Nelson: “We will see pretty good growth in the early part of next year but then I think we'll see that inflection point where things will start to slow down.”

SAN FRANCISCO—Everyone seems to be contemplating when the next downturn will take place. With the current cycle taking on a theme of “As Good as it Gets,” Andrew Nelson, chief US economist for Colliers International, says the economy is strong now but is likely to start slowing in 2019 and more intensely in 2020, as the Fed attempts a soft landing.

“Things are really good right now in terms of the overall economy and property fundamentals,” Nelson tells GlobeSt.com. “From the economic side, 2018 will probably go down as the strongest in this cycle with reasonably robust job growth, especially considering that we are at or near full employment.

Nelson says property fundamentals are still strong, including rent rates remaining steady, absorption still reasonably positive, prices holding up with modest increases and inflation and interest rates finally rising in earnest. However, for a variety of reasons, the slowdown is in full view and the economy is much closer to the top of the market cycle than the bottom, he says.

For one, property markets peaked in 2015 and have been slowing since. For example, leasing and sales transactions have been slowing, notwithstanding a pickup earlier this year as the economy strengthened. Also, financial returns will continue easing as cap rates stabilize/rise. However, strong investor interest will maintain asset values for now.

“We're much closer to the end of the expansion than the beginning,” Nelson tells GlobeSt.com. “We will see pretty good growth in the early part of next year but then I think we'll see that inflection point where things will start to slow down. We have another one to two good years left, but there will be rising downside risks by 2020. Whether we will go into a technical recession remains to be seen, but it will feel like one.”

In analyzing the impetus behind the slowdown, the GDP holds a clue. GDP growth in the second quarter of this year was 4.2%, which economists uniformly agree was the high-water mark; third quarter GDP was 3.5% and it is expected to come down further in the fourth quarter to the 3% range. Economic growth in this quarter will still be pretty positive, Nelson predicts.

Some of the current economic drivers include:

• Fiscal stimulus from the tax cut/reform and new budget spending is providing a short-term boost
• An exuberant business sector ramped up investing, though the pace is softening
• Global growth and trade are slowing again after brief peak in 2017
• The Fed has pivoted from expansionary to neutral to contractionary policies
• Increasingly tight labor markets are raising wages and cooling job growth

“Even though the demand drivers are strong, the economy is robust, wages are going up and people have jobs, the housing market is showing signs of slowing in recent months,” Nelson tells GlobeSt.com. “This is a leading indicator as one of the first sectors to turn into a recession. Home sales have turned down, home starts have turned down, and price appreciation is falling.”

One reason: Homes are increasingly becoming less affordable due to rising interest rates and sharply escalating labor material costs. These factors make housing more expensive to build, Nelson says.

“So builders have to charge more and they are finding resistance at the high end now,” he tells GlobeSt.com. “Business investors are also starting to pull back on their investments, in part because of higher interest rates. Even though business confidence is very high, there is some concern about the outlook. And the consequences of that are, of course, they stop investing in adding jobs and then making investments in plant and equipment, which sows the seeds of an economic slowdown.”

Nelson indicates there are some near-term risks such as the rising dollar and growing costs of trade wars, rising financial market volatility and the risk of a correction and accelerating inflation from rising wages, fiscal overdrive and deficit spending. But the greatest risk is from an overcorrection from the Fed.

The Fed tries to engineer a so-called soft landing, which means the economy slows down gradually, Nelson says. This is simple in concept but difficult to execute. What the Fed is attempting is to let some of the steam out without having the economy overheat and blow up with a sharp contraction.

“So, the Fed is going to continue the slowing of the economy with its gradual pace of rate hikes,” Nelson tells GlobeSt.com. “Usually the Fed acts more quickly in raising rates, but it's been slow and measured in its approach this time. I think there is a good chance the Fed will get it right and will slow the economy a bit before it overheats. The prospects are reasonably good that we may avoid a technical recession and just have a slowdown, but that is in no means a certainty.”

Economic cycles have some benefits in terms of taking off some of the steam, and allowing sectors to regroup and prepare for the next cycle, Nelson observes.

“Even if we do go into a recession, we shouldn't except a replay of the last one. The Great Recession was given that name for a reason: it was unusually deep and long-lasting, and widespread, and unusually focused on the property sector,” he points out. “Those factors are the most unlikely to be repeated in the next recession.” Nelson notes most recessions are more selective, hitting some parts of the country hard and some much less so. Also, the impacts will vary by economic sector, with the property sector likely to be less roiled this time.

“This bodes well for the next recession: it is likely to be shallower, not as widespread, not as long lasting, not hurt as much overall and not be as focused on the property sector,” Nelson predicts.

But as with any recession, not everyone or every sector will fare the same, he says.

“There will be relative winners and losers,” Nelson observes. “The challenge is knowing what will trigger the next recession: is it going to be the tech, energy or financial sectors? Until we know that, it will be hard to speculate who gets hurt worst. But I think we can make some educated guesses in the property sector.”

Nelson offered a glimpse into the property sectors for an inside baseball analysis.

Industrial is the favored sector which will keep outperforming because of structural changes due to e-commerce and logistics demands.

Multifamily is in a strong place. These properties are likely to fair relatively well in a recession due to demand shifts toward renting over homeownership because homes never recovered to the previous level before the last downturn.

Office should hold up better than in the last recession as construction has been more restrained in this cycle and coworking space may moderate the downturn, but the sector is still likely to suffer declining occupancy and wide swings in rental rates as office tends to be the most cyclical sector. Part of that can be blamed on how long it takes to construct an office building due to the complexity of the construction. By the time one gets out of the ground, another recession is starting, Nelson says. He points out that was the case in the recession of 2008 and 2009 when many buildings were completing just as demand was plunging.

Retail will be the weakest going into the next downturn. It never fully recovered from the last recession and structural changes such as e-commerce have benefited industrial at the expense of retail.

With all of that said, is now the time to get defensive? Nelson says yes, but it's a balancing act.

“You miss out on the last few percent of gains with the risk of getting defensive too early,” he cautions. “But you get crushed in the downturn with the risk of waiting too long. Many real estate investors would rather be a little early in getting into their defensive crouch.”

Nelson says this is the time to get a little more defensive by locking in tenants with longer-term leases and inflation adjustments, reducing debt and risk by not taking on risky projects in risky markets, dialing back acquisitions and new construction, looking for buying opportunities when prices fall and playing for the longer term.