Friday, June 10, 2016

"Letting the Air Out of the Commercial Real Estate Balloon," UCLA Anderson Forecast, June 2016

                               “U.S. properties are priced to perfection.”
                                  Christopher Ailman, Chief Investment
                                  Officer, California State Teachers’ Retirement
                                  Quoted in Bloomberg, April 13, 2016

Fueled by cheap money, low levels of new construction except for apartments, and modestly improving demand commercial real estate values have more than doubled off their financial crisis lows of 2009. (See Figure 1) The best properties are trading at record low capitalization rates (net operating income divided by purchase price) of below 5% and the required unleveraged return over a ten year time horizon ranges from 5%-6%. We are truly living in heady times for commercial real estate.

Figure 1. Green Street Advisors Commercial Property Index, Dec. 97 – April 16, 2007 Peak =100

Source: Green Street Advisors

Nevertheless prices are leveling off as investors have become concerned that the period of extraordinarily low interest rates may soon be coming to an end and stresses have emerged in the all-important commercial mortgage backed securities market (CMBS) with new issue volume expected to be off by more than 50% this year. Although credit spreads of come in from this year’s high they are still well above what prevailed a year ago. (See Figures 2 and 3) With new risk retention rules scheduled to be phased in, the investment banks have become more cautious with pricing.

Figure 2. CMBS Issuance, 1999 – 2016F, In $ Billions

Sources: Real Estate Alert and UCLA Anderson Forecast

Figure 3. CMBS Spreads, 10Year AAA Senior vs. 10 Year BBB- to Swaps, Jan 23, 2015 – May 12, 2016

Source: Trepp

On the equity side the demand for yield seems to be insatiable and has been enhanced by legislative changes in the Foreign Investment in Real Property Tax Act (FIRPTA) that makes it easier for non-U.S. domiciled investors to access U.S. real estate. However, the fact remains that the behemoth sovereign wealth funds of the petro-states are suffering under the weight of low oil prices. Simply put, reduced cash flows and increased domestic priorities are curbing their appetite for international investment.

Domestically the implementation of fiduciary investment standards by the Department of Labor for retirement accounts has already and will continue to reduce the demand for high fee private real estate investment trusts (REITs). To be sure these investments would have been banned under earlier drafts, but the fact remains that the $20 billion flow into private REITs in 2014 will be cut by at least half in 2016.
In terms of operating fundamentals, job growth, the source of much real estate demand, will inevitably slow as the economy approaches full employment. After gaining 675,000 jobs a quarter over the past three years, quarterly job gains will slow to 400,000 in 2017 and a much lower 125,000  in 2018. (See Figure 4) Just as job growth is slowing, supply will pick up as the new construction started in recent years and the construction now in planning stages break ground are delivered in 2017 and 2018. (See Figure 5) The increases in new construction will be somewhat mitigated by the growing caution on the part of construction lenders and their regulators.

Figure 4. Payroll Employment, 2007Q1 -2018Q4F, Quarter over Quarter Change, In Thousands

Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 5. Real Commercial Construction Spending, 2000Q1 -2018Q4, In Billions of 2009$

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

Into this mix we are forecasting that interest rates increase modestly over the next few years with the federal funds rate approaching 3% by the end of 2018 and the yield 10- year U.S. Treasury notes reaching 3.5% in 2018. (Figure 6) These yields are high compared to today, but on a historical basis remain low. Thus the overall environment for commercial real estate will become less favorable over the next few years and the sector will continue to be pressed by the technological disruption coming from e-commerce and reduced square footage per office worker.[i] But make no mistake, we are not forecasting a real estate crash, but rather we are about to enter a period of modestly declining commercial real estate prices. If you are looking for an analogy you can look at the recent behavior of stock prices which have been flat to down since December 2014. We will next discuss the retail, warehouse, office and apartment sectors in turn.

Figure 6. Federal Funds vs. 10-Year U.S. Treasury Yields, 2007Q1 -2018Q4

Sources: Federal Reserve Board and UCLA Anderson Forecast

High Drama in Mall Real Estate

As if on cue following the Wall Street Journal headline “Glut Plagues Department Stores” on April 25th, both Macy’s and Nordstrom in early May reported poor first quarter results and weak guidance for the entire year. The Journal noted a report by Green Street Advisors indicating that roughly 800 department stores about 20% of all anchor space in U.S. malls will likely close over the next few years and with that many malls will close with them. The stock market response was vicious taking the share prices of both Macy’s and Nordstrom down more than 50% from the recent highs. Simply put, the department store business hasn’t been good for years and the stock market is now recognizing that sobering fact. Remember Nordstrom is a staple in most of the best malls in the country.

Moreover the problem in the mall is not just limited to the anchor department stores. In the first quarter Simon Property Group the largest owner of regional malls in the U.S. once again reported that same-store sales for in-line shops were down on year-over-year basis. And it is not that Simon owns lower quality assets, they, in fact, own among the best assets in mall land. Generally speaking Class A+ malls have sales in excess of $700/square foot while Class B and C malls have sales below $350 a square foot.

It is not that overall retail sales have been declining, to the contrary retail sales have been increasing, albeit at a modest pace. What has been happening is that there has been a decided shift toward e-commerce. For example in April on a year-over-year basis department store sales declined by 1.7%, clothing store sales advanced by 1.3% and non-store retail (e-commerce) surged by 10.2%. Indeed since 2000 the e-commerce share of retail sales advanced from just under 1% to about 8% in the first quarter. (See Figure 7) However this data understates the full impact of e-commerce on retail sales because if you back out those sectors of retail that are not amenable to e-commerce (automobiles, gasoline, food and restaurants) the e-commerce share rises to 14%.  Moreover since 2000 e-commerce has taken about 30% of the growth in retail sales less the categories mentioned above.

Figure 7. E-Commerce Sales as a Percent of Total Retail Sales, 2000Q1 – 2016Q1

Source: U.S. Department of Commerce via FRED

In order to stay competitive major mall operators have ramped up capital spending to make their assets more attractive to consumers to include more restaurants and experiential activities. Note that these forms of retail are not subject to internet competition. Examples of the high level of capital spending include Westfield’s Century City with an $800 million program and Taubman’s Beverly Center clocking in at $500 million. Both of these assets are in West Los Angeles and compete with each other.

Nevertheless the competitive pressures mentioned above have only modestly showed up in the vacancy data as vacancy rates have yet to decline to the levels achieved in 2006. (See Figure 8) However it is important to note that the vacancy data do not include the population of shuttered malls. Indeed the stock market is reflecting the prospect of increased mall closures with the shares of the Class B operator CBL yielding a very high 10.2%, while the shares of Class A+ operator Simon yielding a far lower 3.3% as of May 18.  The yield differential indicates that the stock market in real estate investors view the Class A+ mall as near “bullet –proof” while the Class B mall is vulnerable to closure.

Figure 8. Mall Vacancy Rates, 1980 – 2016Q1

Sources: and REIS.

Thus far the operators of grocery oriented shopping centers have been immune from the onslaught of e-commerce competition, but with Amazon making moves to get into the private label grocery business and attempting to do same-day deliveries convenience oriented retail may soon be disrupted as well. Indeed the still prized Whole foods anchor is now suffering from increased competition in the organic food space. Simply put the retail environment is brutal.

Two years ago we noted that the real bright spot in retail real estate was street level retail in dense urban centers that have a significant tourist component to support underlying demand. That thesis proved true until very recently when the impact a strong dollar and weakness in much of the global economy has diminished international tourist spending. As a result asking rents are beginning to drop in, for example, Manhattan which was a major beneficiary of the luxury international tourist boom.[ii]

Industrial: A Beneficiary of E-Commerce

What has been bad for retail real estate has been good for industrial real estate.  E-commerce is warehouse intensive and as the need to shorten delivery times has increased, the demand for close-in modern warehouses in major population centers has soared. While overall warehouse rents have recently been growing at a 5% clip, in such markets as Los Angeles, East Bay San Francisco and northern New Jersey rents have increased at a double-digit pace over the past year. The increase in rents has been buttressed by the long decline in the availability rate. According to CBRE the industrial availability rate declined from 14.5% in 2010 to 11% in the first quarter of 2014 to a cyclical low of 9.2% in the first quarter of this year.

Of longer term importance is the widening of the Panama Canal to accommodate the larger container ships scheduled for opening later this month. This mega-project has spurred port expansions along the east and gulf coasts in such cities as Houston, Savannah and Charleston that will offer new competition for the west coast ports and has the potential to negatively impact the demand for warehouse space in the giant southern California market.

Office: In a Late Cycle Recovery

After seven years of economic recovery, albeit slow, the national office vacancy rate has barely come down from about 18% to 16%. To be sure new construction has been very sluggish until recently, but the demand has been far more muted than in past cycles. (See Figure 9) Two of the pillars of office demand are not what they once were. Financial Activities employment, though now on the rise, is still below its 2007 peak and legal services employment growth has stalled as both of these industries are still in the throes of a fundamental restructuring. (See Figures 10 and 11).

Figure 9. National Office Vacancy Rate, 1980 – 2016Q1

Sources: and REIS

Figure 10. Financial Activities Employment, 2000Q1 – 2018Q4F, In Millions, SA

Sources: Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 11. Legal Services Employment, Jan. 2000 – Apr. 2016, In Thousands, SA

Bureau of Labor Statistics via FRED

Perhaps more important has been the demand depressing factor of the decline in square footage per employee. Technological disruption is obviating the need for physical file space and reference rooms along with a shift to open floor plans has led and is continuing to lead to the reduction in the square footage needed per employee. Instead of allowing for 200 square feet per employee, space planners are now allowing for only 150 square feet. This trend is far from running its course.

The one really bright spot in for office demand has been the rapid growth of office employment in the technology sector. The cities with vibrant demand are generally those with a strong base of employment in the technology, advertising, media and internet sectors or TAMI in the lingo of the industry. Thus it is no surprise that such tech heavy cities as San Francisco, San Jose, Seattle, Boston and West Los Angeles are booming. Within cities it the tech portion of the economy that is driving office demand. For example the traditional high priced Park Avenue market north of Grand Central Station in New York City is relatively suffering when compared office submarkets one mile to its south.

A simple example of technology as demand driver can be seen in the growth in the computer systems design and related services sector. Here, instead of total employment we use the year-over-year change in employment and we can see surge to 120,000 jobs a year in 2015. (See Figure 12) However, as the boom venture capital funded technology start-ups wanes, employment growth has slowed to 80,000 a year. This decline, in part, has given rise to worries about the sustainability of office demand growth in the above referenced tech hubs.

Figure 12. Computer Design and Related Services Employment, Jan. 2000 – Apr. 2016, Year- Over- Year Change, In Thousands

Bureau of Labor Statistics via Fred

Multi-Family Housing: Running Out of High Income Renters

                       “…operating trends will likely cause same
                         store revenue growth to fall modestly
                        short of our original guidance midpoint.”

                          Equity Residential, First Quarter 2016 Earnings Release

Multi-family residential housing has been in a sustained boom since 2011. Despite a surge in new supply with starts on track to reach 400,000 units this year, rents continue to rise much faster than the overall prices. (See Figure 13) According to the official data residential rents were up 3.7% year-over-year in April, but because of quirks in the data the true increase in market rents is in excess of 4% and in more than a few markets, twice that. (See Figure 14) The rise in rents is supported by a dramatic decline in the apartment vacancy rate, which, of late, has leveled off at a very low 4.5%. (See Figure 15)

Figure 13. Multi-Family Housing Starts, 1990 – 2018F, Annual Data, In Thousands

Sources: Bureau of the Census and UCLA Anderson Forecast

Figure 14. Consumer Price Index, Rent of Primary Residence, Jan. 2000 –Apr. 2016, Percent Change Year Ago

Sources: U.S. Bureau of Labor Statistics and UCLA Anderson Forecast

Figure 15. Apartment Vacancy Rate, 1980 -2016Q1

Sources: and REIS

One of most powerful factors effecting rental demand has been the long decline in the homeownership rate. (See Figure 16) Whether out of choice or necessity, consumers are opting to rent. Part of this phenomenon is due to a shift in preferences for a more urban lifestyle and a delay in such life cycle events as marriage and childbirth as well as far more stringent lending criteria than was prevalent a decade prior. With the gradual rise in single-family home starts, we believe that the long decline in the homeownership rate has about run its course.

Figure 16. Homeownership Rate

Sources: U.S. Department of the Census via FRED

Nevertheless as investor demand continues to drive supply, tenant demand begins to ebb with a slowdown in employment growth coupled with a leveling off in the decline in the homeownership rate, apartment owners are discovering there might not be enough tenants to support $3500 a month rent for one bedroom apartments. That in fact was the gist of Equity Residential lowering its guidance range and the once white hot Manhattan and San Francisco markets begin to cool. The apartment business now appears to be in transition from great to good.


The combination of a less favorable financial environment along with weakening fundamentals arising from increased supply and reduced demand will likely bring to an end the seven year bull market in commercial real estate. To be sure we are in no way forecasting a “crash”, but rather an extended period of sideways to down prices. Simply put financial conditions will transition from being extraordinarily easy to just plain easy making it unlikely for us to witness a repetition of the events of 2007-2009.

[i] For a full discussion on this topic see, Shulman, David, “The Changing Landscape of Commercial Real Estate,” UCLA Anderson Forecast, June 2014.
[ii] See Weiss, Lois, “Shopping Pall Trashes NYC Commercial Real Estate,” New York Post, May 16, 2016.

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