Small-Cap Fundamentals Finish 2018 on Solid Footing

Michael Tucker

February 21, 2019

Small-cap commercial real estate fundamentals finished the fourth quarter on solid footing, but some "cracks in the foundation" persist, raising concern about the market's future expansion, said Boxwood Means, Stamford, Conn.

"The top-line numbers for the fourth quarter and full-year 2018 were very favorable," said Boxwood Means Principal Randy Fuchs, noting fourth-quarter net absorption remained positive for the thirty-third consecutive quarter across the office, industrial and retail sectors.

But Fuchs noted the "ambivalent" news that the occupancy gains represented a 40 percent year-over-year decline and the fourth quarter was the lowest fourth quarter total since 2011. "Furthermore, net absorption for the full year, though commendable, was off by 20 percent compared with 2017 and the lowest annual amount in six years," he said.

Most primary property types contributed to the pullback, Fuchs said. Small-cap industrial property absorption decreased 22.3 percent year-over-year. Similarly, retail occupancy gains reflected a 17.7 percent decline for 2018. On the other hand, the office sector edged out a 1.4 percent gain year-over-year.

"Some market observers might conclude that the decelerating occupancy growth is much ado about nothing and with a market bound by tight vacancies and sizable rent growth, fundamentals are sufficiently robust to maintain healthy market conditions and investment momentum," Fuchs said. "There's no disagreement here on the current solid state of the market, but we'd be remiss without addressing some undercurrents that may slowly be eroding that sturdy base."

Fuchs said "Main Street" businesses face new challenges to sustained growth. "The nation's very low unemployment levels have created the unintended, troublesome result that many small businesses are simply unable to find workers," he said. "This trend, in turn, has slowed small business growth for the last two years including an accelerated pace of decline during last year according to the Paychex/IHS Markit Small Business Employment Index."

The taut labor market also partially explains the pullback in occupier demand, Fuchs said. "The needs and plans for expansion space can diminish when some small businesses cannot find and hire new workers," he said. "The declining total number of direct leases signed over time is suggestive of a waning appetite for new facilities among small businesses. A second possible cause for slackening demand is space scarcity."

A severe imbalance between demand and supply has created another challenge for expansion-minded small businesses, Fuchs said. "Completions have consistently trailed demand during the market's recovery, and the cumulative effect nine years into the market's expansion is that we have a state of disequilibrium in small-cap commercial real estate," he said. He noted annual supply across industrial, retail and office property types fell 16.2 percent year-over-year despite "insistent" demand. "[Strong] demand meeting inadequate new supply means that vacancies have sunk to a bottom previously untouched, if not unthinkable," he said.

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