Economists and commercial real estate experts largely agree that U.S. job growth year-to-date can best be described as disappointing. Although non-farm payrolls increased by 337,000 in October — a portion of which resulted from post-hurricane hiring of construction workers in Florida — employers have added an average of only 170,000 jobs monthly since the start of the year. To put that number in perspective, monthly job growth in the go-go days of the late 1990s routinely exceeded 300,000.
The labor market in 2004 wasn't supposed to be this choppy. At the beginning of this year, even the most conservative projections called for the creation of 200,000 jobs per month. “I, for one, thought that the economy would have emerged stronger out of the blocks. But the good news is that we are in for a slow and steady recovery,” says Paul Briggs, senior real estate economist at Property & Portfolio Research.
While October's job report was encouraging, at least two more months of job formation exceeding 200,000 will be required to instill confidence that the economic momentum that took shape between August 2003 and April 2004 has been restored, according to Lloyd Lynford, CEO of Reis, a research firm.
Gross Domestic Product (GDP) grew at an annualized rate of 3.7% in the third quarter, up from 3.3% in the second quarter. “The current level of GDP growth should sustain job formation at an annual rate of at least 2.3%, or 250,000 jobs per month,” Lynford wrote in a recent presentation titled “The Markets in Autumn: Stirring, Stretching, Rousing.” But higher oil prices or interest rates could undermine those expectations, Lynford adds, resulting in less absorption than anticipated.
The largely tepid job growth in 2004 has led to some starkly contrasting views about what is likely to unfold in 2005. Lawrence Fiedler, a professor at New York University's Real Estate Institute, has a decidedly bearish outlook. “This economy is like a headless horseman. It just can't seem to create the jobs that it needs to recover.” He projects that 2005 will see less than 100,000 jobs created per month. “It's very hard when you rely so heavily on interest rates as a way to manage your economy,” says Fiedler, referring to the historically low long-term rates.
Yet Jim Smith, chief economist at the Society of Industrial and Office Realtors, strongly disagrees. Smith calls for roughly 300,000 new jobs per month through mid-year 2005.
While experts may disagree on the pace of recovery, no one disputes that the fundamentals across the office, industrial and multifamily sectors remain soft. Here's a snapshot of each sector:
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The national office vacancy rate at the end of the third quarter registered an unhealthy 16.3%, according to CB Richard Ellis, a reduction of only 50 basis points from the 16.8% vacancy rate posted in the third quarter of 2003. Further, Reis reports that in the second quarter, 34 of 64 metro markets recorded effective rent declines, 20 had vacancy rate increases and 18 experienced negative absorption.
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The industrial market also is suffering from excess space, but to a much lesser degree. The CB Richard Ellis Industrial Availability Index — which measures the supply of available space in large industrial buildings as a percentage of the total amount of space — ended the third quarter at 11.2%, down from 11.7% a year earlier.
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Although the national apartment vacancy rate is showing definite signs of improvement — it's dropped 50 basis points during the last six months to now stand at 6.6% — Reis anticipates that the vacancy rate will climb to 6.9% by the end of this year due to new completions.
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The fundamentals in the hotel sector are much more encouraging. For the 12-month period ending September 2004, overall occupancy jumped from 59.1% to 63.3%, according to Smith Travel Research.
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The retail market remains strong. The vacancy rate at shopping centers in the top 62 markets fell 10 basis points to 6.9% in the third quarter as absorption exceeded completions by 928,000 sq. ft., reports Reis. Though rising energy prices and interest rates have begun to influence spending patterns, their full impact has not yet been felt, according to Reis (For more details on each sector, please turn to page 28).
Underlying Factors
Why has job growth been so tepid this year? “There was the short-term impact of high energy prices, falling confidence and the elections,” says Hessam Nadji, managing director at Marcus & Millichap. “And companies are finding ways to produce with fewer workers while limiting their traditional, full-time payroll positions due to increasing health care and material costs.”
Health insurance premiums have risen by 7.5% through the first nine months of 2004, according to Mercer Human Resource Consulting. Although oil prices are down from their peak of $55 per barrel in October, they remain quite high.
Fiedler of NYU agrees with Nadji, adding that over the past few years U.S. employers have leveraged employee productivity through technology. Productivity, for example, grew by 1.9% in the third quarter. Fiedler believes these efficiencies, combined with employers' cost-cutting measures, are softening demand for office space. Outsourcing jobs to places like India and China isn't helping either.
What Will Drive Office Absorption?
It's still unclear which industries will lead the real estate market out of the office doldrums. Torto Wheaton Research, which pegged the national office vacancy rate at about 17% in the third quarter, projects that the national office vacancy rate will fall by only 2% over the next three years. That would put the vacancy rate just below 15% in three years — still a tenants' market.
Tenant representatives surveyed by the Urban Land Institute and PricewaterhouseCoopers as part of the 2005 “Emerging Trends In Real Estate” report believe that smaller businesses are taking advantage of the tenants' market, which could lead to a wave of leasing activity.
That bodes well for the office market, but there's a catch: Many of the new jobs created this year fell on the lower end of the economic spectrum, reports “Emerging Trends,” which surveyed real estate players from a cross-section of disciplines. Restaurants, temp agencies, retail sales and building services have added new workers, but these jobs don't fill office buildings or generate growth in other property classes.
The good news is that some growth is expected in the white-collar job sector. Some 23.3% of all domestic jobs utilized office space as of September 2004 — but that percentage should rise to 23.8% by the end of 2009, reports Property & Portfolio Research. Also, most of the jobs that were created within the past year are office jobs. “Since the start of the year, 24.7% of the newly created positions have been office using jobs,” says PPR's Paul Briggs.
So, where will the much-needed office-jobs come from? Respondents to the “Emerging Trends” survey are looking to the health care and biotech sectors to drive leasing growth as aging baby boomers require more medical services. Respondents caution that the worst may be over, but 2005 is still too early to expect much improvement in leasing demand.
Modest job growth in the legal and finance sectors helped Brookfield Properties Corp. post a 19% increase in funds from operations (FFO) in the third quarter. Brookfield owns several trophy office properties, including lower Manhattan's One Liberty Plaza and the World Financial Center. Ric Clark, president and CEO of Brookfield, says that tenant expansions are driving occupancy growth within the Brookfield portfolio.
Last year, the company signed 400,000 sq. ft. of new leases, according to Clark. For all of 2004, he expects to sign roughly 1.5 million sq. ft. of new leases. Despite the encouraging leasing activity, occupancy actually slipped from 94.3% at the end of the third quarter of 2003 to 93.9% in the third quarter of 2004 as leases signed in the late 1990s came up for renewal.
Brookfield isn't the only downtown landlord benefiting from renewed leasing demand. Midtown law firm McKee Nelson, for example, has signed a 15-year lease for nearly 70,000 sq. ft. of office space at 1 Battery Park Plaza, owned by the Rudin and Rose families, two New York real estate dynasties.
The average asking rent in the building is $35 per sq. ft., nearly half what comparable space in Midtown would cost. The law firm, which occupies 25,000 sq. ft. at 5 Times Square, is nearly tripling its space.
“Tenants have pent-up demand to expand, and we're finally seeing it,” says Clark, who admits there is not much opportunity to raise rents significantly. “I believe that 2006 will be a much better year for rental growth.”
Frothy Capital Markets
Although the jobs picture remains a bit murky, virtually no one expects a major retreat in the heady investment sales market, not with billions of dollars trying to find their way into commercial real estate. During the first half of 2004, $71 billion of apartment, industrial, office and retail properties were sold, according to Marcus & Millichap — a 32% increase over the same period in 2003.
Trophy properties in major U.S. cities are in such demand that investors are pursuing Class-A assets in secondary markets. The demand for product is compressing capitalization rates around the country.
The average cap rate for apartment properties nationwide was about 5% during the third quarter of 2004, reports Real Capital Analytics. That was the lowest average cap rate for any property class. Office properties, by comparison, were trading at about 6% during the third quarter.
Sources expect real estate capital flows to remain heavy in 2005, driven mainly by pent-up demand from institutional buyers. These buyers should fill the vacuum left by private investors and syndicates, if interest rates rise dramatically.
Monetary Stimulus Fades Fast
One burning question is whether interest rates will rise faster than real estate fundamentals. If so, highly leveraged investors with marginally performing properties could begin to feel the strain.
On Nov. 10, the Federal Reserve raised the federal funds rate by 25 basis points to 2%, the fourth increase this year. The credit tightening campaign is expected to continue in 2005. “Real estate is there to generate income, not to act as a poker chip,” says Craig Thomas, a real estate economist at Torto Wheaton Research. He believes that higher rates and a strong economy are preferable to lower rates and high vacancy.
Thomas isn't alone. “We'd prefer to have strong economic growth and higher [interest] rates in 2005 rather than weak growth and low rates,” says Joe Parsons, president of North American Equity Holdings at GE Commercial Finance Real Estate, whose firm manages $196 billion worth of assets.
Strong economic growth ultimately translates into a stronger real estate market — and that beats the limited upside of merely having low interest rates. Sources emphasize that low interest rates can simply mask weak property fundamentals.
Ultimately, a booming economy could prove to be a double-edged sword for commercial real estate. “If we see a super-heated economy, it's conceivable that a lot of this capital will flow into other investment alternatives,” Parsons says.
That scenario could be problematic for real estate investors, particularly those looking to sell in 2005. But Douglas Duncan, chief economist at the Mortgage Bankers Association, thinks that's an unlikely scenario. “We believe that slower growth with a lower-rate horizon is the one which will occur,” says Duncan. “That is a good short-run story for real estate, but in the long run [economic] growth is key regardless of the accompanying rise in rates.”
Editor Matt Valley contributed to this story.
ECONOMISTS' PREDICTIONS FOR Mid-year 2005
NREI asked five economists to predict the direction of key indices. Here are their responses:
Douglas Duncan: Chief Economist, Mortgage Bankers Association
Prediction: “Taxes will be the top domestic issue.”
Kenneth Rosen: Economist with the University of California, Berkeley and President of Rosen Consulting
Prediction: “A terrorist attack on the Saudi Arabian oil supply could push the global economy into a recession.”
Craig Thomas: Director of Research, Torto Wheaton Research
Prediction: “I don't think we are done with the nastiness of the presidential election.”
Jim Smith: Chief Economist, Society of Office and Industrial Realtors
Prediction: “Iraq puts 4 million barrels a day of oil on world markets and oil prices fall to $20 a barrel.”
David Wyss: Chief Economist, Standard & Poor's
Prediction: “Red Sox win another World Series. On the economy, oil prices slump.”
| GDP (%) Growth | Job Creation | 10-Year Treasury Yield (%) | Oil ($ per Barrel) | |
|---|---|---|---|---|
| Duncan | 3.3 | 900,000 | 4.5 | $55 |
| Rosen | 2.5 | 900,000 | 5.5 | $40 |
| Smith | 4.2 | 2.2 million | 4.5 | $21 |
| Thomas | 3.1 | 1.1 million | 4.7 | $44 |
| Wyss | 3.5 | 1.1 million | 4.8 | $40 |