“U.S. properties
are priced to perfection.”
Christopher
Ailman, Chief Investment
Officer,
California State Teachers’ Retirement
System
Quoted in
Bloomberg, April 13, 2016
Fueled by cheap money, low levels of new
construction except for apartments, and modestly improving demand commercial
real estate values have more than doubled off their financial crisis lows of
2009. (See Figure 1) The best properties are trading at record low
capitalization rates (net operating income divided by purchase price) of below
5% and the required unleveraged return over a ten year time horizon ranges from
5%-6%. We are truly living in heady times for commercial real estate.
Figure 1. Green Street Advisors
Commercial Property Index, Dec. 97 – April 16, 2007 Peak =100
Source: Green Street Advisors
Nevertheless prices are leveling off as
investors have become concerned that the period of extraordinarily low interest
rates may soon be coming to an end and stresses have emerged in the
all-important commercial mortgage backed securities market (CMBS) with new
issue volume expected to be off by more than 50% this year. Although credit
spreads of come in from this year’s high they are still well above what
prevailed a year ago. (See Figures 2 and 3) With new risk retention rules
scheduled to be phased in, the investment banks have become more cautious with
pricing.
Figure 2. CMBS Issuance, 1999 – 2016F,
In $ Billions
Sources: Real Estate Alert and UCLA
Anderson Forecast
Figure 3. CMBS Spreads, 10Year AAA
Senior vs. 10 Year BBB- to Swaps, Jan 23, 2015 – May 12, 2016
Source: Trepp
On the equity side the demand for yield
seems to be insatiable and has been enhanced by legislative changes in the
Foreign Investment in Real Property Tax Act (FIRPTA) that makes it easier for
non-U.S. domiciled investors to access U.S. real estate. However, the fact
remains that the behemoth sovereign wealth funds of the petro-states are
suffering under the weight of low oil prices. Simply put, reduced cash flows
and increased domestic priorities are curbing their appetite for international
investment.
Domestically the implementation of
fiduciary investment standards by the Department of Labor for retirement
accounts has already and will continue to reduce the demand for high fee
private real estate investment trusts (REITs). To be sure these investments
would have been banned under earlier drafts, but the fact remains that the $20
billion flow into private REITs in 2014 will be cut by at least half in 2016.
In terms of operating fundamentals, job
growth, the source of much real estate demand, will inevitably slow as the
economy approaches full employment. After gaining 675,000 jobs a quarter over
the past three years, quarterly job gains will slow to 400,000 in 2017 and a
much lower 125,000 in 2018. (See Figure
4) Just as job growth is slowing, supply will pick up as the new construction
started in recent years and the construction now in planning stages break
ground are delivered in 2017 and 2018. (See Figure 5) The increases in new
construction will be somewhat mitigated by the growing caution on the part of
construction lenders and their regulators.
Figure 4. Payroll Employment, 2007Q1
-2018Q4F, Quarter over Quarter Change, In Thousands
Bureau of Labor Statistics and UCLA
Anderson Forecast
Figure 5. Real Commercial Construction
Spending, 2000Q1 -2018Q4, In Billions of 2009$
Source: U.S. Department of Commerce and
UCLA Anderson Forecast
Into this mix we are forecasting that
interest rates increase modestly over the next few years with the federal funds
rate approaching 3% by the end of 2018 and the yield 10- year U.S. Treasury
notes reaching 3.5% in 2018. (Figure 6) These yields are high compared to today,
but on a historical basis remain low. Thus the overall environment for
commercial real estate will become less favorable over the next few years and
the sector will continue to be pressed by the technological disruption coming
from e-commerce and reduced square footage per office worker.[i]
But make no mistake, we are not
forecasting a real estate crash, but rather we are about to enter a period of
modestly declining commercial real estate prices. If you are looking for an
analogy you can look at the recent behavior of stock prices which have been
flat to down since December 2014. We will next discuss the retail, warehouse,
office and apartment sectors in turn.
Figure 6. Federal Funds vs. 10-Year U.S.
Treasury Yields, 2007Q1 -2018Q4
Sources: Federal Reserve Board and UCLA
Anderson Forecast
High
Drama in Mall Real Estate
As if on cue following the Wall Street
Journal headline “Glut Plagues Department Stores” on April 25th,
both Macy’s and Nordstrom in early May reported poor first quarter results and
weak guidance for the entire year. The Journal noted a report by Green Street
Advisors indicating that roughly 800 department stores about 20% of all anchor
space in U.S. malls will likely close over the next few years and with that
many malls will close with them. The stock market response was vicious taking
the share prices of both Macy’s and Nordstrom down more than 50% from the
recent highs. Simply put, the department store business hasn’t been good for
years and the stock market is now recognizing that sobering fact. Remember
Nordstrom is a staple in most of the best malls in the country.
Moreover the problem in the mall is not
just limited to the anchor department stores. In the first quarter Simon
Property Group the largest owner of regional malls in the U.S. once again
reported that same-store sales for in-line shops were down on year-over-year
basis. And it is not that Simon owns lower quality assets, they, in fact, own
among the best assets in mall land. Generally speaking Class A+ malls have
sales in excess of $700/square foot while Class B and C malls have sales below
$350 a square foot.
It is not that overall retail sales have
been declining, to the contrary retail sales have been increasing, albeit at a
modest pace. What has been happening is that there has been a decided shift
toward e-commerce. For example in April on a year-over-year basis department
store sales declined by 1.7%, clothing store sales advanced by 1.3% and
non-store retail (e-commerce) surged by 10.2%. Indeed since 2000 the e-commerce
share of retail sales advanced from just under 1% to about 8% in the first
quarter. (See Figure 7) However this
data understates the full impact of e-commerce on retail sales because if you
back out those sectors of retail that are not amenable to e-commerce
(automobiles, gasoline, food and restaurants) the e-commerce share rises to 14%.
Moreover since 2000 e-commerce has taken about
30% of the growth in retail sales less the categories mentioned above.
Figure 7. E-Commerce Sales as a Percent
of Total Retail Sales, 2000Q1 – 2016Q1
Source: U.S. Department of Commerce via
FRED
In order to stay competitive major mall
operators have ramped up capital spending to make their assets more attractive
to consumers to include more restaurants and experiential activities. Note that
these forms of retail are not subject to internet competition. Examples of the
high level of capital spending include Westfield’s Century City with an $800
million program and Taubman’s Beverly Center clocking in at $500 million. Both
of these assets are in West Los Angeles and compete with each other.
Nevertheless the competitive pressures
mentioned above have only modestly showed up in the vacancy data as vacancy
rates have yet to decline to the levels achieved in 2006. (See Figure 8)
However it is important to note that the vacancy data do not include the
population of shuttered malls. Indeed the stock market is reflecting the
prospect of increased mall closures with the shares of the Class B operator CBL
yielding a very high 10.2%, while the shares of Class A+ operator Simon
yielding a far lower 3.3% as of May 18. The yield differential indicates that the
stock market in real estate investors view the Class A+ mall as near “bullet
–proof” while the Class B mall is vulnerable to closure.
Figure 8. Mall Vacancy Rates, 1980 –
2016Q1
Sources: Calculatedriskblog.com and
REIS.
Thus far the operators of grocery
oriented shopping centers have been immune from the onslaught of e-commerce
competition, but with Amazon making moves to get into the private label grocery
business and attempting to do same-day deliveries convenience oriented retail
may soon be disrupted as well. Indeed the still prized Whole foods anchor is
now suffering from increased competition in the organic food space. Simply put
the retail environment is brutal.
Two years ago we noted that the real
bright spot in retail real estate was street level retail in dense urban
centers that have a significant tourist component to support underlying demand.
That thesis proved true until very recently when the impact a strong dollar and
weakness in much of the global economy has diminished international tourist
spending. As a result asking rents are beginning to drop in, for example,
Manhattan which was a major beneficiary of the luxury international tourist
boom.[ii]
Industrial:
A Beneficiary of E-Commerce
What has been bad for retail real estate
has been good for industrial real estate.
E-commerce is warehouse intensive and as the need to shorten delivery
times has increased, the demand for close-in modern warehouses in major
population centers has soared. While overall warehouse rents have recently been
growing at a 5% clip, in such markets as Los Angeles, East Bay San Francisco
and northern New Jersey rents have increased at a double-digit pace over the
past year. The increase in rents has been buttressed by the long decline in the
availability rate. According to CBRE the industrial availability rate declined
from 14.5% in 2010 to 11% in the first quarter of 2014 to a cyclical low of
9.2% in the first quarter of this year.
Of longer term importance is the
widening of the Panama Canal to accommodate the larger container ships scheduled
for opening later this month. This mega-project has spurred port expansions
along the east and gulf coasts in such cities as Houston, Savannah and
Charleston that will offer new competition for the west coast ports and has the
potential to negatively impact the demand for warehouse space in the giant
southern California market.
Office:
In a Late Cycle Recovery
After seven years of economic recovery,
albeit slow, the national office vacancy rate has barely come down from about
18% to 16%. To be sure new construction has been very sluggish until recently,
but the demand has been far more muted than in past cycles. (See Figure 9) Two
of the pillars of office demand are not what they once were. Financial
Activities employment, though now on the rise, is still below its 2007 peak and
legal services employment growth has stalled as both of these industries are
still in the throes of a fundamental restructuring. (See Figures 10 and 11).
Figure 9. National Office Vacancy Rate,
1980 – 2016Q1
Sources: Calculatedriskblog.com and REIS
Figure 10. Financial Activities
Employment, 2000Q1 – 2018Q4F, In Millions, SA
Sources: Bureau of Labor Statistics and
UCLA Anderson Forecast
Figure 11. Legal Services Employment,
Jan. 2000 – Apr. 2016, In Thousands, SA
Bureau of Labor Statistics via FRED
Perhaps more important has been the
demand depressing factor of the decline in square footage per employee. Technological
disruption is obviating the need for physical file space and reference rooms
along with a shift to open floor plans has led and is continuing to lead to the
reduction in the square footage needed per employee. Instead of allowing for
200 square feet per employee, space planners are now allowing for only 150
square feet. This trend is far from running its course.
The one really bright spot in for office
demand has been the rapid growth of office employment in the technology sector.
The cities with vibrant demand are generally those with a strong base of
employment in the technology, advertising, media and internet sectors or TAMI
in the lingo of the industry. Thus it is no surprise that such tech heavy
cities as San Francisco, San Jose, Seattle, Boston and West Los Angeles are
booming. Within cities it the tech portion of the economy that is driving
office demand. For example the traditional high priced Park Avenue market north
of Grand Central Station in New York City is relatively suffering when compared
office submarkets one mile to its south.
A simple example of technology as demand
driver can be seen in the growth in the computer systems design and related
services sector. Here, instead of total employment we use the year-over-year
change in employment and we can see surge to 120,000 jobs a year in 2015. (See
Figure 12) However, as the boom venture capital funded technology start-ups
wanes, employment growth has slowed to 80,000 a year. This decline, in part,
has given rise to worries about the sustainability of office demand growth in
the above referenced tech hubs.
Figure 12. Computer Design and Related
Services Employment, Jan. 2000 – Apr. 2016, Year- Over- Year Change, In
Thousands
Bureau of Labor Statistics via Fred
Multi-Family
Housing: Running Out of High Income Renters
“…operating trends will
likely cause same
store revenue growth
to fall modestly
short of our original
guidance midpoint.”
Equity Residential, First Quarter
2016 Earnings Release
Multi-family residential housing has
been in a sustained boom since 2011. Despite a surge in new supply with starts
on track to reach 400,000 units this year, rents continue to rise much faster
than the overall prices. (See Figure 13) According to the official data
residential rents were up 3.7% year-over-year in April, but because of quirks
in the data the true increase in market rents is in excess of 4% and in more
than a few markets, twice that. (See Figure 14) The rise in rents is supported
by a dramatic decline in the apartment vacancy rate, which, of late, has
leveled off at a very low 4.5%. (See Figure 15)
Figure 13. Multi-Family Housing Starts,
1990 – 2018F, Annual Data, In Thousands
Sources: Bureau of the Census and UCLA
Anderson Forecast
Figure 14. Consumer Price Index, Rent of
Primary Residence, Jan. 2000 –Apr. 2016, Percent Change Year Ago
Sources: U.S. Bureau of Labor Statistics
and UCLA Anderson Forecast
Figure 15. Apartment Vacancy Rate, 1980
-2016Q1
Sources: Calculatedriskblog.com and REIS
One of most powerful factors effecting
rental demand has been the long decline in the homeownership rate. (See Figure
16) Whether out of choice or necessity, consumers are opting to rent. Part of
this phenomenon is due to a shift in preferences for a more urban lifestyle and
a delay in such life cycle events as marriage and childbirth as well as far
more stringent lending criteria than was prevalent a decade prior. With the
gradual rise in single-family home starts, we believe that the long decline in
the homeownership rate has about run its course.
Figure 16. Homeownership Rate
Sources: U.S. Department of the Census
via FRED
Nevertheless as investor demand
continues to drive supply, tenant demand begins to ebb with a slowdown in
employment growth coupled with a leveling off in the decline in the
homeownership rate, apartment owners are discovering there might not be enough
tenants to support $3500 a month rent for one bedroom apartments. That in fact
was the gist of Equity Residential lowering its guidance range and the once
white hot Manhattan and San Francisco markets begin to cool. The apartment business now appears to be in
transition from great to good.
Conclusion
The combination of a less favorable
financial environment along with weakening fundamentals arising from increased
supply and reduced demand will likely bring to an end the seven year bull
market in commercial real estate. To be sure we are in no way forecasting a
“crash”, but rather an extended period of sideways to down prices. Simply put
financial conditions will transition from being extraordinarily easy to just
plain easy making it unlikely for us to witness a repetition of the events of
2007-2009.
Nice information about commercial real estate.
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