"Real Estate in the Post-COVID Economy" UCLA Ziman Center Economic Letter, June 2020

The link to the article:
https://www.anderson.ucla.edu/documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_06.24.20_V4.pdf

The article highlights the real estate sections of the June UCLA Anderson Forecast.

Real Estate, the Macroeconomy and COVID-19

A webinar prepared by the UCLA Anderson Forecast and the Ziman Center for Real Estate featuring myself, Stuart Gabriel, Jerry Nickelsburg and Stan Izeman.

https://www.youtube.com/watch?v=vCHoVwXFRtk&feature=youtu.be

The Link to the UCLA Ziman Center Version of "Sum of All Fears"

Below is the link to the UCLA Ziman Center version of my "Sum of All Fears" report. It has a comment on real estate AND all of the figures are available on their pdf format.

https://www.anderson.ucla.edu/documents/areas/ctr/ziman/UCLA_Economic_Letter_Shulman_03.17.20.pdf

Political Risk comes to Manhattan Real Estate

To paraphrase Exodus 1:8, now there arose a new mayor over New York who knew not Michael Bloomberg or Rudy Giuliani. With the reactionary Bill de Blasio becoming the presumptive Democratic nominee for mayor and the odds-on favorite to win the general election in November, the 20 years of progress New York City has made threatens to become undone. Simply put de Blasio is throwback to the truly horrible mayors New York had prior to 1993. Think "bungling" Bob Wagner, the limousine liberal John Lindsay, the hapless Abe Beame and de Blasio's idol, David Dinkins. The last, of course, served as Mayor during the nadir of New York City's modern history. What all of these past mayors had in common was that they turned the city's fisc over to the public employee unions and they let crime run riot. By 1990 most informed opinion believed that the purpose of city government was to manage decline, not to create the thriving city that New York is today.

To New Yorkers of today and for that matter the real estate investors of today, that history is only dimly recollected at best. Instead of rewarding success, de Blasio seeks to punish it with high taxes. Instead of building  on the school reforms of the past decade, de Blasio wants to turn the schools back over to the unions. Instead of managing the budget, de Blasio will reward his union backers with pay raises unrelated to productivity. Instead driving down the crime rate to make New York the safest big city in America, de Blasio would end the very successful stop, question and frisk policy of the Bloomberg Administration. Of course the initial victims will be the people of color that now support de Blasio.

What all this means is that real estate investors who now take New York's well run government for granted will have to price in higher taxes and a diminution of services. Given the heady values of Manhattan real estate all the risk appears on the downside. The same goes for the big office REITs with a Manhattan focus, Vornado, SL Green and Boston Properties. The only hope is that Republican Joe Lhota pulls off an upset.

The Shaky Foundation Supporting Long-Term REIT Performance

Reprinted by permission from REIT WRAP Special Report dated August 16, 2010.

By David Shulman

Though the first decade of the 21st century has been characterized as “lost” for most equity investors, REITs stood out by generating a 9.75% compound annual return as measured by the total return version of the MSCI U.S. REIT Index (RMS) for the 10- year period ending in July 2010.

This performance is truly remarkable when viewed against the backdrop of a small negative total return for the S&P 500. Moreover after undergoing a near death experience in 2008/2009, REIT investors are once again looking forward to high single-digit returns for the new decade.

However, REIT performance over the last decade did not come from rising earnings and dividends; rather, it came from the tailwind of multiple expansion that is hardly sustainable. Add to that the “meltdown’s” impact (e.g. dilution resulting from massive stock issuance and significant dividend cuts, which helped right-size balance sheets) and the future appears guarded.

Where in 2000 REITs typically traded at FFO multiples in the 6-9 X range, today they trade in the 15-20+ X range. Moreover in 2000, according to data provided by Green Street Advisors, REIT forward AFFO yields were about 700 basis points above the forward earnings yield for the S&P 500; today, REIT forward AFFO yields are nearly 400 basis points below the S&P 500.

In other words, from a valuation perspective REITs are trading at the mirror image of their levels in early 2000 and it is more than likely going forward REIT performance will suffer from the headwind of multiple contraction.

TROUBLING RECORD

Beneath this stellar REIT performance is a very troubling record with respect to earnings and dividend growth. I dare say that few analysts in 2000 would have forecast the flat to down earnings that most REITs experienced over the past decade. To be sure 2000 represented a cyclical peak in REIT earnings and 2010 represents results around a cyclical trough, but the fact remains that 10 years is a long time.

Let’s get into the data. I examined the earnings and dividend performance for almost all (20) of the equity REITs that are covered by the Value Line Investment Survey. The data excluded those REITs who were bought out during the decade. Nevertheless, I believe it to be a good, though far from perfect sample, in that it leaves out a few of the major mall companies that did well.

I used Value Line because the data is readily available and it presents long term results on a consistent basis. However to be more current, I am using current IBES estimates for 2010 and Zachs Investment Research for future growth rates. The 10 year record for FFO and dividends are presented in a table at the end of this column.

Several of the “blue chip” REITs did well over the decade. The best FFO growth was reported by Public Storage (PSA) where FFO almost doubled and dividends more than doubled. Simon Property Group (SPG), Vornado (VNO), Federal Real Estate Investment Trust (FRT) and HCP (HCP) all reported credible increases in FFO and dividends. Boston Properties (BXP) reported higher FFO but a slightly lower dividend and AvalonBay (AVB) and Washington REIT (WRI) reported modest increases in FFO, but significantly higher dividends. (NOTE: In 2000 FRT, PSA, HCP and for that matter SPG weren’t as highly regarded as they are today. Moreover with respect to BXP and VNO the data ignore the impact of very substantial capital gain distributions made by those two REITs.

On the hand there were many REITs in 2000 that were perceived to be of high quality that faltered during the past decade. Apartment Investment and Management (AIV), Duke Realty’s (DRE), Prologis (PLD) and Developers Diversified (DDR) had their FFO and dividends decline by more than 50%. Such highly regarded REITs as Kimco Realty (KIM) and Equity Residential (EQR) will earn less and pay smaller dividends in 2010 than they did in 2000. The same is true for Weingarten Realty Trust (WRI), UDR (UDR), and BRE Properties (BRE). The mid-Atlantic office companies, Mack-Cali (CLI) and Liberty Property Trust (LRY) are also earning less and paying out less to their shareholders. The same holds true for Healthcare Realty Trust (HR).

In contrast to their short-run low-balling of earnings estimates, sell-side analysts are ever optimistic with respect to long term growth. Going forward analysts believe that REIT FFO growth rates will be in the range of 4-7% for most REITs, save for a few outliers. It may turn out that way, but history is on the side of the skeptics.

To be sure real estate fundamentals might drive REIT earnings higher, but where most analysts miss the mark it is with respect to capital expenditures and adverse changes in capital structure which are inherently difficult to forecast. Remember that the fastest growing REIT in the sample was PSA with a historic growth rate of 6.1%. Among the better performing REITs the growth rates ranged from 5.1% at SPG to 0.7% for AVB. Against the backdrop of the past decade, a seemingly modest 4% growth rate is stellar.

Similarly dividend growth left much to write home about. AVB, FRT, PSA, VNO and WRE reported solid dividend growth -- in the range of 32%-106%. On the other hand dividend payouts were crushed at AIV, DDR, HR, and PLD. This is hardly a record that inspires confidence for the coming decade.

Said differently, for REITs to work in the coming decade, multiples have to remain high and historically optimistic analyst forecasts have to be realized. We do not have the luxury of low multiples to protect us from untoward events.

Figure 1. REIT FFO and Dividend Growth Per Share, 2000 – 2010E



REIT '00 '10 CAGR Est.CAGR '00 '10 %Ch
FFO Dividend

AIV $4.81 $1.28 -12.4% 6.3% $2.80 $ .40 -86%
AVB 3.70 3.97 0.7 6.6 2.24 3.57 59
BRE 2.38 1.87 -2.4 6.1 1.70 1.50 -12
BXP 3.46 4.23 2.0 5.2 2.04 2.00 - 2
DDR 2.19 .86 -8.6 N/A 1.44 .08 -94
DRE 2.46 1.08 -7.9 26 1.64 .68 -59
EQR 2.50 2.16 -1.5 4.9 1.58 1.35 -15
FRT 2.56 3.88 4.2 7.1 1.82 2.64 45
HCP 1.66 2.15 2.6 6.4 1.47 1.86 27
HR 2.62 1.32 -6.6 5.3 2.23 1.20 -46
KIM 1.35 1.11 -1.9 3.0 .91 .64 -30
LRY 3.17 2.65 -1.8 8.7 2.13 1.90 -11
CLI 3.79* 2.79 -3.0* 5.0 2.38 1.80 -24
PLD 2.21 .59 -12.4 34 1.35 .60 -56
PSA 2.59 4.70 6.1 19 1.48 3.05 106
SPG 3.28 5.40 5.1 7.9 2.02 2.40 19
UDR 1.47 1.11 -2.8 4.4 1.07 .73 -32
VNO 3.86 5.17 3.0 10.3 1.97 2.60 32
WRE 1.79 1.97 1.0 1.0 1.23 1.73 41
WRI 1.93 1.66 -1.5 4.6 1.33 1.04 -22

*-Corrected

David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. Heis now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at:david.shulman@baruch.cuny.edu

The New Macro Environment for Commercial Real Estate

Reprinted by permission from Reit Wrap Special Report Dated February 10, 2010

by David Shulman*

Thankfully the economy now appears to be on the mend and employment will soon be rising, but I fear that few real estate professionals fully realize how deep of a hole the demand for commercial real estate is in. For the most part real estate investors believe that after leveling off in 2010, rents and occupancies will begin to increase in 2011 and with severely limited new construction, “normal” market conditions will return by 2012 or 2013. It is on these assumptions that today’s pro formas and REIT FFO estimates are being built.

If the economy were recovering from a cyclical recession I would fully endorse the market consensus. Unfortunately the Great Recession of 2008-09 was not a cyclical recession; it was a balance sheet recession whose effects will linger for many years to come. Let me explain. A normal cyclical recession is usually induced by Fed tightening seeking to tame inflation. Once the tightening takes hold, the Fed eases and after awhile the economy begins to grow again.
Indeed the natural state of the economy is to grow and within a year or so economic activity surpasses the prior cyclical peak.

A balance sheet recession is different. In this instance consumers and businesses find themselves over-leveraged with assets trading at values well below the debts on them. Thus balance sheets have to be repaired and this process takes time. For example the U.S. economy, even after the huge stock market rally, still finds itself $10-11 trillion poorer in terms of stock market and home values. As a result, consumers who once thought themselves as rich now think themselves as poor. They react to this reality by paying off debts and increasing savings. Simply put the credit constrained consumer can’t spend and the more affluent balance sheet impaired consumer won’t spend. When all consumers respond in this manner, aggregate demand stays depressed for years.

Sluggish economic growth going forward would not matter all that much if the economy were operating close to its natural capacity. However this is not the case. After peaking in December 2007, total payroll employment is off by 8.4 million jobs making the recession 3-4 times worse than prior postwar recessions. In fact total employment in January has now returned to where it was in September 1999! If employment growth is a rough proxy for commercial real estate demand, than every project built in the first decade of the 21st century can be viewed as superfluous. To be sure there is a more than a little hyperbole involved with the prior sentence, but you get the picture. That is why even in a limited construction environment, excess capacity will weigh on commercial real estate for many years to come.

A skeptic might argue that total employment, which includes manufacturing and construction jobs, might have little to do with office, and high end retailing and apartment demand. A fair point so let’s look at financial activities employment. As of January financial activities employment was off by 709,000 jobs since its December 2006 peak, a decline of 8.5%. An industry that was once viewed in secular growth category has proved itself to be highly cyclical, not a good omen for the stability of future office demand. More importantly financial activities employment is now back to where it was in May 1999!

In a related vein even the law business is now under extreme stress. Employment in legal firms over the past year declined by 44,000 jobs, or 3.8%. Now here is a business, a core tenant for Class A office space, which was once thought to be recession-resistant, now suffering through the pains of a fundamental restructuring of its business model, the billable hour.

In terms of the office demand I am hard pressed to come up with a scenario where demand recovers quickly and because the employment declines have been so severe it is reasonable to assume that many office using firms a carrying excess space relative to their needs. Thus as leases roll over tenants will just as likely reduce their space demands as increase them.

In the case of retail demand, the consumer has been chastened by the bear market in homes and stocks and a significant fall in the rate of pay increases. Where earlier in the decade private sector compensation was growing in the 3-4% range, of late it has been increasing at a 1.3% rate. Earlier in the decade and in 1990s consumers finance part of their consumption out gains accruing from rising stock and home prices. As a consequence the savings rate collapsed from an historic 7-10% down to around 1-2%. It has subsequently popped to 4-5% and in all likelihood it is on the road back to 7%. Along the way consumers have started to pay down debt in an unprecedented manner. After rising inexorably for decades total revolving consumer credit outstanding dropped by an unprecedented $109 billion or 11% from September 2008 to December 2009.

Thus it does not take rocket science to explain that the combined effects of falling asset values, slowed compensation growth, high unemployment and debt pay downs have made for a very disappointing retail environment. To be sure retail sales have bounced off the bottom, but remember total retail sales in December were still 7% below their November 2007 peak. This data certainly smells like there is quite a bit of excess capacity in retailing.

Of course many of you reading this article will probably shrug it off as one of Shulman’s perpetually bearish rants. Trust me, me I do not want to be right about this, but it is hard for me to see anything but a long hard slog ahead of us. Indeed much of the recent strength in the economy has come from massive doses of fiscal and monetary stimulus. In a nutshell, the economy is highly medicated. Thus we won’t really understand the underlying strength of the economy until the Fed ends its zero interest rate policy and the federal deficit drops from 11% of GDP to an optimistic 3% of GDP.

I would like to think we have learned a lot over the past few years. One of the lessons that I have taken away from the experience is that the Great Moderation of 1982-2007 is over and we are about to enter a new world that is beyond the working experience of most professionals now in the field. My guess is that going forward commercial real estate will be growing more slowly and that it will be more cyclical.

*David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. An earlier version of this article was presented at the University of Wisconsin Real Estate Club.

Letter to The Wall Street Journal, Nov. 6

Don't Follow Failed Japanese Example

The new regulations allowing banks to classify underwater commercial real-estate loans as "performing" will create "zombie" banks that will plague our economy well into the next decade ("Banks Get New Rules on Property," Money & Investing, Oct. 31). These regulations mimic the failed Japanese approach of the 1990s and will, unfortunately, have the same effect. Simply put, weighed down with bad loans "zombie" banks don't lend.
Instead of restructuring real-estate loans, the underlying banks should be restructured through equity infusions from the public or with TARP funds, with the underlying real estate sold into the marketplace. Broadly speaking, that was the Resolution Trust Corp. solution of the early 1990s.
David Shulman
Berkeley Heights, N.J.
Mr. Shulman was head of real-estate research at Salomon Brothers from 1986 to 1991 and was senior REIT analyst at Lehman Brothers from 2000 to 2005.