Sunday, June 22, 2014

An Open Letter to Janet Yellen

Dear Chair Yellen,

As a kid from Queens I am always willing to give the benefit of the doubt to a kid from Brooklyn. Nevertheless in your great fear of avoiding an error of commission I fear you are on track to a make an error of omission. I realize that you rightfully fear that Fed might raise rates prematurely thereby stalling or even reversing the economy’s painful progress since the Great Recession lows of 2009. Although it happened 77 years ago, the Fed is still haunted by its policy tightening in 1937 that was one of the proximate causes of the severe 1937-38 downturn. Never mind that my reading of the history of that period would assess much of the blame on a sudden contraction of fiscal policy.

More recently we all witnessed the severe bond market effects a year ago of your predecessor’s comments about the need to start tapering the Fed’s bond buying program. Although not the only cause, it certainly knocked the wind out of what was looking like a very strong housing upturn. Just as in medicine, the principle of “do no harm” certainly works for central bankers.

However, when you called the recent uptick in the consumer price index “noisy”, you ignored some really important evidence that the economy shifted its bias away from deflation and towards inflation. You know the data far better than I, but to state a few facts on a year-over-year basis headline inflation as measured by the CPI is now running at 2.1% and the core rate is 2.0%. And for two important categories, tenant paid rent and medical care services the year-over-year rate of increase is 3%, hardly benign. Moreover the rent component is understated because the over-weighting of rent controlled jurisdictions in the data tends to suppress measured inflation in a rising rent environment.  Indeed, over the last three months headline inflation is now running at a 3.3% rate and core inflation 2.8%. To me there is more signal than noise in the data.

Yes, I know the Fed uses the deflators for personal consumption expenditures to measure inflation and by those measures year-over-year inflation as of April is running at around 1.5% (1.6% headline and 1.4% core), well below your 2% target. But I caution you, the public likely measures inflation by the widely publicized CPI and if that appears to running well above 2%, the well anchored inflation expectations that the Fed loves to brag about might soon give way.

To be sure measured wage inflation remains modest at 2% and if we looked at that alone, there would not be much to worry about on the inflation front, but a lot to worry about on the labor market front. However there is hard statistical evidence that the labor market is improving with the unemployment rate on the road to below 6% by yearend and anecdotal evidence that wage rates are picking up. A good thing, but when you combine that with the other inflation data cited above, it will be harder for you to be so cavalier about the uptick in inflation .It would be better to start laying the ground work now, rather than waiting until it is too late. History suggests that a Fed behind the inflation curve wreaks far more havoc on the financial markets than one modestly ahead of it.

On that score I would note that after your press conference last week both the TIPS market and the gold market rallied strongly. A few days don’t make a trend, but these auguries of inflation might just be sending you a message.

Let me add that you may have something more to worry about than signs of “irrational exuberance” in the credit markets and recent surge in corporate mergers and acquisitions. There are signs in the real economy of what the Austrians, and I do not call myself an Austrian economist, of malinvestment. For example there is real evidence that the demand for electric power generating facilities, office building, shopping centers and hotels are about to be technologically disrupted. Yet investment, in those areas, especially in existing assets, continues unabated because the capital market remains wide open to them. Trust me, an unwind here will not be pretty.

Finally, let me close by rephrasing what I noted earlier. Sometimes an error of omission can be just as dangerous as an error of commission. Meantime enjoy your trip to beautiful Jackson Hole later this summer.

Yours truly,

David Shulman

Wednesday, June 18, 2014

My Amazon Review of Hillel Halkin's "Jabotinsky (Jewish Lives)"

Hillel Halkin brings to life in a short and very readable biography, the story of Vladimir Jabotinsky (1880-1940), the founder of Revisionist Zionism. Jabotinsky was far from the prototypical Zionist of the early 20th Century. Being born in the cosmopolitan port city of Odessa, he was far from the shtetls of Poland and Russia. He was far from religious and didn’t really like living in the Palestine of the 1920s.

Nevertheless he was extraordinarily clear-eyed about the future of Zionism. Jabotinsky understood:

·       * The real need for Jewish Legion to assist in the British invasion of Ottoman Palestine thereby establishing the first organized Jewish fighting force in nearly 2000 years.

·      *  The local Arab population would not be passive to a surge in Jewish immigration. He leads in the formation of the Haganah out of the remnants of the Jewish Legion. The Haganah was the forerunner of today’s Israel Defense Forces.

·      *  The Nazi nightmare would wipe out European Jewry and urged the Jewish community to pack up and leave. He supplied chartered steamers to illegally transport Jews to Palestine.

·        *The Israeli economy organized along the socialist lines of Labor Zionism would not be viable and urged more market oriented policies.

Halkin discusses in great detail Jabotinsky’s long time and very acrid rivalry with David Ben Gurion. They fought each other for control of the Zionist Organization in the 1930s. To put it mildly they did not like each other and Ben Gurion prevented Jabotinsky’s reburial in Israel until after he stepped down as prime minister in 1964.

A failing of the book is that Halkin expends too many words on Jabotinsky the journalist and the writer and not enough on his leading his Revisionist Zionist group and his founding of Betar, its youth group. Menachem Begin was so inspired by Jabotinsky that he joined and became a leader of Betar. Nevertheless I would recommend “Jabotinsky” for those readers who want to go beyond the standard Labor Zionist version of the founding of the State of Israel. A great companion piece would be Daniel Gordis’, “Menachem Begin: The Battle for Israel’s Soul.”

For the Amazon URL see:

Tuesday, June 17, 2014

"Technology vs. Commercial Real Estate: Retail, Office and Hotel Markets Face Major Disruption," UCLA Economic Letter, June 2014

This is a condensed version of my previous post on commercial real estate. It does, however, include two charts. The URL is:

Saturday, June 14, 2014

"The Changing Landscape of Commercial Real Estate," UCLA Anderson Forecast, June 2014

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


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: 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.


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: 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.


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


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: 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


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