The Outlook for Commercial Estate: Asset Prices Ahead of Fundamentals, UCLA Anderson Forecast, June 2011

The bull market psychology of the mid-2000s has returned to commercial real estate with prices for quality properties just 13% below their bubble peak in 2006. (See Figure 1) Near record low cap rates (the cash yield before capital expenses for real estate) of below 5% for quality office buildings in Manhattan and Washington, D.C. and for Class A apartments in broader geographies are becoming more the rule than the exception. In contrast assets in less than desirable markets are trading at 7-9% cap rates. Indeed the Manhattan office market has become so frothy that developers are now talking about starting 25 million square feet of space this decade, the highest level since the 1980s.

Similarly, though still well below their 2007 peak, the publicly traded real estate investment trusts (REITs) have tripled off their financial crisis lows of March 2009. (See Figure 2) Moreover, bankers who as recently as twelve months ago were shunning real estate loans have aggressively returned to the market. Simply put a near zero federal funds rate and 3% 10-Year U.S. Treasury yields have lit a fire underneath the high quality end of the real estate market.

Figure 1. Green Street Advisors Commercial Property Index, Dec 97 – April 11

Source: Green Street Advisors


Figure 2. Dow jones Real Estate index, I-Shares, June 2006 –27 May 2011, Weekly Data



Source: BigCharts.com

Indeed the long moribund commercial mortgage backed securities (CMBS) market is showing signs of recovery. Although issuance remains low, spreads for existing securities have dropped enough to enable new securities to be created. (See Figure 3) However, the Dodd-Frank financial reform legislation requirement for issuers to retain an interest in the securitization may limit a full revival of this sector of the market.

Figure 3. CMBS Issuance, 1999-2011E, In $billions




Source: FBR Capital Markets and UCLA Anderson Forecast

Despite the ebullience discussed above, all is not well in the commercial real estate capital market. When you go beyond “A-List” properties regional and community banks are probably sitting on about $200 billion in 20% or more “under-water” real estate loans. The nation remains littered with vacant office buildings, warehouses, hotels and strip centers in fringe locations. Indeed even higher quality assets in what are perceived to be second and third tier cities find it difficult to attract a bid from institutional investors. Of course the longer interest rates remain abnormally low the likelihood increases that the search for yield will ultimately find its way to assets that the institutional investor community are currently shunning.

Thus as long as the interest rate environment remains benign, commercial real estate capital markets will continue to do well. At least until the over-leveraging excesses of a few years ago return. However, the very low interest rate environment is not likely to remain with us for long. After all that environment is a result of the emergency conditions of the financial crisis. As we mention elsewhere in this forecast report, we expect both long and short term interest rates to raise, with 10-Year U.S. Treasury yields approaching 5% in 2013 and with that the very low cap rates of today will give way to a pricing correction.

Figure 4. Federal Funds vs. 10 Year U.S. Treasury Yields, 2000Q1 – 2013Q4F

Sources: Federal Reserve Board and UCLA Anderson Forecast

Lack of Supply Underpins Fundamentals

The financial crisis of 2007-2009, for all practical purposes, halted commercial construction. (See Figures 5 and 6) Since the 2007 peak total commercial construction declined by 64%, new starts by 80% and multi-family housing starts also suffered a peak to trough decline of 80%. To be sure, the collapse in demand coupled with the completion of starts occurring during the boom, sent vacancy rates soaring. (See Figure 6) But with no new supply, even modest increases in demand will work to gradually lower vacancy rates over time and with that rents will increase and in the case of apartments, because of some very special factors, rents are already rising noticeably.

Figure 5. Real Commercial Construction Spending, 2000Q1 – 2013Q13F
Source: IHS Global Insight and UCLA Anderson Forecast

Figure 6. Multifamily Housing Starts, 2000Q1 – 2013Q4F

Sources: U.S. Department of Commerce, and UCLA Anderson Forecast

But Weak Demand is the Problem

Although supply is not a problem; demand is. Simply put the economy is growing far too slowly to meaningfully reduce vacancy rates for all product types (especially office buildings), with the exception of apartments. (See figure 7) Even with employment increasing at a rate of 200,000-250,000 jobs a month; it will take a few years to return to the peak achieved in late 2006. (See Figure 8) And the all-important financial activities sector for the office sector, employment in 2013 will still be well off the prior peak. (See figure 9) This is hardly an environment for robust rent increases, especially for the suburban office market which is still suffering from the collapse of the single family home market. Remember all too many suburban office buildings are tenanted by financial service companies tied to housing (e.g. real estate brokers, title companies, mortgage brokers, lawyers, architects and banks).

Furthermore the on-going restructuring of the legal services business will weigh on demand for prestigious central business district office space. (See Figure 10) Simply put the business model of the legal profession is facing challenges from computerized document searches, outsourcing to India and a corporate rebellion against the “billable hour. Indeed several large law firms have created a non-partnership track for lawyers and have set up satellite locations in low cost locations such a Wheeling, West Virginia and Dayton, Ohio.

Figure 7. National office Vacancy Rate, 1991Q1 -2010Q1



Source: REIS
Figure 8. Nonagricultural Employment, 2000Q1 – 2013Q4F
Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 9. Financial Activities Employment, 2000Q1 -2013Q4, SAAR


Sources: Bureau of Labor Statistics and UCLA Anderson Forecast




Figure 10. Legal Services Employment, 1990-Apr 2011, Monthly Data, In Thousands.



Source: Saint Louis Fed

The bright side of commercial real estate is the apartment market where the shock of dramatically lower prices has altered consumer psychology with respect to single family home purchases. (See Figure 11) A rush to buy has been replaced by a reluctance to buy and that reluctance is being reinforced by tighter credit standards. As a result the homeownership rate is falling to the benefit of rental apartments with the national apartment vacancy rate dropping from 8% to 6.2% over the past year. (See Figure 12) Moreover with much of the single family home vacancies sitting in the exurbs, the glut of vacant single family homes make them far less competitive with closer-in apartments.

According to a recent national survey net effective rents on move-ins and renewals are rising 4-4.5%, well above the 1% increase reported by the official consumer price index. It is because of the combination rising rents and low cap rates; we are forecasting a doubling multi-family starts from early 2011 to late 2013. As actual rental rates get reflected in the official consumer price index, the rate of increase in the so-called core CPI will vault above the Fed’s informal 2% target thereby inducing a tighter monetary policy. It is ironic that the seeds for higher cap rates will have its origins in rising residential rents.

Indeed with house prices at near record affordability levels and after a few years of rising real rents, consumers will once again learn the virtues of homeownership. In response ownership housing starts will return to more normalized levels and full apartment buildings will face a decline in occupancy rates.

Figure 11. S&P Case-Shiller 20 City Home Price Index, Jan. 2000 – March 2011, Jan. 2000=100



Source: Standard & Poor’s

Figure 12. Home Ownership Rate, 1997 -2010Q1, Percent


Source: U.S. Census Bureau and The New York Times

The demand for retail oriented real estate can be characterized as a tale of two consumers. The higher end consumer, benefiting from rising stock prices and employment stability is back while the lower end consumer is being ravaged by high unemployment, high gas prices and weak home prices. After all, 5% of the households account for 40% of aggregate household income. Simply put the Nordstrom shopper is spending while the Wal-Mart shopper isn’t.

Although retail sales have recovered, the growth rate in sales is well off the path of the mid-2000s. (See Figure 13) Consumers are still in a retrenching mode as the savings rate normalizes from the near zero level of five years ago. (See Figure 14) In addition e-commerce inexorably gains share over store-based retailing year after year. Witness the bankruptcies of Blockbuster and Borders as prime examples of the impact of e-commerce on store-based retailing. As a result, retail real estate which was the investment “darling” of the last decade faces a far more difficult future going forward.

Figure 13. Retail & Food Service Sales, Ex Autos, 1992-Apr 2011, Monthly Data, In $ billion.

Sources: Federal Reserve Bank of Saint Louis

Figure 14. Personal Savings Rate, 2000Q1 – 2013Q4F

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Reflecting a weaker than normal rebound in consumption, warehouse demand is slowly recovering from the massive inventory liquidation that took place during the recession.(See Figure 15) Inventories are now rising and will likely receive an impetus from the tragic tsunami/earthquake in Japan. Why? One of the many lessons coming out of Japan was the realization how fragile the global supply chain is. While “just-in-time” inventory control is still the order of the day, there will be a role for “just-in-case” supply management with a resultant increase in the level of inventories.

Figure 15. Real Business Inventories, 2000Q1 – 2013Q4
Source: U.S. Department of Commerce and UCLA Anderson Forecast

Furthermore, because much of what is held in storage is imported, the rise in imports is an encouraging signs. (See Figure 16) Real imports have recovered all of the lost ground that occurred during the recession and are now making new highs. This factor certainly augers well for coastal-based warehouse-distribution facilities.

Figure 16. Real Imports, 2000Q1 – 2013Q4F, Quarterly Data

Sources: U.S. Department of Commerce and UCLA Anderson Forecast

Nevertheless the widening of the Panama Canal in 2014 has the potential to remake corporate logistical maps. No longer will Asian exporters be forced to use a ship-to-rail-link through west coast ports to reach the consumer markets of the Midwest and East. New competition for west coast ports will arise in Houston, Texas; Savannah, Georgia; and Charleston, South Carolina as shippers diversify their alternatives. Simply put, the west coast ports will lose their pricing flexibility.

Conclusion

It’s a happy time for quality commercial real estate in major markets and for apartments in general. As long as interest rates remain low investors will continue to pay historically high prices for those types of real estate. However, because demand growth remains tepid, market prices are increasingly vulnerable to even a modest rise in interest rates. In the meantime with the exception of rental housing new construction will remain muted over, at least, the next eighteen months. Thereafter a modest rebound in the other sectors of commercial real estate will likely occur.