Quoted in The Wall Street Journal on Commercial Real Estate

 “Basically, what you have is a decaying asset,” said David Shulman, formerly a real-estate investment trust at Lehman Brothers and now an senior economist at UCLA Anderson Forecast. “If it’s a decaying asset it’s a hot potato that you should get rid of as fast as you can.”  

"Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts as Defaults Grow" 

 The Wall Street Journal (online, paywall), July 24  Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts as Defaults Grow - WSJ

The Video Link to the UCLA Anderson Forecast on Commercial Real Estate

Presented below is the video link to the UCLA Anderson Forecast for Commercial Real Estate. The initial part shows the UCLA forecast for the economy. My short discussion on commercial real estate appears at 1:41 and the panel discussion starts at 1:55. The panel consists of Stuart Gabriel, Moderator and Head of the Ziman Center for Real Estate, Carl Muhlstein, Executive MD at JLL, Jackie Levy, CFO of the Caruso Group, and Paige Serden, Sr. Dir. at Gantry, and yours truly. You might find some of this worth your while.

 UCLA Forecast: June 2023 Economic Outlook - YouTube

Has the Recession Arrived?

Has the long forecasted recession arrived? My answer is YES. Here is why:

* The banking system is crippled with huge mark-to-market losses on securities held to maturity. (See: Shulmaven: Winter Comes to the Bank Stocks) Further the loan losses associated with bad commercial real loans have yet to be recognized. Hence lending is being curtailed across a broad front of borrowers.

* New claims for unemployment insurance reached an 18 month high last week at 264,000. The labor market is nowhere near as strong as it was.

* The price of copper made a new low for the year at $3.72/pound down 14% from its January high. This is the metal with a Ph.D. in economics, although as my friend John Lipsky always reminds me it is from the Universidad de Cattolica de Chile. 

* The stock market has gone nowhere over the past two years with nominal stock prices down 1% and real stock prices down 14%. Hence the consumption fuel coming from the wealth effect has evaporated.

* First quarter consumption was flattered by an 8% increase in Social Security payments, obviously not to be repeated for the balance of the year.

* Although real GDP is likely to to be up in the second quarter because of a modest swing in inventories, real final sales will decline and that will set the stage for a decline in both final sales and the overall GDP in the third quarter.

* Because inflation will remain sticky, the Fed will need a significant move up in the unemployment rate before pivoting to a lower interest rate regime. Thus the Fed policy would allow for a mild contraction in the economy.

My Interview with Greystone on the Post-Covid Apartment Outlook

UCLA Economist: Market Outlook Post-Coronavirus

The COVID-19 pandemic, which has touched every corner of the world and impacted every industry throughout the United States, has left an indelible mark on the economy. Greystone spoke with David Shulman, a senior economist with UCLA Anderson Forecast, part of the University’s Anderson School of Management, about his predictions for how COVID-19 may change the commercial real estate landscape.

Q. What is the outlook for CRE in 2020-21? Are there some sectors that will perform better than others?

A. The multifamily sector is better off than property sectors such as retail and hotels. Probably the one sector that may be most impacted is senior housing. The industrial sector is good so far, and for offices there are long-run questions about how businesses will change their configurations or allow more people to work remotely.

The multifamily sector came into the year strong. Rents were going up and most owners were happy campers. The big risk they were facing was regulatory issues such as rent control. The pandemic has exacerbated that with things like the moratorium on evictions New York City’s legislature is considering extending the moratorium for the entire year.

Q. How is the virus and the financial fallout from the shutdown economy expected to impact multifamily owners and managers?

A. In the near term, there will be pressure on apartment owners because of the wave of unemployment. But they will be OK if they are not overleveraged. Rents will be under pressure all year, but the industry was coming into the year in good shape. A one-year setback is not that big a deal because even if rents fall a little now, occupancy should stay strong.

One long-term outcome could be more regulations leaning towards tenants and away from landlords. We won’t see a ‘no evictions’ policy forever, but we’re likely to see it become much more difficult for landlords to evict tenants.

Q. What should multifamily owners do now to position themselves for a return to normal?

A. Apartment owners and managers need to figure out how to do digital marketing to attract new tenants. They also need to be hypersensitive about cleaning their buildings and letting people know they are doing it. The last thing anyone wants is a COVID-19 outbreak in their building, so they need to use special equipment to disinfect everything.

To keep their tenants, landlords need to be proactive about dealing with people. Maybe they can defer the rent or make a deal. It is better to get 50 percent of the rent for four months vs. none, especially if the tenants are unlikely to be able to pay their back rent after a few months.

Q. What lessons from previous crises can help apartment owners and investors?

A. This situation is so different that you really cannot take many lessons from previous crises. The great recession was more of a slow-motion train wreck that lasted for years. This is hitting a wall all at once.

After 9/11, I predicted that big companies would want their headquarters to be in a nondescript office in a suburban office park, but I was 100 percent wrong about that.

One question is where people will choose to live if they can work remotely. They may choose to work from Nashville or somewhere rather than an expensive coastal city.

The other question is whether people will want to move to the suburbs or to a smaller town. The big cities could be perceived as giant petri dishes for this virus. If that is what people are thinking, this could be better for investors in smaller midrise apartments in the suburbs. But that is a question for 2021 or 2022.

Q. Are there differences in expectations for mid-size multifamily owners compared to larger owners?

A. Smaller buildings and smaller investors are likely to be hit harder by unemployment because they may have fewer tenants who can pay rent. They will be especially hard hit if they are overleveraged.

In the higher-end luxury buildings, which tend to be owned by larger investors, most tenants paid their rent in April. The impact of unemployment is much worse on people with lower paying jobs and those are the people more likely to rent in smaller, more affordable buildings.

Q. What should developers anticipate about the availability of capital for investments?

A. There will be capital to invest. We are in a zero-rate world, so if you buy something at five percent, that is good. But the market needs to know what net operating income (NOI) will be in 2021. Once that is known, we will see lots more investment. The longer the economic shutdown goes on, the harder it will be to come back. If things start to return to normal this summer, we will see more investment faster. It may be that investor appetite will be greater for less urban areas and for cities other than gateway cities, but that is still a big unknown.

Greystone link: https://www.greyco.com/insight/ucla-economist-economic-outlook-post-coronavirus/

The Link to My Ziman Center Report: "Commercial Real Estate: The Good, the Bad and the Ugly"

https://www.anderson.ucla.edu/documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_06.05.19.pdf

Bank OZK: A Canary in the Commercial Real Estate Coal Mine?

Bank OZK, formerly Bank of the Ozarks surprised the market today by reporting a 439% increase in loan loss provisions to $42 million over the year ago quarter. The stock is down 9+ points today to 25, half of its 52 week high of 51. 

Why is this important to commercial real estate? Over the past few years this once obscure Arkansas bank has plunged into construction and development lending in such non-Arkansas locales as New York City, Miami and Los Angeles. Those three cities account for half of the bank's $12 billion loan book. For many small and mid-size developers Bank OZK has become the go to lender for C&D loans and therein lies the problem. In order 
to gain market share they had to be aggressive with respect to price and terms.

To be sure half the increase in the loan loss provisions was due to two loans originally made in 2007 and 2008 one for an enclosed mall in South Carolina and the other for a residential land development project in North Carolina. Nevertheless absent those two projects, the loans loss provision in quarter would have almost tripled versus a year ago.

My guess is that if we are in the early phases of a commercial real estate decline, future commentators will note that Bank OZK gave the market a fair warning of what was to come.

My Amazon Review of Sebastian Mallaby's "The Man who Knew: The Life and Times of Alan Greenspan"

From Sideman to Conductor of the Global Economic Orchestra

Sebastian Mallaby has written a magnificent well-written book about Alan Greenspan and the times that shaped him. (Full Disclosure: I am mentioned in the book.) It is a story about a musically talented Jewish kid from Washington Heights who became a sideman playing the saxophone in a 1940s jazz band and who by the dint of his intelligence rises to become chairman of the Federal Reserve Board. We follow Greenspan through his undergraduate days at NYU where is math geekiness shines through to his stint in an economics graduate program at Columbia. There he meets future Fed Chairman Arthur Burns and learns the importance of knowing every number in the economic data set. By doing this he sees the economy from the ground up rather from the top down approaches of grand theory. His knowledge of the data will become most useful as his career progresses.

After a brief interlude he forms the economic consultancy of Townsend-Greenspan and garners a host of industrial and Wall Street accounts. He becomes the man who knew. About the same time he falls into the ultra-libertarian cult of Ayn Rand. Somehow he managed to keep the practicalities of his work separate from the extremes of the cult. In 1959 he authors a paper describing how share prices influence corporate capital expenditures. It is a precursor to Tobin’s Q for which James Tobin wins the Nobel Prize in economics. Simply put when share prices exceed replacement cost there is an incentive to expand and vice versa. Forty years later Larry Summers jokes that Tobin owes Greenspan a share of Nobel cash.

By the late 1960s Greenspan catches the political bug and works as an insider on Nixon’s presidential campaign. It is from that beginning he has an involvement in every Republican administration that came later. He learns how to wield power and bests Henry Kissinger in a bureaucratic fight over an Iran oil deal that never came to pass. By 1980 he was one of the key negotiators in the aborted attempt to have Jerry Ford become Reagan’s 1980 running mate. Far from being a sideman he was inside in the thick of it.

In 1987 Reagan appoints him to chair the Federal Reserve and of a sudden the stock market crashes. He with others work to prevent a repetition of 1929 and he comes out of it with an enhanced reputation. He has an icy relationship with the Bush Administration but gets along famously with the Clintons. It is then when the late 1990s economy takes off that he becomes the conductor of the global economic orchestra and is practically deified for a sustained period of high growth, low unemployment and low inflation. He rightly diagnoses well ahead of the data that productivity was surging. That was brilliant, but all those factors lead to “irrational exuberance” in the stock market.

But herein lies the problem that would haunt his reputation 10 years later. By targeting inflation and employment he necessarily ignored the asset markets and their potential to trigger instability. He ignored the warning of Hyman Minsky who noted that “stability leads to instability” as investors anticipate that the good times will last forever. When they don’t the financial system is undermined and with that the safety and soundness of the banking system.

Greenspan’s critics argue that he should have stopped the housing bubble of the mid-2000s through increased regulation. Mallaby rightly argues that getting the regulations right is a difficult task and in the midst of a bubble it is hard to do politically. Greenspan was unwilling to spend his political capital on this.  Where Greenspan failed was that he believed that bankers in their own self-interest would prevent risk from getting out of control. They didn’t. I made a similar mistake in thinking that the Wall Street investment banks would not end up eating their own cooking by keeping so much bad paper on their balance sheet. They did. On the other hand Mallaby supports the critics in thinking that Greenspan should have been more aggressive in raising rates in 2004-06. To be sure bubbles are hard to detect and there was belief that the authorities could clean up a mess after the fact, but as it turned out the cleanup costs in 2008-2010 and still ongoing were enormous.

Mallaby also discusses Greenspan’s private life. After a failed marriage in the 1950s Greenspan becomes a serial monogamist dating staff members at Townsend-Greenspan, a speech writer in the Ford Administration, television personality Barbara Walters, and a host of others until he marries NBC newswoman Andrea Mitchell.

My few quibbles with the book is that in Mallaby’s discussion of the economic history he leaves out the importance of the Garn-St.Germain Depository Institutions Act of 1982 which enabled savings and loan associations to diversify their asset portfolios. That in combination with the new Reagan depreciation schedules created a marriage made in hell between the S&L’s and the tax syndicators that helped overbuild America in the 1980s. He doesn’t discuss the 1985 Plaza Accord whose effect was to flood the global economy with money setting up the 1987 crash and the final surge of the commercial real estate boom. He also fails to note that the Fed missed the rolling recession in commercial real estate that began in Texas, went to Phoenix and finally the Fed woke up when it reached New England. But New England was a weigh station on the road to Southern California and the New York City metropolitan area. Leaving these points aside I would highly recommend this book for readers interested in the life of a very interesting man and how economic policy is really made.

For the full Amazon URL see: https://www.amazon.com/review/R2J36O1D479XA5/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv

"Commercial Real Estate's Slow Motion Slowdown," UCLA Ziman Center for Real Estate, July 2016

See the URL below for the full article. This is a different version of my prior post "Letting the Air out of the Commercial Real Estate Balloon."

http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_07.12.16.pdf

"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

                                  System

                                  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 25^th, 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: Calculatedriskblog.com 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: Calculatedriskblog.com 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: Calculatedriskblog.com 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.

Conclusion

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.

Calpers Makes the Top

The Wall Street Journal reported today that the giant $300 billion California Public Employees Retirement System (Calpers) will increase its real estate allocation from $26 billion to $33 billion. It is not news that commercial real estate prices have surged and are now well above the frothy peak or early 2007. Just as in the late 1980s and and in 2005-2007 it appears that Calpers is weighing in at the top of the market.

Recall that Calpers bought the California land play Catellus and the UK property company Randsworth Trust at the peak of the late 1980s real estate boom. Those investments, to say the least, soured. In 2007 Calpers bought into the giant and highly leveraged Stuyvesant Town apartment project in Manhattan as de-rent control play. Like Randsworth Trust that investment was a wipe-out.

To be sure one can say that Calpers has learned from their previous episodes. This time it will be concentrating on lower risk "core" assets that have become extraordinarily pricey in the global search for yield. Therefore the risk here is very straight forward, cap rates could rise. Basically to take a major position in commercial real estate today the investor has to believe that cap rates will remain low for a decade. To me this could be the riskiest bet of all. After all more money has been lost in the search for yield than in practically any other investment endeavor.

As a result real estate investors should be forewarned. It looks like, yet again, Calpers will be making another top.

"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:

http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_6-16-14.pdf

"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

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 21^st 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.

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[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