On the surface it would appear that the
commercial real estate asset market is booming. The prices of “institutional
grade” real estate have surpassed the prior boom levels of 2006-2007, the
commercial mortgage backed securities (CMBS) market has risen from its nadir in
2009 and is half way back to the level of 2007, interest rates remain
extraordinarily low, and commercial construction generally remains constrained,
at least for now. (See Figures 1, 2, 3, and 4) Capitalization rates (net
operating income divided by purchase price) for high quality properties are in
the 5% range or lower and investors in a yield-starved world are willing to accept
ten year pro forma internal rates of return in the 6-7% range. We are in truly
heady times.
However, beneath the surface commercial
real estate, with the notable exception of apartments, faces the challenge of
disruptive technology that is undermining tenant, as opposed to investor,
demand for commercial real estate.[i]
Put simply, disruptive technology is defined as a low cost solution that offers
lower performance but, represents a true value at the price. Think tablet computers compared to personal computers.
In the following sections I will discuss the major issues facing each property
type in turn.
Figure 1. Green Street Advisors
Commercial Property Index, Dec 97 –April 14, 2007 Peak = 100.
Source: Green Street Advisors
Figure 2. CMBS Issuance, 1999-2014F, In $ Billions
Source: Real Estate Alert and UCLA
Anderson Forecast
Figure 3. Real Commercial Construction
Spending, 2000Q1 – 2016Q4F
Sources: U.S. Department of Commerce and
UCLA Anderson Forecast
Figure 4. Federal funds vs. 10 Year U.S.
Treasury Yields, 2005Q1 – 2016Q4F
Sources: Federal Reserve Board and UCLA
Anderson Forecast
Retail
Fifteen years ago fear
of internet competition stalked the retail real estate world. Then the fears
were premature; today it is reality. The share of retailing going to e-commerce
has risen from 1% in 2000 to 6.2% today. (See Figure 5) Indeed if you strip out the non-e-commerce intensive automobile,
gasoline, retail food and restaurant groups the share of retail spending
devoted to e-commerce doubles to 12.5%. In fact since the recession lows e-commerce
sales have advanced 110% while retail sales ex- autos have risen just 23%; not
a pretty picture. Slowly but surely e-commerce is eroding the very foundations
of retail real estate.
Figure 5. E-Commerce
Sales as a Percent of Total Retail Sales, 2000Q1 – 2014Q1
Source: U.S.
Department of Commerce via FRED
This trend is
manifested in still very high mall vacancy rates which are at recession levels,
and in the bifurcation of the mall business. (See figure 6) For now the Class A
malls are thriving with sales per square foot exceeding $700. However the
bottom tier malls with sales/ square foot of less than $300 are suffering. They
are certainly not being helped by the slow motion demise of JC Penney and
Sears. Of the 1050 open and enclosed malls in the U.S. about 150 of them have
vacancy rates in excess of 20%.[ii] Instead of being retail draws they have
become places where retailers go to die. At the end of the most of those malls
will be “scraped” with alternative uses found for the land.
Figure 6. Mall Vacancy
Rates, 1980-2014Q1
Sources:
Calculatedriskblog.com and REIS.
Although the top tier
malls appear to thriving underlying sales growth has been eroding over time.
For example Simon Property Group, the nation’s largest mall owner, has reported
consistently rising leasing spreads (new leases above existing leases), sales
growth is stagnating. (See Figure 7) This trend is not sustainable. Simply put
retailer profitability is eroding in the face of sluggish consumer spending and
greater pricing transparency induced by smart phones and to the detriment of
the mall; retailers are upping their own e-commerce games. Thus it is no
surprise that mall operators are keen to add more restaurant tenants into their
mix and they too will have to up their investment in technology. Thus the
travail of the B-malls might just represent the canary in the coal mine.
Similarly power and
community and even neighborhood centers are facing digital competition. Home
Depot is no longer expanding its store count as it is now concentrating its
efforts on e-commerce. Although there are e-commerce retail food distribution
models, the entrance of Amazon into this arena certainly bears watching.
Needless to say e-commerce is making huge inroads into kitchen, bath personal
care and pharmacy items. Look out Bed, Bath and Beyond.
Figure 7. Simon
Property Group, Sales/Square Foot, Percent Change, Year over Year vs. Releasing
Spread, 2011Q4 – 2014Q1
Source: David Harris,
Imperial Capital
What is working in
retail appears to be street level retail in dense urban centers that have a
significant tourist component to support underlying demand. For example retail
rents in Manhattan have been known to exceed $2000 a square foot with rents in
high hundreds common. Contrast this with top mall rents of around $100 a square
foot. Critical for this model to work is a dense environment of high income
consumers. Aside from Manhattan, think Boston, Chicago, San Francisco and parts
of West Los Angeles/Beverly Hills/Santa Monica.
Office
Aside from a few
exceptions such as Manhattan, San Francisco, San Jose, Seattle, and Houston, the
office market remains in the doldrums. The national office vacancy rate stands
at a high 16.8% and has only marginally come down from its recession peak of
17.5%. (See Figure 8) There are two very important factors at work. First as we
discussed previously, the historic drivers of office demand, financial and
legal services employment are but a shadow of their former selves.[iii]
(See Figures 9 and 10) For example,
financial activities and legal services employment increased by historically
modest 55,000 and 1,000 jobs over the past year and both are still below their
pre-recession peaks. In contrast employment in computer systems design,
management and technical consulting and support services for mining (largely
oil and gas) increased by 63,000, 51,000 and 29,000 jobs, respectively. Indeed
all three categories are at new highs.
This change in the
pattern of office employment growth explains why the technology and energy
related office markets are doing so much better than the more traditional
markets. And it also explains why the previously out of favor mid-town south
markets of Manhattan, where technology firms tend to concentrate are doing far
better than the very traditional Park Avenue market. In the Los Angeles the
same goes for Silicon Beach compared to Brentwood.
Figure 8. National
Office Vacancy Rate
Sources:
Calculatedriskblog.com and REIS.
Figure 9. Financial
Activities Employment, 2000Q1 – 2016Q4F
Sources: Bureau of
Labor Statistics and UCLA Anderson Forecast
Figure 10. Legal
Service Employment, Jan 2000 – April 2014, In Thousands
Sources: Bureau of
Labor Statistics via FRED.
A far more serious
challenge to office demand is that under the impetus of changes in technology
and technology-oriented tenants, the space demanded per office worker is
dramatically contracting. Instead of 200 square feet of office space per
worker, office space is now being designed around utilizing 150 square feet per
worker. Moreover in many new buildings for tech-oriented tenants space planners
are now allotting only 120 square feet per worker.
Why is this happening?
First technology has reduced the demand for file space and reference rooms as
records have become digitized. Second technology firms emphasize collaborative
work environments utilizing open floor plans. The densification of work spaces
has not been limited to technology firms as Goldman Sachs, Credit Suisse and
Unilever have adopted floor plans allocating 150 square feet per worker.
What this means is that much of the existing office
stock is technologically obsolete. It
is no easy task to go from 200 square feet per employee to 150 square feet or
less. At higher employment densities existing building have issues with
elevator, restroom, ventilating and fire stairwell capacity. Further in
suburban markets with limited mass transit, the traditional parking ratio of 4
spaces per 1000 square feet of office space will prove to be inadequate. Thus
even in high vacancy markets we will see new construction to accommodate the
new workplace of the 21st century. Put bluntly, even at higher rents
an office building in a dense configuration can cost less on a per employee
basis than a lower density building. As
a result the national office vacancy rate will stay high for many years to
come. And it should surprise no one that urban office buildings are being
converted to residential use and suburban office buildings are being “scraped”
to make way for high density residential development.
Industrial
The industrial market
is gradually recovering from recession as the availability rate has gradually
declined from 14.5% in 2010 to around 11% today according to CBRE. Industrial
space has and will continue to benefit from e-commerce as warehouse space is
substituted for retail space and the need to be closer to the consumer. However
the main driver of demand on the coasts has weakened with softer import growth.
Of greater consequence
will be the completion of the delayed widening of the Panama Canal in 2016 to
accommodate the larger container ships. That mega-project has the potential to
shift warehouse demand from the west coast to the gulf and east coast ports benefiting such port cities as Houston, Savannah and Charleston. (See Figure
11)
Figure 11. Panama
Canal Logistics
Source: Google
Hotels
Technology has made
the hotel business far more transparent. There are a host of on-line services
that supply up-to-the-minute pricing data for hotel rooms throughout the world.
There are also consumer reviews available for practically every hotel in
America. More than ever hoteliers have to be on their toes. All of this has
been true for about the past decade. What is new is the rise of the “sharing
economy” where individuals offer up their own houses, apartments or rooms to be
made available for temporary rental.
The prototype of this
new form is Airbnb a website that offers up private accommodations in people’s
homes. Earlier this year Airbnb received venture financing that established a
$10 billion value for the firm, greater than the market capitalization of Hyatt
Hotels. This is truly disruptive competition. It doesn't have to be as good as
a hotel room. All it has to be is cheap and convenient. Of course it should not
be surprising that the regulation-heavy cities, under the guise of protecting
rent control, of New York and San Francisco are making moves to stifle this new
form of competition to the hotel industry. There is also the issue of
collecting hotel taxes where the owner is responsible for both collection and
payment of the tax. Airbnb is in the process of seeking legislative change to
allow it to collect and pay the required taxes. Meantime a recent perusal of
the Airbnb found a host of accommodations in or near Westwood Village at prices
ranging from $50-$350 a night.
Multi-Family Housing
Multi-family housing
is in the sweet spot. The sector is benefiting from:
· A decline
homeownership rate (See Figure 12)
· An increased
consumer preference for urban and suburban density.
· A still sluggish
economy that is delaying such life cycle events as marriage and childbirth.
· The need for 24/7
tech workers to be close to their employment.
· Transit-related
development being viewed as “green.”
Figure 12.
Homeownership Rate, 1995Q1 -2014Q1.
Source: Bureau of the
Census
All of these forces
have led to a free fall in the apartment vacancy rate to 8% from the recession
high of 4%, increasing rents, and a surge in construction. (See Figures 13, 14
and 15) We would also note that the 3% increase in year-over year rents
reported by the Bureau of Labor Statistics is understated because of a few
technical issues. Specifically we are forecasting multi-family housing starts
to easily exceed 400,000 units a year in 2015 and 2016 which will represent
their highest level since the mid-1980s. Of course by 2016 the increases in
construction and a leveling off in the homeownership rate will cause vacancies
to rise and rent increases to abate. Meanwhile the boom is on.
Figure 13. Apartment
Vacancy Rate,
Sources:
Calculatedriskblog.com and REIS.
Figure 14. Consumer
Price Index, Rent of Primary Residence, Jan 2000 – Apr 2014, Percent Change
Year Ago.
Sources: Bureau of Labor Statistics via
FRED.
Figure 15. Multi-Family Housing Starts,
1980 – 2016F
Sources: Bureau of the Census and UCLA
Anderson Forecast
Conclusion
In this report we have outlined several
very important issues facing commercial real estate. We do not expect investors
will focus on the technological disruption facing retail, office and hotel real
estate until capital market conditions become less favorable. There is too much
money pouring into real estate to worry right now. Simply put the worriers
don’t get the deals. Nevertheless when the capital markets turns investors will
wake up to the changing landscape for commercial real estate.
[i]
For a discussion of disruptive technology see, Christensen, Clayton M., “The
Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail,” (Boston:
Harvard Business School Press, 1997)
[ii]
See Kapner, Suzanne and Robbie Whelan, “Struggling Malls Suffer as Penney,
Sears Shrink,” The Wall Street Journal,
May 10,11, 2014, p.1.
[iii]
See Shulman, David, “An Uneasy look at office Space Demand,” UCLA Economic Letter, December 2012
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