As 2006 draws to a close, the U.S. economy and the Federal Reserve are in the midst of a difficult high-wire act with little margin for error. For the moment, the economy is moderating and appears to be on course for slower, if not spectacular, growth. Yet it could easily tumble into recession in the event of a shock or further tightening by a Fed intent on quelling mounting inflationary pressures.
That leaves the commercial real estate industry with the difficult task of preparing for the challenges ahead while economists are still attempting to divine those challenges. The good news is that commercial real estate fundamentals are improving in most markets and property sectors. The national office vacancy rate, for example, declined 30 basis points during the third quarter to stand at 13.5% at the end of September, according to Reis.
But employment growth, a critical driver of demand for commercial space, is trending downward with fewer jobs created each month. The U.S. economy added 92,000 jobs in October, but even if that anemic figure is potentially revised upward as has been the case in recent months, that pales by comparison to last year's monthly average of about 183,000.
Consequently, demand for space in some product types will decline along with job growth in 2007, predicts Property & Portfolio Research. The research firm projects a 30% decline in absorption rates for both office and industrial space, while the slowing housing market will boost demand for apartments by approximately 20%. “We're seeing slower demand growth, slower economic growth, rising wages and above-comfort-level inflation right now,” says Josh Scoville, director of strategic research at PPR. “We don't think [the economy] will get too out of control, but the risks are there.”
Nation on a tightrope
The Federal Reserve dampened the economy through 17 consecutive hikes in the fed funds rate, which banks charge for overnight borrowing. That achieved the desired result, evidenced by Gross Domestic Product (GDP) growth that dropped to 1.6% in the third quarter from 2.6% in the second quarter. But the Fed's actions also rendered the nation vulnerable to economic shocks, particularly while inflationary pressures remain.
While energy prices abated 7.2% in September, other inflationary pressures persist, including wage growth that could raise employer costs and fuel price growth. Inflation is a lagging indicator of the economy, which explains why, despite the drop in GDP growth, core inflation grew at an annualized rate of 2.7% in the third quarter. That's down from 2.8% in the second quarter but well above the Fed's comfort zone of 1% to 2%. The Fed is unlikely to provide economic stimulus even to avoid recession until inflation comes closer to its comfort zone.
The current period of waiting for prices to fall in line with a slower pace of growth puts the Fed in an awkward position, according to John Burford, senior vice president and investment portfolio manager at The International Bank of Miami. The Fed is charged with fighting inflation, and does so through rate hikes, but shoulders a responsibility in the public's eye to provide stimulus in the form of rate cuts when the economy lags.
“The Fed is on a razor's edge right now, and it could go either way,” Burford says. “If the economy surges, and you have reasonably solid growth in 2007, then the Fed will resume with rate increases. If the economy starts to sag under the weight of falling home prices and consumer spending retrenchment, then the Fed will cut rates.”
The third and preferred option is for the market to traverse this delicate period to reach solid ground again, but there's no safety net under this high-wire act while inflation persists. First and foremost an inflation fighter, the Fed has never lowered interest rates to stimulate the economy during a period of low unemployment, Burford says. Unemployment fell to 4.4% in October, its lowest level since May 2001.
A contrarian points to history
Among the possible directions the economy could take in 2007, recession appears the least likely, according to most economists. Yet one respected voice — James Smith, director of business forecasting at the University of North Carolina — believes recession is a near certainty due to the inverted yield curve, which occurs when long-term interest rates are lower than short-term rates for an extended period of time.
The 10-year Treasury yield has bounced around below short-term lending rates since early July, suggesting that bond traders expect the economy to falter in the near term. The 10-year yield registered 4.6% on Nov. 14, well below the three-month Treasury yield of 5.1%. Many economists argue that 10-year Treasury yields are reacting to extensive bond purchases by foreign central banks, which have kept rates low and potentially skewed the inverted yield curve as an indicator of pending recession.
Smith acknowledges the influence of foreign bond buyers, but is sticking to his guns in projecting a recession early in 2007. “In the almost 93 years we've had a Federal Reserve system, we have never had three-month Treasury yields above 10-year Treasury yields for more than three months without having a recession,” Smith says.
The inverted yield curve signals a weak economy that is particularly vulnerable to recession, concurs Dr. Rajeev Dhawan, director of economic forecasting at Georgia State University. The yield curve was inverted through most of 1989, and the invasion of Kuwait by Iraq in 1990 provided a sufficient external shock to spark a recession that year.
Entering 2007, the economy is again perilously close to recession. “The economy is beginning to enter a slowdown with a lot more risks than there were six or eight months ago,” Dhawan says. “The danger of inflation is there, but any small shock can send us into bad territory.”
Dhawan expects the Fed to begin a series of three rate cuts in March that will bring the fed funds rate down to 4.5% by mid-year. “These cuts will help the economy climb back toward normalcy by late 2007,” he says.
The inflation factor
Inflationary pressures remain despite the slowdown in the GDP, including wage growth that could raise employer costs and fuel price growth (see sidebar, p. 26). Will these sources of inflation fade in the coming months, just as energy prices have already done?
Not necessarily, according to Craig Thomas, director of research at Boston-based Torto Wheaton Research. High prices for fuel, steel, concrete and a range of other commodities indicate the economy is operating at capacity, which leads to frequent price spikes and crises when demand exceeds available supplies.
Inflation occurs when businesses begin to anticipate price spikes, and build that added cost into their contracts, pricing and investment decisions. In that respect, an inflationary outlook reflects optimism that the economy will continue to run full steam ahead, he says. “Inflation is something that comes with an economy that's working at capacity,” Thomas says. “We're optimistic about the economy, and that means we have to expect continued inflationary pressure.”
Adjusted expectations
However the economic cards fall, commercial real estate operators in 2007 will have their work cut out for them as they seek to boost returns in an economic environment that will be less accommodating to passive investors, says Thomas of Torto Wheaton. “For folks that are new to real estate or in it for the short run, the income is going to look disappointing relative to what were souped up income trends based largely on cheap leverage and cap-rate compression,” he says.
Investors that purchased properties while prices were at record highs must pay particular attention to asset management, says John Falco, principal in the Atlanta office of real estate consulting firm Kingsley Associates. “You really need to protect that net operating income by focusing intensely on operating those assets at a high level,” he says. “There's no room for error.”
As has been the case for several years, investors' greatest challenge will be finding suitable acquisitions, says Jim Woidat, a principal at Kingsley Associates' San Francisco headquarters. While many pension funds have increased target allocations for commercial real estate to between 7.5% and 8.5% of their portfolios, few have met those targets and continue to search for deals.
Betting on resilience
The best outcome for commercial real estate and the nation as a whole is the middle path between inflation and recession. That's the soft landing the Fed set out to achieve through its interest rate hikes and pauses, and that strategy has helped to curb the home-building enthusiasm that threatened to send the economy spiraling out of control.
The bursting housing bubble alone won't end the current expansion, according to Dana Johnson, chief economist at Comerica Bank in Detroit. “Many people view the economy as being on a knife's edge, but the last 25 years have shown us that's just not true,” he says, referring to the economy's demonstrated ability to overcome setbacks in specific industries, such as manufacturing.
Johnson believes the economy is simply working out excesses, which included both an overactive housing market and the Fed's excessively low fed funds rate, which was 1% before it began raising rates. “The economy has demonstrated that it can absorb blows, time and again,” he says. “My instinct increasingly is to bet on resilience, to bet on continued growth, rather than to exaggerate the potential problems these sectors can create.”
Like Johnson, a number of economists believe this period of adjustment could usher in a more sustainable second half of the current expansion. Among those embracing this view is Diane Swonk, chief economist at Mesirow Financial in Chicago. “Expansions are like fine wine, they get better with age,” says Swonk.
Consumers, which account for 70% of the economy, will help to drive continued expansion, Swonk says. Home equity loans won't fan the consumption flames this time around, but consumers are employed in record numbers and can expect raises from employers flush with cash. Corporations have logged four years of record profits and have yet to deploy most of that capital, Swonk says.
Moderate growth isn't likely to bring rapid job creation and a high demand for new commercial real estate, but it is definitely better than no growth, or growth with spiking inflation. “If the Fed has to tighten a couple more points, it ain't going to kill this economy,” Swonk says. “This is a healthy time to make these choices.”
Matt Hudgins is an Austin-based writer
PREDICTIONS FOR MID-YEAR 2007
NREI asked eight forecasters to predict the direction of key indices. Here are their responses:
Dr. Rajeev Dhawan: Director, Economic Forecasting, Georgia State University
Prediction: “The Fed will cut rates three times, starting in March, and will be done by June.”
Dana Johnson: Chief Economist, Comerica Bank
Prediction: “Within six months, we're very likely to see that there's been some reversal in core inflation.”
Hessam Nadji: Managing Director of Research Services, Marcus & Millichap
Prediction: “The economy will perform better than expected as easing inflation pressures will allow the Fed to stay neutral for at least the first quarter.”
Josh Scoville: Director, Strategic Research, Property & Portfolio Research Inc.
Prediction: “We're looking at declines in net absorption next year on the order of 30% for office, retail and warehouse space, and an increase in apartment demand of around 20%.”
James Smith: Director, Business Forecasting, University of North Carolina
Prediction: “A short, mild recession will begin on May 16 at 9:15 a.m. EST and end on Nov. 15 at midnight.”
Diane Swonk: Chief Economist, Mesirow Financial
Prediction: “If we're surprised on the upside next year, it will be because the corporate sector puts their money where their mouth is and starts investing in the future.”
Craig Thomas: Senior Vice President, Torto Wheaton Research
Prediction: “Fair-weather investors may well be looking toward other asset classes for stronger returns, leaving real estate to traditional investors interested in long holding periods and steady cash yields.”
Jamie Woodwell: Senior Director, Commercial Research, Mortgage Bankers Association Prediction: “The commercial/multifamily real estate market will continue to show strength.”
| GDP (%) Growth | Monthly Job Growth | 10-Year Treasury Yield (%) | Crude Oil ($ per Barrel) | |
|---|---|---|---|---|
| Dhawan | 2.16 | 93,000 | 4.95 | $58 |
| Johnson | 2.5 | 100,000 | 5.35 | $55 |
| Nadji | 2.7 | 116,000 | 5.0 | $55 |
| Scoville | 2.9 | 110,000 | 5.0 | $55 |
| Smith | 0.8 | -98,000 | 4.43 | $35.62 |
| Swonk | 3.5 | 130,000 | 5.1 | $55 |
| Thomas | 2.5 | 120,810 | 5.36 | $60 |
| Woodwell | 3.0 | 80,000 | 4.9 | $66.70 |
Rent bumps likely as lease renewals crop up
A high volume of leases coming up for renewal could prove to be a landlord's best friend in 2007. Lost in the consternation over supply-demand fundamentals is the simple fact that tenants renewing their leases today across the property types are doing so in a landlord's market.
Slowing job growth in 2007 will reduce the rate at which commercial space is absorbed, so vacancies will decline little next year, even without significant construction.
However, most office and industrial leases expiring from 2007 through the end of 2009 were signed in a tenant's market just after the technology bust. Those leases will renew in a landlord's market at substantially higher rates, according to Hessam Nadji, managing director of research services at Marcus & Millichap.
To some extent, the position of property types in the market cycle reflects how quickly landlords have been able to raise rents. Shorter lease terms have enabled multifamily owners to boost rents more quickly, Nadji says.
Hotels, which are best able to increase income by raising rates when occupancy is high, are doing exceptionally well right now and will continue to do so through the end of 2007. By early 2008, new construction will result in empty rooms that temper the hot hospitality streak, according to Don Ratajczak, a consulting economist in Atlanta. “They'll continue to build until they eliminate profitability,” he says.
Shopping center owners have reason to worry, Ratajczak says, because construction will increase total retail space by 3% to 4% next year, outpacing consumer spending. “That means less sales per square foot, and you don't raise rent when that happens.”
Nadji disagrees, reasoning that with some 40% of planned retail construction tied to the expansion of large national chains, nearly half of all retail projects in the pipeline can be shut down quickly if sales slump.
What does delayed rent growth mean for investors? In the office and industrial sectors, would-be buyers calculating purchase offerings may be able to figure in one or two years of rent growth between 8% and 11% on most properties, rather than an arbitrary 3% to 4% per year based on inflation, Nadji says. “That can make things more feasible for an acquisition,” he says.
There is even room for continued sales price increases based on growing income rather than shrinking capitalization rates, says Dan Fasulo, market analysis director at Real Capital Analytics, which tracks real estate investment sales. “We're still in the beginning, or maybe the middle, of that cycle,” concludes Fasulo.
(For more on the forecast of individual property sectors, see pages 27-31.)
— Matt Hudgins
Scarcity of workers will hamper absorption
Slowing job growth threatens to fuel inflation as well as throw a damper on commercial real estate development in 2007, some experts say. Workers are in high demand but short supply. The number of unfilled jobs climbed to 4 million in October, up 11% from a year ago, yet October's unemployment rate reached a five-year low of 4.4%.
“Employers can't find people to fill job openings because the unemployment rate is so low,” says Josh Scoville, director of strategic research at Property & Portfolio Research. “That's going to become an issue over the next 13 or 14 years as the baby boomers exit the workforce.”
Demand for space will diminish along with job growth. Net absorption will decline about 30% in 2007 for office, retail and warehouse space, Scoville predicts. Some economists worry the tight labor market will create inflationary pressure by sparking wage growth. As employers are forced to pay higher salaries to lure and retain workers, companies may charge more for goods or services to recover swelling payroll costs. Unit labor costs rose 5.3% in the third quarter from a year earlier, the largest annual increase in 24 years.
Not all economists subscribe to the link between wage growth and inflation, however. “High wages have never caused inflation, anywhere. If that were true, China would have about 40% inflation, and it's closer to 2% right now,” says James Smith, director of business forecasting at the University of North Carolina. In practice, employers facing a high cost of labor are more likely to compensate by boosting efficiency, doing more with less, Smith says.
One reason job growth has slowed is a low participation rate, meaning many working-age individuals are staying in school, retiring early or relying on working spouses rather than taking on jobs. A reversal of that trend could enable acceleration in employment — and the demand for space. Such a shift occurred in the 1990s, when large numbers of people left school, their homes or retirement to fill available jobs.
“People started coming out of the woodwork,” recalls Diane Swonk, chief economist at Mesirow Financial. “We've not yet seen that labor force participation response [this time around].”
The irony is that job growth may prove inconsequential for owners of existing commercial real estate, says Craig Thomas, a senior vice president at Torto Wheaton Research. “They're fairly agnostic about it either way,” he says. “The income a building can produce isn't based on runaway growth, it's reflective of the supply-demand balance in that market.”
— Matt Hudgins