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Executive Summary

Gross Domestic Product (GDP) grew by 0.7% (annualized) in the first quarter, coming in below the consensus expectation of 1.1% and the year-earlier rate of 0.8%. This was GDP’s lowest quarterly growth since shrinking in Q1 2014.

Q1 has been the year’s weakest quarter for five of the past eight years and two of the past three. The seasonal adjustment factor used in the GDP calculation is the subject of significant debate and questioning among economists of late. Some argue that the adjustment is skewing first-quarter numbers downward, relative to the second and third quarters.

Fed Watch

The Fed won’t be overly concerned about this slowdown, as its focus has shifted to inflation. Core PCE inflation accelerated to the Fed’s target of 2% in Q1, from 1.3% the previous quarter. Despite the weak Q1 GDP figure, the Fed is still expected to raise interest rates twice more in 2017, with the chance of a rate increase in June estimated at 70%. The Fed has also begun to signal that it will be unwinding its balance sheet in the near future, which will have a much greater impact on the long end of the curve than the Fed Funds rate will. The Fed is unlikely to begin action until late 2017 or early 2018, but how it plans to engage in that policy change will likely be communicated beginning this summer.    

Interest Rate Impact on CRE: After a run-up following the inauguration, 10-year Treasury yields have settled at 2.3% (down from 2.7% in February) as the market has begun to discount the forecasted growth. Higher interest rates will put more pressure on cap rates. If—and this is a big if—the administration and Congress can pass tax reform and an infrastructure program that is truly expansive to the economy, tenant demand might increase to offset potentially rising cap rates. None of the policies announced to date meet that standard.

Positives

Growth Remains Diversified: The first quarter’s increase in real GDP reflected positive contributions from nonresidential fixed investment, exports, residential fixed investment and personal consumption expenditures (PCE).

Capital Investment: Equipment investment increased at a 9.1% annualized rate, while investment in non-residential structures decreased by 22.1%.

Consumers Have firepower: Although growth in PCE decelerated in Q1, personal income growth accelerated and the savings rate increased. Consumers are more able to increase their spending without stressing their balance sheets.

Single-Family Strength: Residential investment (RI) increased by 13.7%, following a strong Q4. The housing market is picking up, with new and existing home sales having increased in Q1.

Negatives

Businesses Turn Cautious: The Q1 deceleration in real GDP reflected a deceleration in PCE and downturns in private inventory investment. As consumption stalls, businesses—clearly worried—are reducing their inventories.

Personal Consumption: Q1 PCE growth was 0.3%, after having risen 3.5% in Q4. Although sentiment indexes say otherwise, consumers have taken a step back in their spending. What they are saying and what they are doing are two different things. Durable goods spending fell by 2.5%—its biggest drop in four years.

CRE Conclusions:

Retail: Consumers have slowed their spending, though their balance sheets remain strong. Store closings are near record levels. We will continue to see a shakeout in this sector as consumer expectations change, regardless of GDP growth. Strong wage growth and healthier balance sheets could help later in the year if consumers increase their spending.

Office: Job growth averaged 180,000 per month in Q1, keeping to 2016’s average pace. The tight labor market means hiring is likely to slow, however. Many businesses are leasing more space, having held off during the latter part of 2016. This is also likely to slow if hiring remains difficult.

Industrial: As e-commerce gains market share at the expense of retail, industrial’s strong start in 2017 is likely to continue. Trade is a looming risk as the president threatens to withdraw from NAFTA, which could significantly disrupt the industrial market—particularly coastal markets with port exposure.

Multifamily: Overbuilding of Class A towers is weighing heavily on the top end of the market. This will trickle down, but the gap between Class A and Class B is still large. Rents are still growing in markets that haven’t overbuilt, and in Class B and C apartments. Rent growth and a tight labor market will help demand for this sector.