The return of economic growth stimulates commercial real estate activity, but will it last?
As 2010 reaches its halfway mark, the euro crisis and the phase-out of economic stimulus programs in the United States are contributing to fears of a double-dip recession. Yet several economic indicators suggest that the year has also ushered in the first stages of recovery for the U.S. economy and the commercial real estate industry.
Job growth, the single-greatest driver of demand for office space and a critical ingredient in fueling demand for other property types, resumed in January after a two-year hiatus. Of the 982,000 jobs created in the first five months of this year, 495,000 were in the private sector. That only begins to chip away at the 8.4 million jobs lost since employment peaked in December 2007, but it’s a move in the right direction.
Meanwhile, the paralysis in the credit markets that had all but shut down transaction activity is easing. Commercial and multifamily mortgage origination volume in the first quarter of 2010 was 12% higher than the same period a year earlier and 26% higher than the fourth quarter of 2009, according to the Mortgage Bankers Association (MBA).
Stabilization in the credit markets has enabled the velocity of U.S. commercial real estate sales to accelerate. Transaction volume across commercial property types totaled $15.3 billion in the first quarter, up 48% from $10.5 billion a year earlier, according to Real Capital Analytics, which tracks deals of $5 million or more.
Consumer spending is showing a surprising rally after declining throughout 2008 and the first half of 2009. Personal consumption spending grew at an annualized rate of 3.5% in the first quarter and contributed more than any other category to a 3% annualized growth rate in Gross Domestic Product (GDP).
Lastly, Corporate America is spending some of its hoarded cash after deep payroll cutbacks. Investment in equipment and software rose 12.7% on an annualized basis in the first quarter and 19% in the fourth quarter, according to the Bureau of Economic Analysis (BEA). Private non-farm businesses also grew their inventories by $37.6 billion in the first quarter following decreases of $13.7 billion in the fourth quarter and $141.4 billion in the third.
“We expect investment in business technology, equipment and software to continue to grow,” says Ben Breslau, director of research for Chicago-based brokerage Jones Lang LaSalle. “That’s good for those sectors and is a leading indicator that business is coming out of hibernation and beginning to invest and think about the future.”
Ready to commit
Indeed, leasing activity is up in most markets. Excluding renewals, office leasing rose 10% in Philadelphia and 30% in Boston in the first five months of 2010 compared with the same period a year earlier, according to Colliers International. In Los Angeles, the 16.9 million sq. ft. of industrial space leased in January through May this year was 13% more than the 14.9 million sq. ft. leased a year earlier.
That marks a behavioral change from 2008 and 2009, according to Ross Moore, chief economist at Seattle-based Colliers. Amid the economic uncertainty of the last two years, tenants across commercial property types were more likely to request short-term extensions when their leases matured rather than commit to a space. “Things aren’t booming,” he says, “but it’s a modest pickup and people are more willing now to sign on the dotted line.”
This early stage of economic recovery is an ideal time to shift attention from the crisis of the day to planning for the longer term, says James Stuckey, divisional dean of the Schack Institute of Real Estate at New York University. “The smart people in the industry are beginning to prepare for growth again.”
A double-dip recession is improbable, with no more than a 30% likelihood of occurring, according to projections by Bethesda, Md.-based CoStar Group. The forecast is far from rosy, however. Most economists expect GDP to grow by 3% or less in 2010 with lingering high unemployment.
How can investors achieve reasonable returns when anemic job growth promises another year or more of weak demand for commercial real estate? Effective strategies must take into account the flight to quality that is driving lenders and investors into bidding wars over stabilized core assets.
Equally as important, tenants in increasing numbers will upgrade to
higher-quality spaces. Some investors are already maneuvering to weight their portfolios with the most desirable properties.
Before embarking on a property upgrade or a hunt for acquisitions, however, investors need to understand the economic recovery thus far, and to appreciate just how tenuous it may be.
Back to work
Close on the heels of a rise in business inventories and spending on equipment and software in the first quarter, employers stepped up hiring. The greatest gains came in April with 290,000 non-farm payroll jobs created, following March’s healthy growth of 208,000.
That momentum faltered in May, when job gains in the private sector slowed to 41,000. Even so, investors can take comfort in the broad scope of private sector hiring.
Manufacturing alone added 126,000 jobs in the first five months of the year. Other industries enjoying job growth in the same period include leisure and hospitality, professional and business services, retail and wholesale trade, mining and logging, and private services. “That tells me there is the beginning of more sustainable job growth under way,” Breslau says.
Sustained job creation is a critical component in Breslau’s economic forecast, which calls for improvement in commercial real estate fundamentals in 2011. Other industry observers expect a similar pattern of commercial and multifamily vacancy bottoming out this year, with rents flattening around the end of 2010 and positive absorption kicking in next year.
There is an off chance that job gains will reverse course, perhaps as part of a drop in GDP growth. If that happens, then commercial real estate fundamentals will languish for another 12 months before picking up in 2012, according to Kevin White, a real estate strategist in CoStar’s Boston office.
But most indicators point to continued hiring. Employment is already outpacing CoStar’s initial projections for this year, which called for 600,000 new jobs for all of 2010. “We have the real estate recovery starting now, with property values across product types bottoming out between now and the end of the year and rents starting to stabilize in mid-2011.”
Faltering job growth could easily delay a commercial real estate recovery if employer confidence withers, cautions Hessam Nadji, managing director of research services for Marcus & Millichap Real Estate Investment Services based in Encino, Calif. (see sidebar).
Of the jobs created in January through May, a hefty 362,000 have been in temporary services. “Temporary hiring is an important signal that companies need help,” Nadji says. “They’re just not willing to commit to hiring significantly.”
U.S. companies have the resources to boost GDP with a wave of purchases. Corporate profits from current production increased $81.4 billion in the first quarter and $108.7 billion in the fourth quarter, the BEA reported.
Business owners can also derive confidence from the stock market, which has recovered much of its lost ground. The Dow Jones Industrial Average was up 54% in early June from a low it reached in March 2009.
“Companies are somewhat flush with cash,” says Breslau of Jones Lang LaSalle. “They’re feeling better about their business outlook, but realizing that they probably need to invest and act in order to continue that type of profit growth.”
Consumers, too, are showing unexpected resilience. Purchases by U.S. residents climbed at an annualized rate of 3.5% in the first quarter and 1.6% in the fourth quarter, according to the BEA.
Consumer confidence continued a three-month climb in May, and White of CoStar believes U.S. consumers will surprise many forecasters with strong contributions to economic growth. “Consumers aren’t going to be driving this economic recovery,” he says, “but they won’t totally derail it either.”
Breslau believes consumer spending is already boosting the performance of retail properties. He points out that personal consumption expenditures contributed 2.42% to GDP growth in the first quarter — the most of any category. “That’s the first time personal consumption has been the largest contributor since 2006.”
Credit is available from a greater variety of sources today, particularly for multifamily deals, which enjoy better prospects for improving fundamentals than other property types. The government-sponsored enterprises of Fannie Mae and Freddie Mac slashed lending by 49% in the first quarter compared with the first quarter of 2009, but life insurers ramped up their loan originations by 131%, according to the Commercial/Multifamily Mortgage Bankers Originations Index.
Commercial mortgage-backed securities (CMBS) lending has begun to stir again, with $3.18 billion in originations in the fourth quarter after 18 months of near dormancy. Observers expect $10 billion to $20 billion in CMBS issuance this year, a figure that pales in comparison with the approximate $230 billion in issuance at the height of the market in 2007.
Lenders are watching the latest generation of CMBS closely and will decide whether to re-enter the space based on the performance of those loans, according to Stuckey of the Schack Institute. “This is the sticking-your-toe in the water stage,” Stuckey says. “I don’t know how long it will be before people jump in head first.”
The latest conduit loans carry fixed rates and terms of five to 10 years at loan-to-value ratios of 65% to 75%, according to Neil Freeman, chairman and chief executive of Aries Capital, a Chicago-based mortgage banker. While conduit loans aren’t yet a widely available resource for commercial real estate, Freeman says both debt and equity capital are more readily obtainable this year to finance properties with net income.
“The (credit) world is getting better,” Freeman says. “It doesn’t seem like it because there’s a lag effect, but it is. Right now there is a return of the capital market.”
Owners can expect competition this year to retain and attract tenants in the flight to quality that accompanies periods of high vacancy. That makes this a good time to spruce up tired buildings and weed out mediocre properties from portfolios, according to Arthur Pasquarella, executive vice president and chief operating officer of Philadelphia-based BPG Properties.
“Quality will matter,” says Pasquarella, who also is the 2010 chairman of The Counselors of Real Estate, a 1,100-member organization of real estate advisors. “The healthy tenants are looking for those kinds of environments that will help them flourish and attract talent.”
Tenants are indeed more willing to make space commitments, says Pasquarella, based on activity in BPG’s portfolio of roughly 25,000 apartment units and more than 25 million sq. ft. of office, retail and industrial space in 28 states.
“What we were seeing in 2009 almost across the board were commercial tenants who were very reluctant to make long-term lease commitments,” he says. “Companies feel better about their financial resources, so they can make commitments again.”
Investors hoping to catch the first wave of market-wide absorption should heavily concentrate their portfolios in apartments, according to Pasquarella. “We’re most keen on purchasing additional apartment communities,” he says. “It’s a faster turn between people getting jobs and seeking housing, particularly rental housing.”
In any product type, however, investors should seek best-in-class assets if they hope to maintain high occupancy levels while market vacancy rates remain elevated, according to lender Jeff Friedman, principal and co-founder of Los Angeles-based Mesa West Capital.
“Over time, the better projects will lease up,” Friedman says, “whereas the inferior buildings or inferior markets are going to experience occupancy declines.”
Mesa West provides bridge loans to commercial property owners who are taking calculated risks on semi-vacant assets. Friedman and his borrowers and investors look for high-quality assets in prime locations, reasoning that tenants will soon take advantage of excess space in the rental market to upgrade to the best properties.
Value-add plays run contrary to the trend in commercial real estate investing. Risk intolerance has resulted in concentrated demand for stabilized, high-quality assets in core locations. The resulting bidding wars are pushing up prices for investors, while competition among lenders drives down returns on real estate debt.
“The herd of institutional investors isn’t willing or interested in financing projects with vacancy,” Friedman says. “We’re open to financing not just multifamily, but also office, industrial and retail where there is vacancy and less in-place cash flow.”
Mesa West has closed five bridge loans so far this year for a total of $200 million, or an average of $40 million per loan. Terms range from three to five years and 60% to 65% loan to value, and the lender hopes to close another $400 million to $550 million in loans by the end of the year.
For Nadji of Marcus & Millichap, the recent increases in lending, leasing activity and transaction volume are good news for the commercial real estate industry. Yet the risk of further turmoil in the global financial markets gnaws at him, and he worries that the fragile economic recovery of 2010 could collapse into an extended period of inactivity.
“We’re definitely in a better place,” he says. “I’m just worried about people starting to go back into their caves.”
Matt Hudgins is an Austin-based reporter.