Mall Valuations Post GGP/BPY

This is my fifth post on high quality mall REIT valuations in less than a year. Going back to my first post on May 4, 2017 ( https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations.html) I noted that the 4.5% cap rates used by most REIT analysts were way to low and I argued that a 5.65% cap rate was more appropriate. This analysis did not receive much support when Unibail announced its acquisition of Westfield last fall that implied a cap rate for its U.S. assets in the high 4% range.

However, the Brookfield Property Partners (BPY) acquisition of the 64% of the shares of GGP that it did not own at an implied cap rate estimated to be in 5.8%-6% range validated my thesis. The BPY offer was valued at around $22 per GGP share, 19% below the Street consensus net asset value of $27.28. Warning: take Street estimates of NAV with a grain of salt.

If anything I was too optimistic. I argued then that high quality mall cap rates were under stress because the e-commerce challenge would require significantly high capital expenditures, lower future estimates of rent growth and cause a downgrading of approximately 15% of the those malls considered to be high quality over the next five years.  As of today the first two of my assumptions are now the conventional wisdom. I also argued that higher long term interest rates would pressure cap rates.  Since then the 10 year treasury yield has increased from 2.3% to 2.8%.

Yesterday mall stocks tanked on the GGP news. However, today the mall REIT shares are soaring on reports that President Donald Trump is out to get Amazon, their arch nemesis. As of 3:00 PM EDT AMZN was off by 5% and SPG, for example, was up by 3%. In my view today's stock market action is a transitory phenomena and the mall REITs will be revalued to reflect the GGP transaction. Simply put, AMZN ain't going away, Trump or no Trump.

What that means is that once the Street adjusts net asset values to reflect high quality mall cap rates in the high 5% range, the stocks will settle in to trade at about a 10% discount from the new asset values which implies moderately lower share prices. Why? There is still too much uncertainty in the space and in my view long term interest rates will be significantly higher by year end.

The Dice are Rolling in Mall Land

Last May we wrote "Thus if private equity or sovereign wealth funds don't come in soon to scoop up the apparent bargain, the Street, as I argued, is way off." (https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations-part.html) Of a sudden, after a long period of sustained discounts to Street estimates of net asset value the dice are starting to roll in Mall Land. First Brookfield Property Partners offered to take in the 64% of GGP that it doesn't already own with a  cash and stock offer valued at $23/share. To be sure the offer was well above the $19/share the stock was trading at, but still well below the $28/share of value ascribed by the Street. As of this writing GGP is trading about 3% above the Brookfield offer price.

We then found out that hedge funds Starboard Value and Third Point have taken a position in Macerich causing its stock to rise from the mid-50s to the mid-60s, still below the $73 valuation estimated by the Street. Further Elliott Management, a $30 billion hedge fund, has taken a position in Taubman that elevated its stock price from the high 40s to the mid-50s again well below the $85 Street valuation. Remember the hedge funds are intermediaries and are ultimately looking for a final buyer like Brookfield to take them out. If no final buyer appears they will find themselves with dead money positions that will be sold back to the market.

Sitting on the sidelines watching and waiting are David Simon of Simon Property Group, the largest mall owner and Jonathan Gray of Blackstone, the largest private equity firm in the real estate arena. How they respond could very well be despositive as to how the price discovery process works out.

My guess is that the potential buyers of mall companies and/or mall assets are looking for what they perceive to be a bargain and with the Street still estimating mall cap rates in the 4-5% range, they will not find a bargain at those prices. Simply put the bid-offer spread is too wide, and as result I do not foresee transactions at anywhere close to the offer side of the market. But again, as we noted in May, time will tell.

"In the E-Commerce Revolution Brick and Mortar Defenses are Limited and Costly" UCLA Ziman Center for Real Estate Report, October 2017

See the URL below for the full report.

http://www.anderson.ucla.edu/Documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_10.10.17.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.

"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