Market analysis

Slow but Steady

The recovery pushes forward through fiscal policy headwinds.

The U.S. economy is now midway through its fourth year of recovery. Ignoring any occasional stock market euphoria, the economy remains on a consistent path of slow improvement. Real gross domestic product is on track to grow at a rate of around 2 percent this year, which is roughly the same growth rate observed in the previous three years of this recovery.

While the 2 percent GDP growth has been enough to allow occupancy levels to slowly improve in most property markets, it remains subpar to the growth rate required for widespread asset appreciation. Beyond a few standout segments such as trophy assets, landlords generally continue to fight fiercely for a thin line of tenant prospects. Even at this maturing stage in the recovery, commercial real estate largely remains a market characterized by clear winners and clear losers.

The positive news: It is becoming apparent that a more robust script is being written. The equity markets, housing markets, and credit markets demonstrate that the economy has the underlying strength to grow at a much faster clip over time. But that faster growth rate won’t happen this year, primarily because fiscal policy won’t allow for it. Under current law, the fiscal drag — the combination of higher taxes and spending cuts — will shave one full percentage point off of GDP growth this year, making it nearly impossible for the economy to register anything better than subpar growth. As that fiscal drag fades in 2014, the U.S. economy and the property markets will be poised to accelerate.

Economy Drivers Are Consistent

Real GDP grew at a healthy rate of 2.5 percent in 1Q13, fueled primarily by stronger consumer spending and inventory accumulation. A sustainable recovery must always be led by confident consumers who are willing to spend and a business community that plans to make and sell a lot more merchandise.

The labor markets have also demonstrated solid progress, as the U.S. economy created an average of 179,000 net new jobs per month for the 31 straight months ending in April. From January to April, job growth accelerated faster, averaging 195,000 net new jobs per month.

Also encouraging is the fact that the recovery is spreading beyond the major metropolitan areas. While major markets such as New York, Houston, and San Francisco are still registering solid employment gains, smaller metro areas including Boulder, Colo., Nashville, Tenn., and Louisville, Ky., are registering higher percentages for job growth. Out of the 378 major metro markets tracked, 302 are logging year-over-year employment gains.

Housing Is Huge

With mortgage rates remaining at record lows, homes in affordable price ranges, and job growth sparking a new wave of demand, the housing sector is powering growth once again. Sales of existing single-family homes are running at an annualized rate of around 5 million units, the highest pace in six years. U.S. home prices are appreciating at a lofty 12 percent rate year to date, and in certain markets, such as Phoenix, Las Vegas, and several California metros, 20 percent to 30 percent price appreciation is more common. Housing inventories have dwindled to low levels similar to the last real estate boom. Developers are well aware of the tightening supply, and housing starts jumped to 1.04 million units in March — a 46 percent YOY increase.

The multiplier effect associated with a housing recovery is huge. Housing typically contributes as much as one full percentage point to GDP growth during recovery periods. Around 30 basis points of housing’s contribution to economic output come from new residential construction; the rest is derived from other housing-related activities such as increased construction employment, mortgage lending, brokerage, and legal services.

The wealth effect is also in play. Every $1 increase in home value typically boosts consumption by 10 cents. Given the way home prices are trending this year, housing could contribute as much as $100 billion to $150 billion in increased personal consumption.

It is also worth noting that housing is a major demand driver for the warehouse sector. The greater need to store concrete, lumber, glass, dishwashers, laundry machines, refrigerators, and similar items could boost warehouse space demand by as much as 15 percent this year. Property market cycles and housing cycles historically have moved in tandem. As a result, if the housing market is at the cusp of rebounding, the commercial real estate market is soon to follow.

Fundamentals Unevenly Improving

With job growth spreading, commercial real estate fundamentals are also improving. However, the improvement is very uneven across different commercial real estate property sectors. A number of factors are contributing to the uneven but steadily improving market.

Multifamily. The apartment segment continues to experience robust demand virtually across the board. U.S. apartment vacancy ended 1Q13 at 4.3 percent — the lowest national vacancy rate in more than a decade.

In addition, all of the 82 markets tracked by Reis posted YOY increases in asking and effective rents. In fact, supply is shockingly scarce in some markets. For example in New York City, the vacancy rate is a mere 1.9 percent. Likewise, San Diego, San Jose, Calif., and Minneapolis have vacancy rates of 2.5 percent or lower.

However, the days of razor-thin inventory are numbered. Developers have 423,000 new apartment units scheduled for delivery between now and 2015. This represents the largest wave of new supply in more than two decades. On top of this supply trend, the housing recovery is already beginning to steal a portion of demand away from the rental market. In 1Q13, demand for apartment units remained healthy but dropped a noticeable 16 percent from the previous quarter. In general, the apartment sector remains a solid bet for investors, but it would be wise to ease up on pro forma assumptions in 2014 and beyond.

Industrial. Aggregate demand figures for the industrial sector have also been impressive. In fact, the U.S. has absorbed 238 million square feet since 2010 — one of the strongest stretches on record since 1990. With increased consumer spending for vehicles, houses, technology, logistics, housing-related goods, and food-based commodities, there is no sign that demand for industrial space will diminish any time soon. In 1Q13 alone, the industrial sector absorbed 32 million sf, which is the strongest reading in the current recovery. In particular, newly built industrial big-box space that caters to e-commerce has been the shining star. Vacancy for that segment is under 3 percent for certain markets, which is a solid 700 basis points tighter than vacancy for older warehouse product.

Office. The office sector is clearly lagging behind multifamily and industrial. The office recovery continues to be hampered by a shift in space utilization along with tenant downsizing. The amount of office space per worker has declined from 225 sf prior to the recession to 180 sf today, according to a CoreNet Global survey. Other studies suggest that while certain industries, such as law firms and tech companies, are decreasing their space needs by 20 percent to 30 percent, most other tenants are simply renewing at their current requirements. Whether it is a dramatic shift to less space or an incremental one, the trend is clearly downward.

Yet, from an investor’s perspective, it is worth noting that newly built class A office space is performing exceptionally well in this recovery. In fact, since 2010, more than 70 percent of net growth in the office sector has been concentrated in this high-quality segment of the market. The flight to quality has many investors looking at older buildings as great opportunities to retrofit and earn higher returns.

Retail. The retail sector is similar to the office sector. It is recovering, and vacancy has trended down slowly for six consecutive quarters. But only the higher-quality retail spaces in densely populated areas are experiencing consistent leasing demand. With e-commerce continuing to gain market share, even if the Marketplace Fairness Act is signed into law, many of the traditional brick-and-mortar retailers will continue to face an uphill climb.

Credit Starts to Flow

The Federal Reserve’s third round of quantitative easing is finally helping to free up credit. Since September 2012, the Fed has been buying $40 billion worth of Treasury securities and $45 billion of mortgage-backed securities each month. This aggressive monetary move is keeping interest rates low, which, in turn, is incentivizing investors and lenders to seek higher returns in riskier assets. The strategy is working: CMBS issuance totaled $31 billion in the first four months of the year, putting it on pace to provide $93 billion in loan volume by year-end. These levels are akin to those achieved in 2004, which is the first year of the last real estate boom.

This is just one of many positive trends taking place on the lending side. The net percentage of banks reporting “stronger demand for commercial real estate loans” in 1Q13 was the highest it has been since the height of the Internet-technology boom in 1998, according to the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices. After three years of deleveraging, total loan volume from large banks for commercial real estate is a net positive thus far in 2013.

Of course, unprecedented monetary stimulus doesn’t come without long-term risks. The Fed has more than tripled its asset holdings since 2008 and now holds more than $3 trillion of Treasury securities and mortgage-backed securities on its balance sheet versus $750 billion prior to the recession. Clearly, as money trickles off banks’ balance sheets and enters the economy, there is a high probability of upward pressure on prices and interest rates. It’s likely the 10-year Treasury will hold close to 2 percent this year, but it will begin rising in 2014 and flirt with 5 percent in 2015.

Delayed Celebration

The trends seen thus far in 2013 have been solid if not upbeat, but that was before fiscal headwinds arrived in full force. The drag will come from two places. First, the U.S. economy is still processing the tax increases that kicked in at the beginning of the year. The expiration of the payroll tax holiday along with higher tax rates paid by higher-income households will begin to weigh on discretionary spending in the second half of the year. Second, sequestration cuts that took effect on March 1 may result in furloughs for nearly one-third of the U.S. federal workforce. Assuming these cuts are not scaled back, which appears increasingly unlikely this year, the combination of spending cuts and tax increases will shave as much as one full percentage point off GDP growth in 2013.

As a result, instead of healthy 3 percent GDP growth, the economy will be lucky to post 2 percent growth this year. Challenges from abroad also cloud the near-term outlook. The eurozone is still struggling through its financial problems with nine of the 17 eurozone countries expected to be in recession for most of the year. Since the U.S. completes approximately 17 percent of its trade with European countries, this will be another setback to growth.

Despite these factors, there are clear signs that U.S. consumers are becoming desensitized to these recurring threats. In April, just as the sequester cuts kicked in and as the Cyprus debt crisis flared up, consumer confidence increased. Retail sales also rose in April even though most analysts were calling for a decline. Resilient trends such as these give credence to the notion that the core of the U.S. economy is as strong as it has ever been in this recovery. Look past the bumps in the road and focus on the bright spots: housing, energy, technology, business profitability, and healthy household balance sheets. Indeed, there is something very robust forming beneath the surface, but we can’t celebrate quite yet.

Kevin Thorpe is chief economist/principal of Cassidy Turley Commercial Real Estate Services in Washington, D.C. Contact him at


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