Will slower growth and residential woes disrupt commercial real estate's performance?
It’s hardly surprising to see the economy slowing down: A tight labor market and slackening productivity gains are holding back gross domestic product growth, and the falling housing market is restraining economic momentum. Since these burdens will take time to remove, GDP growth is expected to drift below its long-term trend for the foreseeable future.
A far more interesting story line to pursue is how slower economic growth will affect commercial real estate. So far the residential market drama has not spun off a commercial real estate sequel. However, the impact of the 8.4 percent drop in existing home sales in March, which is the largest decline in 20 years, coupled with the subprime lending problems — nearly 13 percent of outstanding mortgage debt is subprime — is bound to send intersecting plot lines through commercial real estate markets. At the very least, the slowdown in new housing construction lowers the demand for land, and the resulting decline in land values affects development and replacement costs in all property sectors.
Another story is the job loss as housing construction slows and subprime lending operators close up shop. While the tight U.S. labor market probably will reabsorb most of these workers, it’s a reminder that the most fundamental driver for commercial real estate is people, particularly people with jobs. Whether demand is for apartments or office cubicles, it comes down to a market’s ability to put heads in beds and you-know-whats in seats. Understanding how this cycle is playing out means understanding where the people are, and perhaps more importantly, where the jobs are.
As the Economy Slows
The first thing to note is that the U.S. economy is not creating nearly the number of jobs it has added in past expansions, and cuts in manufacturing and housing-related sectors are compounding the issue. While the economic expansion has been reasonably healthy but increasingly uncertain, job growth topped out at a relatively weak level. Unemployment in the most recent recession peaked at only 6.3 percent, leaving fewer people to drive job growth in this cycle. Furthermore, unemployment now is 4.4 percent and only 1.7 percent among college-educated people, about as tight as it has ever been. The bottom line is that there are just not that many bodies available to hire.
Unlike the circumstances in past expansions, job growth is expected to remain weak, particularly in the near term. Following the addition of 2.3 million jobs in 2006, employment growth is expected to close 2007 up 1.2 million jobs. Regionally, slow job creation will be most concentrated in the previously heated housing markets on the East and West coasts due to housing-related layoffs, and in the midwestern industrial markets, which continue to suffer from domestic auto industry weakness. Meanwhile, lower-cost metropolitan areas in the South and West should post better-than-average job gains fed by robust labor force growth.
Nationally, the demand for commercial real estate will mirror the slackening economy. Office absorption — which also is positively correlated with hotel occupancies — is slowing, retail sales growth already has sunk, and falling inventory levels are reducing the need for new warehouse space. On the other hand, demand for apartments is expected to pick up as fewer renters make the leap to homeownership. However, the picture is not completely rosy in the multifamily market: Unsold housing inventory in many markets is rising and that shadow supply will start to compete with apartment inventory if it hasn’t already.
Real estate capital flows have increased dramatically in the past few years as investors have become enamored with real estate’s total returns. The more capital that has flowed into real estate, the larger the capitalization rate compression and the better the total returns, creating a self-fulfilling prophecy for investment performance. More recently, however, investors have balked at pricing, and rightfully so, as risk premiums have worn thin. In fact, apartment properties were trading at just 55 basis points over Treasuries earlier this year, and office spreads had dipped to about 115 basis points. With spreads this thin, any upward movement in interest rates quickly will translate into upward pressure on cap rates, and in some cases, valuations could fall.
There will be winners and losers from here on out: Some markets will have enough net operating income growth to allow values to climb in the face of increasing cap rates, and others will not. Avoiding the markets that lose value will be the hallmark of successful investors over the next several years.
Office’s Guiding Light
Despite the job market’s lack of vigor, the U.S. is adding office-using jobs faster than non-office jobs. This fact fueled the office market recovery through the end of 2006, but absorption has slowed this year, in step with cooling growth in office-using employment. The slowdown will be particularly notable in Orange County, Calif., where the unraveling of the subprime market has led to space givebacks, and also in core markets such as Boston, Chicago, Washington, D.C., and San Francisco, where vacancies are tight, rents are high, and the bounce-back generally has played itself out, as there now are fewer workers to hire. Indeed, labor force constraints have aligned well with demand growth in the office market: Weak labor force–growth markets also tend to post weak office demand, while faster-growing metros in the South and West will rank higher in terms of absorption this year. But New York, Boston, and San Francisco still will top investment charts: The tightness in these markets will keep rents running harder longer, especially in supply-constrained central business districts.
The office market also has benefited from temperate construction levels, but this is starting to change. Investors have gobbled up office product in many of the top markets, driving up pricing. These higher prices are causing some investors to move dollars from acquisitions to development. Construction already has picked up in markets with low-supply hurdles such as Orange County, San Diego, and Seattle. Speculative construction also is bubbling up in the core markets mentioned above. But the good news for current property owners is that this supply still is a few years out.
The best chances for NOI growth lie at the intersection of supply and demand, as low or falling vacancies generally lead to stronger NOI gains. A subset of secondary markets will buck the national trend of flattening occupancy gains and continue to post falling vacancies in the near term. These include San Jose, Calif., Charlotte, N.C., Denver, and Minneapolis.
Housing the Young and the Restless
While the multifamily space market is particularly tight today, occupancy gains have ended in most markets and vacancies are trending up. The falling housing market, which has helped staunch the flow of renters into homeownership, also is causing an uptick in competitive inventory, often in the form of shadow supply. This trend is especially pronounced in San Diego, Las Vegas, and Florida, where the combination of condominium conversions, new construction, and tightened lending standards has pushed up unsold housing inventory volume. In some cases, entire projects are being converted back to rental units, while in others, individual owners unable to find buyers are being forced to rent. Shadow supply is not just an issue in Florida and select CBDs: There has been a fair amount of condo construction in suburban markets as well.
The good news for apartment landlords is that the demand side of the equation remains healthy. Affordability issues in many markets are locking renters out of the housing market, and demographics will be a tailwind going forward. The echo boomers — baby boomers’ children — will enter their prime apartment-renting years, ages 20 to 34, en masse in 2008, replacing the much smaller generation X as the biggest pool of apartment renters. While major cities such as Los Angeles will see their 20-to-34-year-old population increase significantly, on a percentage basis some less traditional locales also will see young population growth. For example, Orlando and Palm Beach, Fla., will gain more than 14 percent cumulatively in the prime renting population. Other big winners will include Las Vegas, Austin, Texas, and San Diego.
Investors certainly are targeting this demand growth, and many of the hot rental markets also are expected to experience heavy new construction. But of more immediate concern for investors is the burning off of condo-conversion-driven pricing. Apartments are priced aggressively today, and any increase in interest rates is likely to result in higher cap rates. Indeed, value losses are forecast to hit over the next six quarters in many of the most richly priced markets.
Retail’s Dark Shadows
The housing market fallout has washed through the retail market as well. Enriched homeowners leveraged low interest rates and a rapidly appreciating housing market to pull equity out of their homes and happily boosted consumption. In fact, in 2006 some $340 billion was pulled out of the housing market through cash-out refinancing, an amount roughly equivalent to Wal-Mart’s U.S. sales. However, the falling housing market and tighter lending standards have reduced the equity available to consumers, and mortgage equity withdrawals will end 2007 at a noticeably lower level. In the absence of these windfall dollars, the traditional drivers of retail demand, wage and population growth, will be back in control, producing positive but more temperate retail sales gains.
The housing market drop-off is affecting retailers differently: Sales of consumer durables are down while sales of nondurables are holding steady. For example, sellers of building materials were the first to see sales decline, while grocery store sales have plodded along at a steady pace. Many of these stores have built solid balance sheets during the retail boom of the past few years and will weather the slowdown well. Slackening demand, however, may force some retailers to shutter stores, and physical vacancies are likely to creep higher.
Perhaps less intuitive is the need for many retailers to continue to add stores amid the slowdown. The publicly owned companies, tenaciously scrutinized on their ability to grow revenues, are unlikely to match the double-digit same-store sales growth posted in the past few years. To replace this growth, new stores will be opened, perhaps leading to economically unjustified construction and putting further pressure on more marginal retailers.
Of course markets matter, and targeting metro areas with better demand prospects and greater barriers to new construction should lead to better returns. Strategies that work in a more-challenging retail environment include targeting redevelopment in infill locations, buying up vacant locations at a discount and re-leasing, or simply developing at the end of the highway in fast-growing metros unaffected by falling home prices — think south of the Mason-Dixon Line and north of the Florida border.
The Bold but Hardly Beautiful Warehouse Market
Wal-Mart set the bar high for managing supply channels, using super-regional hubs as part of its distribution improvement. The strategy worked, and when the rest of the retail world finally caught on, the warehouse market enjoyed robust demand in 2005 and 2006 due to retailers’ realigned distribution strategies. However, demand has since slowed, and national distribution centers are particularly hard hit, facing weaker absorption in 2007. The Inland Empire’s total demand, largely driven by retailers, will slow from 13 million square feet in 2006 to 7.3 million sf in 2007. Slowdowns also are on tap for Chicago, Dallas, Atlanta, and Indianapolis.
Fortunately supply also is slowing. Warehouse developers have shorter lead times for building new product, and the commodity-like nature of warehouses makes it easier to judge demand. As a result, supply generally shuts down quickest in the warehouse market. A ramp-up in supply still remains a risk, but if construction is well-behaved, vacancies will continue to float within arm’s reach of their long-term average.
Despite slower growth in warehouse demand, fundamentals are healthy, and rents continue to grow. Since warehouse also has the highest cap rates of the four core property types, it is attracting investor interest, especially institutional capital. These investors will continue to target markets insulated from new supply and in the path of growth. However, many national markets such as Los Angeles look fully priced, and investors are going further out on the risk spectrum and targeting less mature regional and local markets such as Portland, Ore., and Fort Lauderdale, Fla. If these investors are frustrated by an inability to find the product they seek, then look for development to kick up.
Cap rate compression made it easy to generate impressive returns in real estate over the past few years, but that show is over. Going forward, investors will need to work harder to achieve outsized returns. Many have recognized the change in the landscape and reacted by taking on more risk to generate the same returns. However, with the economy slowing, some of these investors may stumble, and buying opportunities may present themselves in the coming year. In the meantime, investors should get back to the roots of good real estate — population growth and insulation from new supply.