth Equity Group, a real estate company specializing in income-producing properties. A few years ago, he was developing single-family homes and multifamily properties on the Mississippi Gulf Coast, namely Gulfport. His thinking: the demand for homes would increase as more workers were needed at the port to handle the increased ship traffic expected from the Panama Canal's expansion.

But the mother lode, as he came to realize, will be the demand for housing in Virginia when the third set of locks at the Panama Canal becomes operational next year. “The Port of Virginia is ideally situated on the East Coast to handle post-Panamax traffic and its demographics and fundamentals support multifamily growth,” Despenas says.

The upshot of this turnaround in thinking? The company has begun acquiring multifamily assets in the vicinity. Within 24 months it expects to have done some $100 million of deals in the commonwealth.

Or consider the falling prospects of some once-high-flying locales in Texas and North Dakota.

Houston, for example, has a robust office construction pipeline, with many of the projects launched when the price of oil was $100 per barrel. Now it is half of that, give or take, and energy companies headquartered in Houston have announced significant cutbacks, including layoffs. It is being openly wondered by some in the city whether office demand will be enough to meet the expected supply.

Apartment rents in certain cities in North Dakota, such as Williston, have dropped a surprising 15% to 20% over the past two months. Property managers, as a Reuters report recently noted, have gone from being extraordinarily choosey about their tenants to practically offering to move in their belongings—all within a matter of weeks.

In a big respect, this is the nature of business: unforeseen risk emerges and businesses must be prepared to roll with it, or fall by the wayside. This dynamic is being felt more acutely in this particular business cycle because of the depth of the recession and the long slog it took to recovery.

Even the term “recovery” is loaded depending on who is using it and how. For example, job growth is undoubtedly on an upward trajectory. In February, the US Labor Department reported that the unemployment rate dropped to 5.5% from 5.7% in January, overshooting estimates from economists that expected a total of 240,000 jobs created for the month and a drop to 5.6% for an unemployment rate.

But throughout the recovery concerns have been voiced about stagnating wages and consumers' still-very-tight budgets. Only now, after six years of economic turnaround, does that appear ready to change, according to a prediction from Cushman & Wakefield. It cites several factors, including the continuing decline of the unemployment rate to 5.5%, now the lowest level in almost seven years.

“In addition, the Labor Department's broader unemployment measure—including those working part time who want full time work and those who are marginally attached to the labor force—was at 11% in February, the lowest level since September 2008,” it said in a report. “The last time these unemployment measures were this low, average hourly earnings were increasing at an annual rate of more than 3%.”

Indeed, C&W is not alone in its projection. In a separate study, about 70% of CFOs surveyed in Duke University/CFO Magazine's global business quarterly outlook said they expect they will have to increase worker pay by at least 3% in the coming months. In addition, 63% said their companies recently increased or plan to raise wages shortly; 26% of those respondents said they did so because they were having trouble attracting or retaining skilled employees.

“Finally, we are starting to see wage growth for employees that outstrips inflation,” says John Graham, a finance professor at Duke's Fuqua School of Business, in a statement. “Given that CFOs expect continued strong employment growth, it is surprising that wage pressures are not even greater.”

The bottom line is this, says Scott Homa, JLL's Mid-Atlantic research director: Most sectors of the US economy are adding jobs at this point, and the country is in the midst of a broad recovery. Leisure, hospitality, education, health, construction, even manufacturing are all growing quickly. “When you see diversified markets like Chicago, Philadelphia, Miami, Phoenix and Atlanta post a collective 11.9 million square feet of absorption in a year like they did in 2014, that's a sign of a broad recovery,” he says.

That said, commercial real estate investment across the country is a bit more nuanced, he continues. “Developers have been slow to take on additional risk in markets that were hit hard by the recession,” says Homa. “There is virtually no new office construction underway in Miami, Phoenix and Atlanta, despite the fact that vacancy has fallen below 15% and those markets are witnessing statistically significant rent growth. Meanwhile, in a lagging market like Washington, DC, where the industry drivers are producing below-average employment gains, we're still seeing healthy flows of investment capital and record-high sales prices. This is driven in large part by foreign capital, and offshore investors seeking to reduce currency risk via purchases of long-term stabilized assets, rather than current leasing fundamentals.”

For those of us keeping count, here is where Homa sees the opportunities at this moment in time:

• Leasing conditions are tightening throughout the Sunbelt and West Coast and rent growth is not artificial due to new supply flooding the market, but rather due to sharp increases in demand from expanding or relocating companies.

• There has been hiring in a variety of sectors in various cities. Education and health/R&D has experienced growth in Cambridge, Philadelphia's University City, the Ballard/U District in Seattle and the South Main/Medical Center district in Houston (so much for worrying about energy companies' pullback).

• Tech firms are hiring, not surprisingly, in the Bay Area, but also in the South Lake Union/Denny Triangle area of Seattle, as well as Bellevue, Santa Monica/Playa Vista in Los Angeles, New York City's Midtown South, Chicago's River North, much of Portland, Cambridge and much of Austin.

If that sounds like a lot of growth in the West Coast, that's because it is. Homa notes that West Coast markets absorbed more than 12 million square feet of space in 2014, their third consecutive year of occupancy growth of 10 million square feet or greater. “Many areas in fact, are still on an upswing, particularly the powerhouses of Seattle and Silicon Valley,” he says.

But for companies thinking at last there is a generality to which they can cling, Homa has one final offering: “The recovery is still uneven on a more micro level. The traditional office park is plagued by a lack of tenant demand in most markets except for tech, which retrofits them with amenities, while core and fringe CBD assets as well as highly amenitized suburban submarkets, such as Reston Town Center, in Northern Virginia, continue to rise in value and interest.”

EVER-RISING CONSTRUCTION COSTS

A significant concern added to this mix is the rising construction costs. In many respects, industry executives have been more worried about this than about rising interest rates, which are going up but at a moderate rate.

Construction costs, though, have no such moderating force. Rising costs will make profitability tricky in the coming years, according to a new JLL report on US non-residential construction.

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“Raw material and labor costs are making it more expensive to get out of the ground than ever before,” Todd Burns, president of JLL project and development services, Americas, relates. “You have to consider the bottom line of every project to make sure it makes economic sense in the short and long term.”

Although many core cities like New York, Dallas and Chicago have a number of large office projects underway, “I don't see new speculative towers going up that there is not demand for,” he says.

In Chicago, for example, developers have broken ground on the 52-story River Point building in response to a very specific demand for more space in the city's West Loop submarket. “In 2007 or 2008, it didn't matter where it was; if it was vacant land, a project was going to go up,” says Burns.

CAPITAL MARKETS' CONTRARIAN TAKE

Capital markets providing financing for these projects, of course, take these factors under consideration as they underwrite projects. But while developers only have to worry about local conditions, the capital markets must also react to national trends in their underwriting.

The result is an occasional disconnect, or so it seems, to the borrower on the ground. For example, in the hospitality sector CMBS lenders are quoting slightly larger spreads, and interest rates and loans are a little more expensive than they were last year, says David Phelps, a Los Angeles-based partner at Akin Gump. This difference, 40 to 50 basis points in the past four months, seems to be the result of the rating agencies' more conservative underwriting of hotel properties.

“This is somewhat counterintuitive since hotel prices are up and hotels generally are performing beyond their peaks,” he says. “lt appears this superior hotel performance may be causing a more conservative underwriting approach by the rating agencies. That said, he adds that the rating agencies have no input on balance sheet lenders or insurance companies “so there are no real changes there. In fact, insurance companies in particular are very aggressive in their pricing on high profile or well positioned hotel assets.”

This is not to say that local development trends aren't important, says Euchung Ung, a partner in the real estate practice of Kleinberg Kaplan in New York City.

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Even during the recession, development was still occurring in primary markets such as New York and Washington, DC, especially in the condominium and hospitality sectors, he says. “This has resulted in a constriction of supply of available real estate for new development in those areas.” Taken together, these factors—a decrease in prime real estate inventory and increase in capital availability—have meant that “developers and investors are entering into transactions in secondary markets where returns may be lower, or taking another look at existing mature properties with a view to investing in upgrades to attract new tenants with the capacity to pay higher rents.”

Overall, the capital markets are characterized by yield compression being driven by the combination of sheer supply of capital and cheap debt, says Steven Bettinger, CEO of Acquire Real Estate. Where underwriters don't want to get it wrong, he says, is the growing improvement in fundamentals in most markets and, by extension, the transition from capital-driven asset pricing to fundamental-driven asset pricing.

“Examples of fundamental-driven asset pricing are the return of underwriting material rent growth and paying full freight for vacancy and under-market rents,” he says. “Buyers are accepting lower going-in yields by paying higher prices with the assumption that they will be able to push rents and lease up vacancy quickly. This is the definition of risk acceptance.”

And of course, the mitigating factor for buying vacancy and pushing rent growth is the lack of new supply across the board and increasing replacement costs. For that reason, another trend underwriters will be watching—as will investors and borrowers—is whether certain assets begin to trade above replacement cost in 2015 and 2016, he says.

CHASING DEALS

But does all of this trump another inexorable fact in today's capital market environment—that is, the never-ending chase for yield? For the past few years, thanks in no small part to the low-interest rate environment and paltry returns of Treasury bonds, capital has flooded most parts of the real estate market looking for deals. Would it really pause before a drop in oil prices?

For the most part, no—at least, not in markets with a diversified economic base. As we move further away from the recession, lenders are becoming more comfortable assuming more risk.

“There definitely is a lot of debt and equity capital competing for a limited number of quality deals, so perhaps how capital sources define what constitutes a 'quality' deal is inextricably tied to how 'risky' they perceive that deal to be,” says Chauncey M. Swalwell, a partner with Stroock & Stroock & Lavan LLP in Los Angeles. “There is more pressure to pull the trigger more quickly on deciding whether to proceed and then close. I have not seen the attention to the underwriting degrade; folks definitely still are looking closely at the financials and other particulars. But competition is causing some capital sources to move the needle on the risk/returns acceptable to get deals done.”

That doesn't mean buyers today aren't making good deals, he concludes. “It means a buyer or lender must assess its individual risk/return tolerances and determine if each deal makes sense in the current environment.”

Yes, but which environment, precisely, are we talking about and for how long? 

US PROPERTIES' GLOBAL APPEAL

At the start of the year the Association of Foreign Investors in Real Estate, in Washington, DC, released its annual survey of investor sentiment. The US was voted the most stable and secure country for investment, surpassing second-place Germany by 55 percentage points, and third-place UK by 60 percentage points.

However, one of the cities usually tagged as a key destination for foreign real estate investment received something of a shock with this year's rankings; Washington, DC was in the top five cities, but only barely at No.5. It was an inauspicious drop for the nation's capital, which has traditionally enjoyed a No. 1 or No. 2 ranking. Worse, it fell to No. 15 on the list of top global cities, from No. 10 the previous year.

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Other US cities held their place on AFIRE's list or moved only slightly. New York, for example, returned to its long-held slots as both the No.1 global and No. 1 US city. Last year was an exception when London nudged it into second place; traditionally New York has held the top rank, both globally and among US cities, since 2010. It was followed by San Francisco, Houston and Los Angeles. Houston is a relative newbie to these rankings, but the reason for its ascendency, at the time, was clear: oil and the strong activity in the energy sector was driving demand for office space and related apartment and retail space as well.

Back to Washington DC, though. Local brokers scoffed politely at the findings. They pointed to other numbers that rightly showed DC received significant levels of foreign investment each year. Indeed, AFIRE CEO James Fetgatter is the first to say—and does so each year—that the AFIRE rankings capture what investors say they will do in the coming months, based on their perceptions of the market.

If their actions turn out to be different, presumably their perceptions have changed.

This makes eminent sense, especially considering the quirky and uneven nature of CRE opportunities in much of the nation, outside of the usual gateway city “sure bets” of New York City, San Francisco and Boston.

In short, while foreign investors do tend to have a more conservative risk profile than domestic investors, they are still influenced by the same shifts in markets and economies.

Take Houston, for instance. Since the start of the year the area's commercial real estate prospects have worsened, and many pending deals have been put on ice, says Douglas Thompson, president of the Dallas-based VistaPointe Partners.

“There have been a number of investors in Houston that have essentially redlined the area until the current volatility has calmed down,” he says, speaking of investors generally and not specifically foreign investors.

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 “No one knows where prices are headed and the institutional reaction has been to hit the pause button.”

Thompson says that he has heard anecdotally of “30 to 50” apartment land deals that have fallen through since the beginning of the year, usually because the financing was lost.

AFIRE's big picture conclusion—the US is a top foreign investment destination—though, is proving to be, as usual, an accurate one.

In general, it is not hard to find examples of foreign investor appetite for US real estate assets.

A vice chairman in CBRE's institutional properties group, Jeff Dunne pointed to recent investments in US suburbs: In Parsippany, NJ, an office building leased to a single tenant with 13 years remaining on its lease was snapped up by a South Korea-based group in its first US acquisition. In Stamford, Israeli firm Clal Insurance acquired two properties.

In New York City, a 27-story office building at 757 Third Ave. was acquired by Canadian real estate giant Bentall Kennedy for approximately $360 million. In Phoenix, UK-based Epic Apollo bought the Apollo corporate headquarters campus for $183 million.

In the nation's capital, there have been a number of interesting deals this year in which foreign buyers were the principal, including some from new-to-the-scene players. In February, GlobeSt.com learned that a private investor based in Brazil, Grupo CB, was acquiring a CBD office property from a partnership between Clark Enterprises and the Oliver Carr Co., for $109 million, or $561 per square foot. In March, AFIAA, an investment foundation of 35 Swiss pension funds, acquired the iconic “Arch Square” property in Chinatown. The fund paid $104 million.

These deals, most of which have occurred in the past three months, preceded a report from Cushman & Wakefield in March, which found the US to be the largest market for real estate investment—after China pulled back its presence.

C&W reported that global real estate investment fell in 2014 for the first time in five years, dropping 6.3% to US$1.21 trillion—a drop attributed to the scale-back in Chinese land purchasing.

Excluding China land sales, global volumes rose 9% in 2014, C&W found, with volume in the Americas surging ahead 11.4% and to stand at 71% of its 2007 peak.

What is really interesting to watch is the mirror image of this activity: US firms that are venturing abroad for commercial real estate opportunities. There is a sense that European properties are perfectly priced and valued for acquisitions and many companies are putting their focus on the Continent. Hotel companies, in particular, are investing in properties there, benefiting not only from the real estate opportunities but also the boost provided by a stronger US dollar.

But companies know they must take precautions as well. Gramercy Property Trust CEO Gordon F. DuGan told listeners on the REIT's recent earnings call that the company expects to close its first European deal—a logistics property in Germany—shortly. In addition, he said, “we have a terrific pipeline over there. I think there's a very large opportunity set for our single-tenant business in Europe.”

But that doesn't preclude the company from accounting for the possible foreign exchange risk to its earnings. When asked about its plans for that, DuGan went into no small detail. ”We're planning to borrow the liability side of the right side of the balance sheet in euros. And then we're in the process of exercising a euro-borrowing option on our credit facility. So we'll fund the equity with a euro borrowing in the United States. So the debt will come from local lender, the equity will come through a euro borrowing. So we will hedge the investment and then we'll swap out future cash flows to minimize any effect on our core earnings.”

It won't be a material number either way, even if it wasn't hedged, he said. “But we are planning to hedge our future cash flows.”