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July 24, 2014

The Future of Commercial Demand

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The Future of Commercial Demand

Financing matters, but jobs will be most important in determining a timeline for genuine recovery.

If you ask 10 commercial real estate professionals what it will take for commercial markets to recover, eight of them will say jobs. (The other two will say financing.) But the local employment picture affects far more than just office vacancies; it touches every major property type. If you don’t have a job, you don’t have money to spend at the mall or to lease an apartment.

A national unemployment rate near double-digits is already taking a toll. In the first two quarters of this year, the U.S. office market had 50 million square feet of negative absorption because of job loss, says Webster Collins, CRE, executive vice president of CB Richard Ellis/New England in Boston. For the same period, community centers had an addition of new and newly vacant space of almost 16.3 million square feet, according to Reis Inc. Industrial vacancies jumped to 10.7 percent in the second quarter, the biggest quarterly increase in 22 years, according to Grubb & Ellis.

Faced with such grim numbers, how long will it take the commercial real estate markets to recover? The short answer: 2012, say many experts. But "that doesn’t mean that at a certain preappointed time, everything will suddenly be fine," says Bob Bach, senior vice president and chief economist at Grubb & Ellis. Instead of a clear upward curve, you need to look for sequential milestones to anticipate when recovery is on the way.

Milestones to Watch

The first place to look for a hopeful sign of real estate recovery is the gross domestic product, which could turn positive by the end of the year, says Bach. GDP growth should provide an early boost to light assembly and warehouse properties if exports pick up and retailers have to restock current low inventories. "It won’t take much," says Bach.

The Consumer Confidence Index is another place to watch for upticks that can help retail sales and warehouse demand. The index dipped in June and July after making a comeback from March lows. "Consumers have been spooked by falling home prices and stock prices in the past year, so they may continue to be extra cautious," says NAR Chief Economist Lawrence Yun. That may make the retail comeback more sluggish than in past recoveries.

The personal savings rate is another bellwether of economic recovery over the next twelve months, says Mark Dotzour, chief economist at Texas A&M’s Real Estate Center. "When Americans save, we have a recession," quips Dotzour. The personal savings rate rose from around 1 percent in the first quarter of 2008 to over 5 percent by the second quarter of this year. Households will gradually adjust to a higher savings rate—assuming it's sustained—and begin spending again, says Bach, but it could take a while.

Quarterly corporate profits are a good way to anticipate future office space needs, says Dotzour. But, he warns, you need to see sustained profits from a variety of companies, not just a few that beat their estimates. "When corporate profits as a whole rise, that’s what creates jobs," he says.

But if you have time to watch only one figure, make it job growth. "All roads toward commercial recovery lead through employment," says Billie Redmond, CEO of Coldwell Banker Commercial TradeMark Properties in Raleigh, N.C.

"Predicting future job growth is a tough one," says Bach, especially since jobs tend to lag the recovery. In the last downturn, job losses didn’t hit bottom until 21 months after the recession started in November 2001. It took another nine months for jobs to return to their pre-downturn levels. Using that timeline, it will be mid-2011 before job growth comes back, he says.

Before we see much job growth, small-business owners, who employ some two-thirds of American workers, need to get their confidence back and start hiring, notes Ken Riggs, CRE, CEO of Real Estate Research Corp. "These people are very nervous," not only about the economy but also about unresolved issues such as taxes and health care costs.

And even after hiring picks up, companies must absorb excess sublease and shadow space before they’ll need new square footage, notes Jim Helsel, CCIM, CPM®, partner with RSR, REALTORS®, in Harrisburg, Penn. "It could be 2012 before you see the more rapid job growth that will increase absorption and cause rents to rise," says Dotzour.

Demand Leaders

Whenever recovery comes, it won’t arrive evenly. Though it seems that demand for every commercial property type fell simultaneously, not all property types will recover on the same timetable, says Robert White, president of Real Capital Analytics. Multifamily will be the first to come back, in part because "it hasn’t fallen as hard. Fannie and Freddie were backstopping the debt," he says.

Yun is also "bullish" on multifamily. He points to the recent slowdown in household formation as an indicator of pent-up demand. A growing number of Generation Y renters, born between 1977 and 1994, will help multifamily demand, as will foreclosed home owners who’ll need to reestablish credit.

Office space is harder to call, in part because job recovery will differ by occupation. A few fields, such as health care, should remain relatively strong. "Health care employment is going to lead us as we go forward and provide opportunities to develop medical office and ambulatory care sites in the community, away from hospitals," says Redmond.

The federal government is another source of demand. "The only sure office bet seems to be the D.C. market," says White. State government is less sure as many struggle with falling revenues.

Educational institutions, especially private universities and vocational schools, are another bright spot for office landlords. "There must be a dozen private colleges leasing office space in our market," says Robin Webb, CCIM, Coldwell Banker Commercial NRT in Orlando. Laid-off workers, retired workers seeking second careers, mid-career workers who need to learn new skills, and Generation Y is helping to fuel this trend.

Technology may be another recovery leader, the Federal Reserve predicted in its Beige Book released in July. "We’re showing a lot of space to start-ups. It’s a positive sign and will pay dividends, but it’s not absorbing significant amounts of space," Collins says.

Start-ups or smaller local entrepreneurs should also help some in lessening high retail vacancies, says Wayne Caplan, director of investment with The Chicago office of Sperry Van Ness, though at much lower rents. A few retail users, such as casual dining restaurants, are still expanding, notes Whit Peyton, senior managing director with CB Richard Ellis/Minneapolis.

Suburban space may benefit from tenant moves to less costly, more accessible non-central business district properties, especially in major metropolitan areas, says Janice Cimbalo, senior vice president of Jones Lang LaSalle in Los Angeles. The trend toward using less space, which started before the recession, could have a negative effect. "I think that corporations will keep up that habit of using as little space as possible after recovery," she says.

Another hard call is hospitality. Hotels traditionally recover rapidly after a recession because they can quickly raise rates. But as aging boomers work longer, they may have less time for leisure travel, says Bach. Tighter corporate budgets may also keep business travel lower even after a recovery starts, predicts Webb.

Cautious Investors

Concerns over deteriorating demand fundamentals are also giving commercial investors yet another reason—along with capital market woes—to stay on the sidelines, says White. "Investors have divergent views, but no one is predicting a near-term turnaround." Those who do buy are assuming a 12- to 24-month decline in net operating income when they underwrite properties, even if properties are well leased, he says.

Falling NOI is also hurting prices. The MIT/CRE Transaction-based Index, which tracks sales of institutional-grade properties, showed sale prices declined 18.1 percent in the second quarter, for a total drop of 39 percent since mid-2007 highs. Cap rates reflect these falling prices. Buyers won’t look at a commercial property except multifamily if the cap rate isn’t 8.5 or 9, says Caplan.

Perhaps more significant than the sharp price declines in the MIT/CRE index was the small (0.6 percent) increases in sales for the second quarter. Whether this represents recognition of a bottom or one-off sales to opportunistic buyers isn’t clear as yet. "When you see one or two significant portfolio transactions with a mix of property types, you’ll know that someone is ready to place a macro bet that commercial real estate will recover," White predicts.

Smaller properties have seen more deal activity than the large properties tracked by the index, but volume won’t pick up until banks start to lend, says Helsel. "At least in my market, if the lending would give way, sales would follow," concurs Blair Gilbert, SIOR, an industrial specialist with RE/MAX Reliance Commercial Services Group in Philadelphia. Buyers also have to get more realistic and stop expecting to get "screaming REO deals" on performing assets, says Eric Nesbitt, president of Denver’s KW Commercial/The Nesbitt Group.

Whether markets begin to clear soon or banks continue to "kick the can down the road," at some point, brokerage activity will rise. And when they do, "it will be a once-in-a-generation opportunity to buy commercial real estate," says Dotzour.


Demand in the Trenches

What does demand look like from 30 instead of 30,000 feet? Brokers weigh in.

Atlanta: Thanks to build-to-suits for corporate end users and demand from food companies like Kraft and General Mills, the industrial sector is active, but it’s not doing much to take vacant space out of the inventory. Green, energy-efficient space and wide truck bays are helping landlords hold on to good tenants amid rising vacancies. Sales are nowhere even as cap rates rise to 8.5 percent. —Wit Truitt, SIOR, CB Richard Ellis

Chicago: Partially completed condo conversions are selling off to experienced apartment landlords, but "you have to sift through the unrealistic bottom feeders to find the legitimate buyers." Neighborhood vacancies are creating chances for smaller local retailers and office users to lock in good locations at good prices if they’ll accept a lease term of two years or less.—Susan Silver, executive vice president, Millennium Properties Inc.

Dallas: New space deliveries in the office sector (2.5 million square feet) have pushed vacancies to their highest levels since the 2001 downturn. "But into my fourth down market," prospects don’t look as bad as in the 1980s. The light rail has spurred apartment and retail activity.—Clifford Bogart, CCIM, KW Commercial/CommAlliance Professionals

Los Angeles: No one expects apartments to appreciate, so cash flow is king as vacancies range from 10 percent at the beach to 15 percent or more in the valley. In this market, "rent-controlled properties look good since you know tenants won’t move out."—Dana Brody, assistant vice president, multifamily, Grubb & Ellis

New York:: Even high-end Madison Ave. retail north of 57th Street isn’t immune to this downturn. Renewals are softening and the "unthinkable" request of landlords paying for tenant build-outs is on the table. Even though they may be missing great rent deals, most retailers are content to kick the tires for now. Salvation may come from overseas retail concepts and from discounters ready to adapt to New York style.—Patrick Breslin, president, retail, Grubb & Ellis


Demand Sources

Want to be the first to see signs of recovery? Check out these data sites:

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