The last batch of critical U.S. economic indicators has gone a long way to alleviate worst-case scenario concerns regarding the U.S. economy. Even amid the worst of the recent turmoil triggered largely by the U.S. debt downgrade in August, the private sector kept adding a modest number of jobs, retail sales increased and manufacturing regained some strength. These factors culminated in a better-than-expected reading in U.S. Gross Domestic Product (GDP) of 2.5% during the third quarter. All of these factors combined confirm that the U.S. economy remains on strong footing and far from recession, even though it lacks any measurable forward momentum. 

Last week’s encouraging progress by the European Union (EU) to provide a more systemic solution to its debt problems was a welcome sign, spurring significant gains in global equity markets. The fragile state of EU’s fiscal conditions was on display already as a potential referendum by Greece threatens to unwind last week’s proposed solutions. Not only does this cloud impact Europe’s consumer and business confidence, banking industry and capitals markets, it directly impacts the United States in measurable ways.  The EU, the largest economic region in the world with total output of approximately $16 trillion, accounts for 18% of U.S. exports. U.S. exports have been a bright spot economically, growing by 7% to 8% a year and accounting for approximately 13% of total economic output in the United States. At a time when residential investment only accounts for 2% of economic output due to lingering problems in the for-sale housing market, exports play an even more critical role than usual. A recession in Europe would certainly put a dent in our export numbers and broader economy. Psychologically, many U.S. multi-national firms have been holding back on expansion and hiring plans partly due to uncertainty in Europe and a practical resolution to Europe’s debt problems would most likely release some pent-up demand, which is badly needed globally – and particularly – here in the U.S.

Given the unpredictable nature of current dynamics, commercial real estate investors are well served to reassess market realities. The good news is that our domestic economy is holding up well through some strong headwinds. Fundamentally, demand for space should be entering a natural recovery cycle but is being held back by fear and uncertainty.  The odds of a severe recession have declined even more in the past 30 days. Now, the most probable economic scenario through 2012 is a painfully gradual recovery with job growth of 1.2% to 1.5%. This is certainly not enough to generate large volumes of demand for commercial properties, but it should be sufficient to keep the recent improvements in occupancies on track. By the end of 2012, two major clouds should break: 1) The election cycle should at least reduce if not break the political paralysis in the United States, and 2) The EU is likely to work out some version of the proposal it announced last week. Should these events occur, the pace of growth moving into 2013 would rise substantially.

In the meantime, low interest rates and a preference for high-quality, low-risk assets are safety nets leveraged by active commercial property investors. Given the ongoing volatility in the stock market and high degree of uncertainty, global demand for hard-asset investments is likely to increase, bringing more capital into U.S. commercial real estate. As I have suggested in past blogs, the yield compression in the upper tier of the market is already starting to push capital into Class B, value-add and secondary market investments. However, the capital migration to higher-risk assets is still cautious and gradual, and will remain so. Tertiary markets and lower-quality assets will continue to lag in a cautiously improving investment market.

 

Hessam Nadji is senior vice president and managing director of Marcus & Millichap Real Estate Investment Services. He is also the interim managing director of Institutional Property Advisors, Marcus & Millichap’s special division designed to serve the unique needs of institutional and major private multifamily investors. Contact him at [email protected].