When I started writing this section in early May my tentative title was “Party Like its 2006.” Despite all of the well publicized problems facing the commercial real estate industry, asset prices for both buildings (up 20%) and publicly traded real estate investment trusts (nearly triple) were recovering rapidly, bidding wars for individual properties were breaking out and credit spreads for commercial mortgages were in steep decline. (See Figures 1, 2, and 3) Indeed the improved environment was reflected in the rising optimism of Southern California office developers. (See Figure 4) Simply put the Fed’s zero rate policy was working its wonders and investors were willing to look past the current problems of high and rising vacancy and mortgage default rates. Remember with very low interest rates the banking strategies with respect to commercial mortgages of “delay and pray” and “extend and pretend” can and actually are working.
Figure 1. Green Street Advisors Commercial Property Index, Dec 97 –April 10
Source: Green Street Advisors
Figure 2. Dow Jones Real Estate Index, I-Shares, June 2006 – May 2010, Weekly Data
Source: BigCharts.com
Figure 3.Super-Senior AAA CMBS Spreads to Swaps, Jan 07 –May 10, Monthly Data
Source: Bloomberg
Figure 4. UCLA-Allan Matkins Office Developer Sentiment Survey
Source: UCLA Anderson Forecast and Allan Matkins
For a short time it seemed that the combination of very low interest rates and slow, but sure economic growth were more than enabling the industry to work its way out of rising defaults in its $3 trillion dollar debt load. However the “Euro Crisis” brought with it rising credit spreads and fears that an aftershock from the 2007-09 credit crisis would make it far more difficult to restructure the industry’s debt burden. Our view is that the improvement in real estate capital market sentiment was way over done. To be sure there will be a recovery, but that recovery will likely occur in fits and starts. In a word it will be rocky. There is just too much debt that has to be worked through and it will take time to re-characterize a significant fraction of it as equity. After all Fitch Ratings has forecast that loans 60 days or more past due in the $536 billion CMBS market will rise from the current 7% to 11% by yearend.
The Collapse in Supply
From a fundamental point view vacancy rates are peaking. (See Figure 5 for office vacancy rates) New starts came to a screeching halt at the end of 2007 and with modest growth vacancy rates will gradually decline. Real commercial construction spending will suffer a peak-to-trough decline by early 2011 of 51% since the 2007 high. (See Figure 6) Similarly multi-family starts declined by 80% from 378,000 in the first quarter of 2006 to 77,000 units in the fourth quarter of 2009 and only a gradual rebound is forecast. (See Figure 7) Thus new supply will not be problem for the next several years.
Figure 5. National Office Vacancy Rate, 1991Q1-2010Q1
Source: REIS
Figure 6. Real Commercial Construction Spending
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Figure 7. Multifamily Housing Starts, 2000Q1 -2012Q4
Source: U.S. Department of Commerce and UCLA Anderson Forecast
Structural Weakness in Demand
The real problem, however, is on the demand side. Put bluntly, the modest economic growth we a forecasting means that it will take several years to bring the supply and demand for commercial real estate into some semblance of balance. Why? The economy is in such a deep hole that total employment in early 2010 was back to where it was in late 1999. (See Figure 8) After peaking in December 2007, total payroll employment dropped by 8.4 million jobs making the recession, in term of employment, 3-4 times worse than prior postwar recessions 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.
Figure 8. Nonagricultural Employment, 2000Q1 – 2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of the first quarter financial activities employment was off by 730,000 jobs since its fourth quarter of 2006 peak, a decline of 8.7%. (See Figure 9) 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 mid- 1999! Indeed employment in this sector is forecast to be well below its peak level at the end of 2012.
Figure 9. Financial Activities Employment, 2000Q1 -2012Q4F
Source: Bureau of Labor Statistics and UCLA Anderson Forecast
In a related vein even the law business, a core tenant for pricey CBD office space, is now under extreme stress. Employment in legal firms over the past year declined by 28,000 jobs, or 2.5%. Now here is a business, 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 and in the late 1990s private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1-1.5% rate. From 1991-2007 consumers financed 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 a low 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7% after an intermediate decline from 2011-2013, caused by increased taxation on high income taxpayers, to the 2-3% range. (See Figure 10) Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total consumer credit outstanding dropped by an unprecedented $130 billion or 5% from September 2008 to March 2010.
Figure 10. Personal Savings Rate, 2000Q1- 2012Q4F
Source: U.S. Department of Commerce and UCLA Anderson Forecast
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 April were still 3.7% below their November 2007 peak. (See Figure 11) This data certainly smells like there is quite a bit of excess capacity in retailing.
Figure 11. Retail Sales, 2005 –April 2010, Monthly Data
Source; U.S. Department of Commerce
Because so much of what is sold by retailers is imported, the demand for coastal warehouse space will be less than ebullient. After collapsing during the recession imports are now growing, but at a rate far slower than during the import boom of 2003-2007. (See Figure 12) Furthermore west coast ports will face increased competition from the Panama Canal where a major widening project is scheduled to be completed in 2014. Simply put the ship-to-rail link to the Midwest and east coast will be facing new competition through an all ship link to the Atlantic and Gulf coasts via the Panama Canal. To be sure the Panama Canal alternative is not without issues, but it does offer shippers the opportunity to limit their dependence on west coast ports.
Figure 12. Real Imports, 2000Q1 -2012Q4F, Quarterly data, In $2005.
Source: Department of Commerce and UCLA Anderson Forecast
Trust me, this not a forecast I want to be right about, but it is hard to visualize anything but a long hard slog ahead for the real estate economy that will be eased by limited new supply. Indeed much of the recent strength in the overall 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. Nevertheless it is a far cry from all of the gloom and doom we heard about commercial real estate in 2009.
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 real estate professionals now in the field. My guess is that going forward commercial real estate demand will be growing more slowly and that it will be more cyclical. As a result investors could very well find it difficult to exceed the long run 7-9% total returns for unleveraged real estate reported by the National Conference of Real Estate Investment Fiduciaries.
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