Are We There Yet? 2013 Spring EO Meeting Briefing
Are we there yet? The eternal refrain of children eager to get to a promised destination is a fair question to ask after years of uncertain market conditions, slow to recover labor markets and constant governmental stumbling. Unfortunately, it seems that the “parents” driving the economic car have less of an idea of how and when we will arrive than they ever did.
(For a print version of this report, click here)
Fortunately, as Abba Eban, the mid-twentieth century Israeli diplomat once pointed out, “Men and nations behave wisely once they have exhausted all the other alternatives”. If he was right, there may be hope that the past five years of economic roadblocks, confusing signs and political road rage could eventually give way to more stable, more prosperous and perhaps even less confusing times.
Meanwhile, real estate investment managers have to find their own path to wisdom. At NAREIM’s Spring Executive Officer Meeting this March in Santa Monica the focus of the discussion was on the landscape of economics, politics, technology and labor – and how these forces will affect smart investment strategy for the foreseeable future.
Insight abounded from thought leaders such as former White House Press Secretary Ari Fleisher on changes in the political climate over the past 10 years; from Los Angeles Mayor Antonio Villaraigosa on ways that big cities are reinventing themselves; and from physicist Geoffrey West on the surprising mathematics of urban growth and from many others. Despite the chaos at the macro-level, cities are growing, changing and evolving as overwhelming demographics and technology are re-shaping our world, and real estate’s role in it.
Were any definitive answers found during this meeting? No. But many questions and many more discussions illuminated how leaders will need to face the challenges of the next several years, known and unknown, if they wish to continue succeeding. A few points-of-view in particular are worth taking into account include:
The Economic View
The economy continues to be difficult to understand, much less predict, but it is not uniformly bleak. While describing the U.S. economy as “foggy with a crack of sunshine,” Doug Herzbrun, Global Head of Research, CBRE Global Investors, suggested that it’s possible to overstate concerns about the global economy. Any continuing weakness in the Eurozone will tend to “stay in the Eurozone,” and China’s recent economic lull is already reversing itself, he noted.
Herzbrun also dispelled the notion that the U.S. is in a jobless recovery, noting that growth has averaged about 50,000 new manufacturing and construction jobs and 150,000 new private services jobs per month. The stock market—still the best single indicator of economic sentiment–has experienced a repeating pattern since 2010, with a strong first quarter followed by a mid-year slowdown, he said. Although it is too early to tell if that cycle will repeat this year, The Labor Department’s April jobs report of over 600,000 new jobs created since January – and an overall unemployment rate of 7.5% suggests the economy may have sufficient momentum to disrupt this annual pattern.
That would be a good change since, according to Michael Zietsman, Managing Director, Jones Lang LaSalle, real estate and the general economy have followed the same pattern. “In the past three years the real estate markets have been schizophrenic,” he said. “They started out with a roar and ended with a whimper. I think 2013 will be different.”
Zeitman noted that there is currently twice as much capital chasing real estate than there are properties for sale. Total investment in 2012 exceeded $250 billion, outpacing the previous year by 19 percent. Today, many investors have aggressive acquisition targets and diminished disposition goals, indicating there is room for prices to rise further.
When analyzed by property type, there continues to be reason to believe that there will be continued growth prospects. In the past couple of years, retail and multi-family have been the clear winners. There is nervousness about some retail, given the continued disruptive nature of e-commerce, but high street retail is back to peak in many areas. Service and experience focused retail like the Apple Stores continue to deliver jaw dropping per square foot sales. But multi-family still seems like a safer bet going forward. According to Herzbrun, “looking forward I would expect apartments to continue to be top performers. They are really the only asset class now that has real, sustainable ability to increase rents.”
With office, it’s a bit tougher to see clearly. “The NCREIF index makes one wonder why so much money is plowed into office,” Herzbrun observed, “it had the worst return and the highest level of risk.” However, during an economic upturn office is generally the strongest property type and construction of new supply is at an all-time low. Depending on how businesses use office space for the next several years there may be cause to invest.
Industrial is about to get interesting. With the expansion of the Panama Canal about to be completed, there will be a rebalancing of market share across the port cities in the US – and according to Herzbrun, “manufacturing is recovering and the U.S. is more competitive than it has been for a while. As an economy we are producing more goods – albeit with fewer people.”
All this means a need for new and reconfigured facilities able to handle more automation, larger capacity and more efficient logistics. “The strongest demand right now is for the really big boxes – 1 million square feet or more for e-commerce fulfillment centers – and there will be further changes to space requirements. There is still a lot of functional and locational obsolescence in industrial space.”
At the same time, investors are also digging deeper for better cap rates, going into smaller cities with growth prospects, such as Seattle, Austin and Denver. Investors are also looking harder at Chicago and Houston, where cap rates on core office buildings are more than a full point higher than they are in New York and Washington D.C.
On the real estate fundamentals alone, New York City “prices defy logic,” Zeitsman said. Prices are setting new records at a time when many renewing legal and financial services tenants are reducing their space per employee by as much as 20 percent.
But Herzbrun observed that real estate prices are partly a function of the bond market. “There is a misconception that commercial real estate is expensive. If you compare the ratio of cap rates with bond rates, the US is experiencing the largest spread in history, making real estate extremely attractive as an asset class,” he said.
But the question remains – how long can the differential between bonds and real estate returns be sustained? And how much will governmental forces continue to influence the real estate market in the months and years ahead?
The Political View
“Things are happening,” enthused Jeff DeBoer, President and CEO of the Real Estate Roundtable, “TARP, Obamacare, the debt ceiling and sequestration are all outcomes of the gridlock in Washington. It’s important to note, however, that this gridlock is really a reflection of the split in the country itself.” But there is more movement today than there was only a few months ago.
After years of frustrating inaction, changes in the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) might actually occur in the next several months. Currently, foreign investors can hold up to 5 percent equity positions without worrying about withholding considerations.
DeBoer noted that there has been cause for hope in recent months. Congress has discussed increasing the withholding threshold to 10 percent and in April President Obama’s proposed infrastructure bill included a measure exempting foreign pension funds from the extra tax on gains, designed to place them on an equal financial footing as domestic investors. If progress of any kind is made in this area, as is expected, there will likely be a significant impact on the amount of non-US capital coming into real estate. “We are right on the cusp of a major decision that would overturn the way distributions to foreign investors are treated.”
Discussion has waxed and waned since the election regarding government sponsored entities (GSEs) Fannie Mae and Freddie Mac. DeBoer observed that the GSE reform debate has extreme views on both sides, with some politicians believing Fannie and Freddie should go away, and others believing that a market where GSEs providing virtually all home mortgages is not a problem. “Neither of those views is right,” said William Walker, President and CEO, Walker and Dunlop. “What we need is more of a balanced long-term solution with these enterprises.”
Last year Freddie and Fannie collectively provided $33 billion to the multifamily market, representing 90 percent of all capital supplied to the sector. The GSE’s provided a much needed stabilizing force for the entire sector and the economy. Looking ahead, Freddie and Fannie are working on a joint securitization program and also looking at ways to bring more capital to single family markets.
By contrast, the $750 billion of TARP funds loaned to banks four years ago were supposed to increase market liquidity, but banks were unable to put that capital to work without the infrastructure in place, according to Daryl Carter, Chair of the National Multi Housing Council and CEO of Avanath Capital Management. “What people underestimate is the value of the infrastructure developed by the GSEs to deliver multifamily capital to the market. That infrastructure works incredibly well.”
Participants in Fannie Mae’s Delegated Underwriter and Servicer (DUS) program for multi-family—unlike most residential MBS loan originators—must hold the first-loss position and service the loans they originate. “It is the only securitization program where private capital holds the risk,” Walker said. “The alignment of risk between private and public capital is why Fannie Mae delinquency rates are very low.”
Multi-family investors pay a price premium for multifamily product that’s directly attributable to the liquidity provided by Fannie and Freddie, as the investors have confidence they can refinance at the end of the loan term, Walker said.
If the government stopped guaranteeing the GSEs and Fannie and Freddie disappeared, the economic disruption would be significant. “The government backed mortgage securities market is the second largest market in the world. If Congress did something to alter that market there would be a big global reaction,” Walker said. At the same time, with no risk retention by loan originators in the single-family market, “you have a system that is bound to fail again.” A better solution would be to bring single-family lending rules more in line with GSE multi-family origination practices.
The Technological View
While economic and political factors have always been central to real estate considerations, disruptive technological change is becoming far more important than ever before as the ways people live, work and play has only begun to shift.
Office in particular seems to be vulnerable to changes in technology. Trends like telecommuting, hotelling and a reduction in the space allocation per employee continue to drive demand for space down even as the population rises due to the millennial generation and immigration. In Q4 2012 the national office vacancy rate averaged 18%. As corporate profits increase and companies resumed hiring, the office vacancy rate has been stubbornly stuck in the high teens.
“I predict office vacancy rates will get even worse in the coming decade because the underlying business model for commercial office space is fundamentally broken.” said Jeremy Neuner, co-founder and CEO of NextSpace. For the first time in history people can work from anywhere they can access wi-fi. “One of the places they will work the least is in office buildings.”
By 2015, there will be 1.5 billion mobile workers worldwide. By 2020, 40 percent of the American workforce will be contingent or fractional workers, earning their income from multiple sources rather than a single source, Neuner said. But all is not bleak for owners of office buildings. Alternative co-working spaces can be offered to workers on a paid membership basis vs. a pure per square foot rental. Contingent and fractional workers often need a place to work that is flexible, convenient, and works much the same way as a Zip Car or country club membership. Neuner’s company has had great success selling memberships to workers in multiple locations – deriving a much higher return than any lease could deliver.
According to Neuner, we should, “Stop thinking about leasing space and start thinking about selling an experience.”
At the same time, there is some reason to believe that demand for more office space could be in the offing. “The cost of office space is declining as a percent of total operating expenses, now down to just 2.4 percent,” said Kerry Vandell, Dean’s Professor of Finance and Director of the Center for Real Estate at the University of California-Irvine. “If you add in some behavior finance thinking it may not be the case that Gen X and Gen Y really wants a hotelling work life.” In the war for talent, larger office space and more amenities could be an inexpensive tool for employers to attract and retain the best and the brightest.
Will office space demand rise or fall? Will businesses rent by the square foot or by the seat? The answers will likely become clearer over time, but today it is almost certain that there is change afoot in the way businesses and individuals use office space.
Retail, of course, is even more affected by Internet and mobility trends. Today, e-commerce comprises 4.4 percent of all non-grocery retail sales, which not only threatens retail bricks-and-mortar profits but undermines state and local tax bases, which are dependent on sales tax revenue. That market share is only increasing every year. Forrester, the information technology research firm, predicts that e-commerce will approach a 15 percent share in just a few years.
Retailers have responded to this growing threat with multichannel marketing initiatives designed to create a seamless experience for customers who may not differentiate between shopping online, by phone or in stores. Increasingly, consumers want to shop online but pick up merchandise in stores, or the converse—checking out products in stores but buying online to avoid tax or to seek a lower price. This strategy may involve changes to the layout and design of retail stores, but the more immediate revolution is in the distribution chain. Supply chain experts have found dramatic cost efficiencies can be achieved through fewer distribution nodes, equipped to handle e-commerce fulfillment and traditional store shipments under one roof.
Retailers are also considering ways to maintain traffic levels in the face of e-commerce competition by offering customer experiences that can’t be replicated online. Chris Macke, CBRE Senior Real Estate Strategist suggested there may be a growing real estate opportunity in the intersection of retail and one of the most reliable growth industries of our time: Healthcare. Specifically, small retail centers are beginning to integrate with and embrace health related service providers in their tenancy – and are creating remarkable synergistic foot traffic for traditional retailers.
Macke cited contemporary examples of “medtail” including Walmart stores with Vision Centers, CVS stores hosting Minute Clinics and Take Care clinics within Walgreens stores. “It isn’t difficult to imagine malls with 10 percent or more medical tenants in the future–not just doctors, but heading aid centers, medical supply companies, physical therapy centers, and wellness centers,” Macke said.
Medtail may be increasingly important to shopping centers as healthcare spending increases for an aging baby boomer population and displaces the share of dollars they used to spend on consumer goods. The marriage holds other advantages as well: doctor’s visits take place during the day when retail traffic is low and parking is convenient for patients; medical tenants will accept hard-to-rent elbow space; and physicians generally sign longer term leases and have higher renewal rates than other retail tenants. The successful retailers of the future may need to know as much about health care as they now know about fashion trends.
No Clear View to the Future – the True Test of Leadership
Discussions in March kept returning to questions of leadership, of human capital, and of how to navigate uncertain, even turbulent times with the right team of the right people. As Matt Slepin of Terra Search Partners put it, “Real Estate is a business about deals and capital…but increasingly, it’s as much a business about people, teams and vision. It’s imperative that we try to look beyond the immediate transaction, beyond the hiring of one superstar, and towards the development of a more resilient, more effective, more successful organization.”
How do you build a team for the challenges of an uncertain world? According to opinions expressed at the meeting, it is important to not only know what your investment strategy and thesis might be, but also to know what differentiates your firm and your team. There’s a need to not only how you will succeed, but why you will succeed – even when the path doesn’t go as planned.
There seems to be a shortage of human capital. Very few young people have come into the real estate business in recent years and the bench strength of many investment management firms falls off under the age of 40. But based on the level of talent represented by “NAREIM Fellows” Kyle Reardon of Cornell University’s Baker Program in Real Estate, Whitney Smith from McDonough School of Business at Georgetown University and Elliot Weinstock of USC’s Marshall School of Business, there is hope for our future. Investment management firms, however, need to take a leadership role in reaching out to University programs to find new talent, help develop real world skills and ultimately create a clear path for young people to take leadership roles in real estate firms of the future.
NAREIM board member Paul Bernard is taking the lead of an education outreach committee to connect with Universities and students around the country – and involve young people in NAREIM internships, meetings and research activities.
Fortunately, young people coming into our business have different experiences than current leaders do – they see things with fresh eyes, they understand intuitively how young people want to live, work and play. They may not understand how to make a deal today – but they likely have insight on what we will need to do tomorrow.
These are uncertain times, and it appears that no one is expecting the “easy money days” of years passed to return anytime soon. Leaders will need a level of intestinal fortitude, flexibility, and humility that may not have been required before. Just as guest speaker Mayor Antonio Villaraigosa, after shattering his elbow in a bicycle accident, went directly to his staff saying, “This is a teachable moment.” and set the impossible task of making Los Angeles a bicycle friendly city…with over 1,600 miles of new bicycle lanes to come – real estate leaders need to be able to jump back from the accidents and drive their future.
Shakespeare once wrote, “Wise men never sit and wail their loss, but cheerily seek how to redress their harms.” The road ahead for real estate leaders continues to be challenging, but we can and will handle it.
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