Reprinted by permission from Reit Wrap Special Report Dated February 10, 2010
by David Shulman*
Thankfully the economy now appears to be on the mend and employment will soon be rising, but I fear that few real estate professionals fully realize how deep of a hole the demand for commercial real estate is in. For the most part real estate investors believe that after leveling off in 2010, rents and occupancies will begin to increase in 2011 and with severely limited new construction, “normal” market conditions will return by 2012 or 2013. It is on these assumptions that today’s pro formas and REIT FFO estimates are being built.
If the economy were recovering from a cyclical recession I would fully endorse the market consensus. Unfortunately the Great Recession of 2008-09 was not a cyclical recession; it was a balance sheet recession whose effects will linger for many years to come. Let me explain. A normal cyclical recession is usually induced by Fed tightening seeking to tame inflation. Once the tightening takes hold, the Fed eases and after awhile the economy begins to grow again.
Indeed the natural state of the economy is to grow and within a year or so economic activity surpasses the prior cyclical peak.
A balance sheet recession is different. In this instance consumers and businesses find themselves over-leveraged with assets trading at values well below the debts on them. Thus balance sheets have to be repaired and this process takes time. For example the U.S. economy, even after the huge stock market rally, still finds itself $10-11 trillion poorer in terms of stock market and home values. As a result, consumers who once thought themselves as rich now think themselves as poor. They react to this reality by paying off debts and increasing savings. Simply put the credit constrained consumer can’t spend and the more affluent balance sheet impaired consumer won’t spend. When all consumers respond in this manner, aggregate demand stays depressed for years.
Sluggish economic growth going forward would not matter all that much if the economy were operating close to its natural capacity. However this is not the case. After peaking in December 2007, total payroll employment is off by 8.4 million jobs making the recession 3-4 times worse than prior postwar recessions. In fact total employment in January has now returned to where it was in September 1999! If employment growth is a rough proxy for commercial real estate demand, than every project built in the first decade of the 21st century can be viewed as superfluous. To be sure there is a more than a little hyperbole involved with the prior sentence, but you get the picture. That is why even in a limited construction environment, excess capacity will weigh on commercial real estate for many years to come.
A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, and high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of January financial activities employment was off by 709,000 jobs since its December 2006 peak, a decline of 8.5%. An industry that was once viewed in secular growth category has proved itself to be highly cyclical, not a good omen for the stability of future office demand. More importantly financial activities employment is now back to where it was in May 1999!
In a related vein even the law business is now under extreme stress. Employment in legal firms over the past year declined by 44,000 jobs, or 3.8%. Now here is a business, a core tenant for Class A office space, which was once thought to be recession-resistant, now suffering through the pains of a fundamental restructuring of its business model, the billable hour.
In terms of the office demand I am hard pressed to come up with a scenario where demand recovers quickly and because the employment declines have been so severe it is reasonable to assume that many office using firms a carrying excess space relative to their needs. Thus as leases roll over tenants will just as likely reduce their space demands as increase them.
In the case of retail demand, the consumer has been chastened by the bear market in homes and stocks and a significant fall in the rate of pay increases. Where earlier in the decade private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1.3% rate. Earlier in the decade and in 1990s consumers finance part of their consumption out gains accruing from rising stock and home prices. As a consequence the savings rate collapsed from an historic 7-10% down to around 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7%. Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total revolving consumer credit outstanding dropped by an unprecedented $109 billion or 11% from September 2008 to December 2009.
Thus it does not take rocket science to explain that the combined effects of falling asset values, slowed compensation growth, high unemployment and debt pay downs have made for a very disappointing retail environment. To be sure retail sales have bounced off the bottom, but remember total retail sales in December were still 7% below their November 2007 peak. This data certainly smells like there is quite a bit of excess capacity in retailing.
Of course many of you reading this article will probably shrug it off as one of Shulman’s perpetually bearish rants. Trust me, me I do not want to be right about this, but it is hard for me to see anything but a long hard slog ahead of us. Indeed much of the recent strength in the economy has come from massive doses of fiscal and monetary stimulus. In a nutshell, the economy is highly medicated. Thus we won’t really understand the underlying strength of the economy until the Fed ends its zero interest rate policy and the federal deficit drops from 11% of GDP to an optimistic 3% of GDP.
I would like to think we have learned a lot over the past few years. One of the lessons that I have taken away from the experience is that the Great Moderation of 1982-2007 is over and we are about to enter a new world that is beyond the working experience of most professionals now in the field. My guess is that going forward commercial real estate will be growing more slowly and that it will be more cyclical.
*David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. An earlier version of this article was presented at the University of Wisconsin Real Estate Club.