Returning to the Ring
Despite a Disastrous Hit, the Economy and Commercial Real Estate Markets Are Expected to Make a Comeback.
In their search for answers about the economy, commercial real estate professionals should consider the career of boxing legend Muhammad Ali. The brash young fighter swaggered to the heavyweight title in the 1960s, dazzling opponents with his speed and power. But a different Ali staged a comeback in the 1970s — one possessing savvy and strategy, who drew on residual strengths and skills and supplemented them with the experience and wise counsel of ring advisers. Ali became the master of defense and counterpunching, winning new respect from fans and foes alike.
Similarly, the economic story of the late 1990s and early 21st century was a string of triumphs. Job growth, low inflation, soaring productivity, record profits, skyrocketing stock prices, and surging confidence describe the halcyon days of the longest economic expansion on record. Real estate markets across the nation saw a steady rise in occupancies, renewed strength in prices, and the return of institutional capital in force.
But the year 2001 brought a sucker punch of historic proportions. An economy that had been flirting with recession for almost a year and a real estate industry already showing signs of wobbling were suddenly rocked by the terrorist attacks on September 11, 2001. Physically, economically, and psychologically, the United States was knocked off its swaggering stride. For 2002, the question becomes whether and how the economy can find the necessary savvy and strategy and the skills of counterpunching and defense to climb off the ropes.
The Economic Challenge
Now that the United States finds itself in the first recession in a decade, the debate centers on the depth and duration of the downturn. Optimists see recovery taking hold during the first half of 2002, while pessimists expect the downturn to last through the end of the year. Based on available evidence, the country should see definitive signs by late spring that the economy is turning around and expanding once again. By the end of the year, real gross domestic product should be back at a growth rate of 4 percent or higher.
However, in large measure, real estate demand is a function of employment growth, which, unfortunately, will lag behind the GDP recovery as it almost always does. Thus, the commercial property industry will be absorbing blows rather than space during the year.
The nation should brace itself for a loss of more than 2 million jobs before the worst is over, which would send the unemployment rate above 6 percent. However, it is unlikely that joblessness will climb above 7 percent at its peak.
On a slightly brighter note, the retail segment of the real estate industry will have some resources with which to work. Due to unemployment insurance, severance packages, and early retirement options, economic measures such as disposable personal income and personal consumption expenditures are expected to rise modestly this year, in the range of 1 percent to 1.5 percent, even in a period of job losses.
The combination of monetary and fiscal stimulus will prove one of our most powerful weapons in coming off the ropes. This recession is characterized by excessive inventories, and the solution has been steep price discounting to move product. Inflation was virtually zero at the turn of the year, which has given the Federal Reserve Board more maneuvering room in early 2002.
The second component of the federal government's one-two punch is deficit spending. In 2002, this will consist of increased defense spending, support to key industries such as the airlines and insurance, and a massive commitment to infrastructure. Since the United States cannot rely upon growth in world markets to expand demand for American goods, bootstrapping the economy with deficit spending and low interest rates is clearly in the national interest.
Against this background, here is the outlook for the principal commercial property types in the coming year.
The 3.6-billion-square-foot U.S. office market systematically worked its way down from a 20 percent vacancy rate in the early 1990s into single-digit vacancy by the end of the decade. New construction activity has been disciplined, but the crash of the dot-com sector and the incipient economic slowdown had pushed vacancy back up to 10.6 percent by mid-2001. An approximate 226 million square feet of new space coming on the market in the next few years most likely will exceed absorption by nearly 150 million sf, moving the vacancy rate to about 12 percent in 2002, then to nearly 14 percent by 2004.
As markets soften, values will adjust downward for several reasons. First, the worsening supply/demand imbalance will compromise market rents and prompt higher concessions, leading to lower net effective rents. On the other hand, building operation expenses will push upward due to increased security and property insurance costs. Therefore, net operating incomes will weaken, putting downward pressure on value.
Second, capitalization rates will rise, as the appreciation potential becomes less certain and a higher level of cash-on-cash return is expected. Long-term lenders have instituted “floor” policies on their mortgage interest rate formulas to protect against holding low-return investments should inflation and interest rates subsequently rise. This lending discipline benefits real estate in this cycle, but it has a cost: Cap rates are kept relatively high when measured by spreads against Treasury instruments.
Lastly, cap rates seek to compensate for the risk of uncertainty. Economically, politically, and socially, the year 2002 begins with much greater uncertainty than 2001.
Where will the impact on the office market be the greatest? In mid-2001, Oklahoma City was the only U.S. market with a vacancy rate greater than 20 percent. By 2004, that number should jump to 13 metropolitan office markets, because of an extended drop in employment or high current construction volumes. These cities include Hartford, Conn.; New Orleans; Fort Worth, Texas; Raleigh, N.C.; Columbus, Ohio; and Las Vegas.
At the other end of the spectrum, mid-2001 saw 16 office markets with single-digit vacancies, but only seven should be that tight by 2004. Prospects include New York, Washington, D.C., Boston, San Diego, and the East Bay market of northern California.
Retail: Breaking the Clinch
Although no longer favored by large investors, retail property is not going away, not when personal-consumption expenditures for food, clothing, shoes, household furniture and equipment, and other store-based goods total $2.3 billion per year. As the recession bores in during 2002, the retail sector aims to be a small target.
Not long ago, regional and super-regional malls were investors' darlings; however, an ongoing shakeout among retail chains, including department store anchors, and trouble in the cinema industry have tempered enthusiasm for this segment. These centers' high-profile nature and their iconic stature as a symbol of America's consumer culture also have become a cause for concern.
Grocery-anchored strip centers and value-oriented power centers are strong contenders for investor support. In leaner economic times, consumers still need to attend to basics such as food and clothing, and centers that compete aggressively on the basis of price have a better opportunity to capture what is still a huge consumer market. In rent growth, power centers will outperform all other retail segments during 2002, and both power centers and strip centers have narrowed the valuation gap separating their pricing para- meters from the malls, according to PricewaterhouseCoopers' Korpacz Real Estate Investor Survey published in October 2001.
Following the money also means finding individual markets where income growth potential is highest. The forecasters at Economy.com peg a number of metropolitan statistical areas as candidates: Houston, Dallas-Fort Worth, and Austin, Texas, are all in positive territory, with their economies expanding in the 1 percent to 2 percent range. While New York itself is expected to have a moderate 0.7 percent decline, its suburban ring — including Long Island and northern New Jersey — is expected to see more, rather than less, economic activity as residential and commercial functions migrate from the central business district to the suburbs in the short run. Investors also are likely to find positive results betting on areas of proven demographic growth such as Phoenix, Riverside, Calif., and Charlotte, N.C.
On the flip side, several markets will experience longer contractions and very weak consumption fundamentals. San Jose, Calif., for instance, may endure a 1.9 percent shrinkage in the overall size of its economy, measured in dollars, during 2002. St. Louis, Boston, and Miami have lesser vulnerability but still are expected to dip about 0.7 percent. Chicago should hold its own, as will Tampa, Fla., and Seattle.
Retail-sector investors will be thinking small and selective during 2002, awaiting clear evidence of improving consumer confidence and increased activity at the cash registers before coming out of their crouch. Their hesitancy may last well into 2003.
Industrials: Jabbing to Buy Time
The investment slowdown and inventory correction that triggered this recession also are shaping the impact on warehouse/distribution properties, light manufacturing, and research and development/flex space. Local markets dependent upon export/import activity or capital goods production likely will see more serious problems in the 2002 downturn. Technology-based markets already may be experiencing the worst effects and, after taking the blow, may be best poised for a sharp rebound in 2003. Regional markets characterized by fast-growing demography, especially in the Sun Belt, could remain fairly strong.
Like offices, industrial vacancy rates have crept up during the past two years, and by mid-2001, vacancy had risen to nearly 9 percent. However, it seems certain that industrial development will dip in 2002, curtailing the chance for a double-digit national vacancy rate.
The industrial sector is consolidating, with rents and prices flat to slightly down. The income flowing from long-term net leases makes this property sector attractive in a risk-averse investment environment. Industrial cap rates typically are higher than in the office sector and are not expected to ratchet upward as much. The short development timetable for industrials, as opposed to offices, also means that this sector will adjust more quickly to shifts in demand, a protection against occupancy volatility.
Regional markets with the best prospects include distribution hubs such as Atlanta, Denver, Indianapolis, and Kansas City, Mo. The suburban areas surrounding New York also should stay fairly strong, as they have little supply in the pipeline and the massive rebuilding effort in Manhattan will require out-of-city staging areas for material. Salt Lake City also will see exceptional demand as it hosts the 2002 Winter Olympics.
On the other hand, port cities are a mixed bag. Some, such as Baltimore, Tampa, Jacksonville, Fla., Houston, and Seattle, will struggle with the global slowdown. A sharp decline in international and domestic tourism will dampen the local economies of Orlando, Fla., and Las Vegas, and this difficulty will spill over into the industrial market as supplies build up in warehouses. But other markets, such as Portland, Ore., and San Diego, should prove more resilient as security and defense technologies are spurred in the war against terrorism.
The industrial sector needs to keep its adversaries at bay for awhile. Investors have enough openings to look for — markets where occupancy remains acceptably high and long-term prospects are good — so that a purely defensive strategy is not required. But this is not the time to move aggressively.
Multifamily: The Defending Champ
Multifamily properties enjoy a considerable advantage in cap rates because these investments are considered relatively safe harbors in times of increasing risk. Since 2002 widely is perceived as riskier than the end of the last market cycle, multifamily has a leg up on other investment property types in the coming year.
This risk-related premium for the multifamily sector comes in part from historical statistics. In the downturn of the late 1980s and early 1990s, office and retail investments lost about half of their value from peak to trough, according to data maintained by the National Council of Real Estate Investment Fiduciaries. Furthermore, it took five to seven years for these assets to recover their value once the market cycle turned upward. By contrast, multifamily investments had a more modest 20 percent value decline and managed a full price recovery in 24 months.
Multifamily also benefits from a largely common-sense appreciation of what happens during hard times. When incomes are stretched, spending will be curtailed, but, by and large, rent will be paid before the other bills. Also, people tend to stay put in a nationwide recession. Support networks are local, and, until some region of the country gives indisputable evidence that it will lead the nation in recovery, households will remain in familiar surroundings.
Real estate investment trust trackers such as SNL Securities provide data that show these characteristics are rewarded in the public markets, where economic opportunity and risk are priced daily. As of October 2001, multifamily REITs had the highest index value of any of the SNL property types with a 16.5 percent total return for the previous 52 weeks, a period when the S&P 500 dropped more than 20 percent.
Population increase is only one variable to be considered in evaluating the outlook for multifamily markets. The willingness and ability to pay for quality housing are connected inextricably to job market conditions. The tenure ratio — the proportion of renters to owners in each MSA — varies considerably, impacting the market share that the multifamily sector can capture. And price counts: Markets with large stocks of inexpensive single-family homes eat into the pool of prospective renters.
The interaction of these variables means that some regions of the country consistently lag in rental growth and overall multifamily vacancy. The Southeast is one such region, despite its excellent record of population gains. If anything, increases in the number of households just encourages a high volume of building; thus, metro markets like Atlanta, Charlotte, Raleigh, and Orlando are forecast to underperform the nation during the next five years in the supply/demand variables critical to investment success. Houston, San Antonio, and Dallas also are comparatively risky because of their robust construction volumes.
Some markets that previously enjoyed very high multifamily rankings look shakier for 2002 and the near future. San Jose and Portland are feeling the residual effects of the technology collapse, and Seattle is coming to grips with Boeing's defection and a huge round of layoffs in the aerospace industry.
But the winners still will outnumber the losers in the national multifamily markets. The very best areas appear to be the suburban areas surrounding New York and Washington, D.C., where decentralization of firms over the course of the next few years will prompt intraregional shifts in housing demand. San Diego and Sacramento, Calif., are slated to outperform the U.S. norm in rent gains and occupancy in the next several years. In the Midwest, Chicago and Minneapolis are the leading choices. Boston's outlook is promising as well, with a mere trickle of construction coming through the pipeline.
At the Bell
Without a doubt, this year's forecast contains more shadows than any since 1991. The economy is absorbing more punches, like Ali did when he used the confusing “rope-a-dope” strategy in an epic battle with George Foreman. He took an inevitable hit early in the bout, but in a way that accepted minimal damage and left enough resources and energy for a comeback in the later rounds.
That strategy is worth consideration on the part of commercial real estate professionals. Denial won't work against market forces, and avoidance is unlikely to be productive. It's better to develop a game plan to survive and to catch the markets on the rebound.
Ali's legendary reputation was made by regaining the championship belt for a second and a third time. That was not a matter of talent and charisma, but a tribute to determination, persistence, guile, and know-how. All of those attributes will be key in fighting the economic and real estate battles in the year ahead.