NAREIM A&A Meeting Notes: Finding Clarity in Uncertain Economic Times
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William Shakespeare wrote in his play, The Tempest, “O Brave New World…” His exclamation is an appropriate response to the times we face today. Real estate investment managers hoping to learn whether 2013 is a good time to buy or to sell assets didn’t come away from the NAREIM Asset Management & Acquisitions Winter Meeting with simple answers. At a time when traditional economic cycles can be disrupted by political machinations and an increasingly mobile workforce, the challenge of finding clear opportunities in any market or product type is more difficult than ever. But in the full-day exploration of the forces shaping the investment management landscape, a few bright spots peeked through the fog of uncertainty.
Speakers covered a wide range of issues affecting real estate investment managers, from operations to market opportunities to data management. Back-to-back panels on the global economy and political considerations ran together seamlessly, as speakers and audience members agreed that economic conditions are a function of government action or inaction, far more today than in the past. And the conversation never strayed far from demographics, as the retirement of baby boomers and entry of millennials to the workforce affects investment strategy and talent development within the advisory business.
Changing Space, Shrinking Geography
“The ground under our feet is changing in real estate,” said NAREIM CEO Gunnar Branson. “Are we selling what people are buying? We may think we are selling square footage, but what people are buying or leasing is a place to live, or to get co-workers together, or to store stuff – and they want all those places to be close together.”
According to the U.S. Public Interest Research Group, the average young person (age 16-34) with a job drove 10,700 miles in 2009, compared with 12,800 miles in 2001. But it isn’t just young people. In the last 7 years, the average American was driving 6% fewer miles per year. Young people today choose to live in cities where they can walk or take mass transit to worksites, restaurants and other places to congregate with other intellectually stimulating people. In the past, they might have gone to cities where job prospects were better, but today it’s often the reverse: companies look for talent in cities where smart young people congregate.
Many in the audience expressed familiarity with the idea of “agglomeration economies,” cities whose high cost of living is more than offset by benefits such as a large employment pool, good transit systems and range of amenities. The gravitational pull works on individuals as well as businesses, which sets up a virtual cycle: people choose cities with good career opportunities, and companies locate in cities where the best talent goes.
“Firms want to be in cities where they can quickly hire talented people when they need them, increasingly on a more flexible basis, and young people are going to cities where, if they lose one job, they have a better chance of finding another one,” said Jim Clayton of Cornerstone Real Estate Advisers LLC. He noted that the FIRE sectors—finance, insurance and real estate—have been virtually flat in terms of job growth, while the intellectual capital, energy and education sectors—known as ICE—have seen the strongest growth in recent years.
Cities that attract the creative class have seen building values rise as more investors are looking in tertiary markets with upside potential. But the risk of prices overheating may be greater in a small city, where a departing tenant may be more difficult to replace. Plus, job growth does not necessarily translate into office space growth in the current market environment.
“Today’s college graduates are very open to collaboration, which allows companies to get higher density in office space,” said George Wells of Piedmont Office Realty Trust. For many buildings, however, high density poses challenges, such as parking requirements as high as 6 spaces per thousand square feet of rentable space in suburban markets, as well as hidden costs in areas such as janitorial services and energy consumption.
Young workers in the creative class also have their own set of priorities in choosing where to live, according to Clyde Holland of Holland Partner Group. For many, the number-one issue is whether an apartment building has 100-megabit-per-second Internet service, so that residents can be competitive in online gaming. “After that, their next question is, where do I socialize? And third is, how do I get to work?”
The Internet is also a primary concern in the shopping center business. “All of our centers have a very progressive digital strategy, “said Kristin Mueller in Jones Lang LaSalle’s Retail group. The faster pace of today’s digital world also feeds the larger trend of retailers, and shopping center owners, being expected to deliver greater productivity from every square foot of space. Consumers have always been driven by value, but now they also expect to get exactly what they want immediately—and that poses new challenges in retail merchandising and staffing, she noted.
Tim Bellman of Invesco noted that job growth averaged 1.8 percent annually between 2004 and 2007, when demand for office space was strong; but the exact same growth rate over the past three years has not brought the same bump in demand. The question is whether the lag is cyclical in nature—companies are waiting for more economic certainty before converting temporary workers to long-term positions—or evidence of a deeper structural change in the global economy whereby companies discount traditional market indicators, and instead chart their own course to success.
Jim Costello of CBRE used the term “disaster fatigue” to describe private-sector players weary of the seemingly unending state of near-emergencies in U.S. and international economies. Other speakers carried this thought forward, noting that corporate profits and rising stock prices are out of sync with the dire warnings coming out of Western governments. “I sense the private sector disengaging somewhat from political debates on things like the debt ceiling, as companies are quietly getting on with the business of deleveraging,” Bellman said.
“Being too cautious may be the greatest risk of all,” said John Sikaitis of Jones Lang LaSalle. “The uncertainty of the past couple of years has mostly been policy related.” Several industry sectors are now positioned for growth that will result in increased space demand, but political wrangling over deficits and taxes continues to be an obstacle.
As the NAREIM meeting took place in January, the U.S. government had recently avoided one government-manufactured crisis—the so-called fiscal cliff—and was still facing a sequestration deadline of March 1, followed by and a new round of battles over the debt ceiling and a potential shutdown in the first half of 2013. The financial news of the day was the Federal Reserve’s advance report that GDP had declined by 0.1 percent in the fourth quarter of 2013, but that news had not brought a negative reaction from stock markets as it may have done in the past. The established path of a productivity dip leads to a market pullback did not apply in this case– investors as a group blazed a new trail. (A month later, the federal government went into sequestration which, contrary to the dire predictions of politicians, was followed closely by a record-high Dow Jones Index.)
The estimated decline in GDP (eventually adjusted to a slight increase) was credited to government spending cuts earlier in the year, which had a ripple effect on the private-sector economy. But real estate markets saw a major uptick in activity after the November election, as decision-makers across several industry sectors gained a level of certainty from Presidential and Congressional election results.
Sectors on the Upswing
For example, office space demand in Washington DC was greater in the final seven weeks of 2012 following the election than in the 45 weeks prior to the election, Sikaitis said. “With the election over, we have more clarity on the direction of the healthcare industry, and we’re moving toward clarity on two booming sectors, technology and energy,” he said.
Healthcare reform—the fate of which was in doubt until the Supreme Court upheld its constitutionality and President Obama’s re-election signaled its popularity—is a major factor driving demand in cities across the country as states set up insurance exchanges, requiring 50,000 to 200,000 square feet for each exchange. States that do not set up their own exchanges will result in residents turning to federally run operations, and space demand in DC is already reflecting this increase in government oversight. “the same markets that are seeing activity in healthcare regulatory compliance are also seeing a boom in their housing markets,” Sikaitis observed.
A bipartisan consensus that immigration reform is necessary also emerged after the election. Although the political focus of the immigration debate has been on unskilled labor, the economic impact of strict immigration policies also falls heavily on the tech industry, which seeks workers from around the world with advanced technical degrees. A policy offering a more certain path to legal immigrant status or citizenship would help tech companies recruit and retain talented people from other countries, many of whom graduated from U.S. universities.
Another industry sector on the rise is energy, with strong growth opportunities on both the fossil-fuel and alternative-energy sides. New technologies that have made natural gas more affordable have driven employment growth in several areas of the country, while green tech industries such as solar and wind energy are seeing dynamic employment growth despite political controversies over the past few years. “We have an energy boom in the making, but a public-private solution that drives innovation and allows exports of natural gas…is probably going to be a challenge,” Sikaitis said.
Although much of the political/economic discussion was U.S. focused, a form of disaster fatigue is also apparent in the European Union, where the mood of real estate investors appears to be optimistic after several years of economic concerns. The question now is where the market can go from here, Bellman said: Investors have bought a majority of high-quality buildings in cities like London and Hamburg with a long-term hold strategy. And if the UK follows through on hints that it may leave the EU, there could be a dampening effect on investment interest in London.
LIBOR in Crisis
The EU is also at the center of an issue that could have a major impact on the investment management business, if not the global economy: The replacement of LIBOR as the standard for setting interest rates. The NAREIM audience was well aware of the wide-ranging scandal that came to light in 2012, as a majority of the 20 banks reporting their lending rates were found, or at least believed, to have consistently underreported rates. In effect, banks bypassed the proper course when they saw competitors taking a shortcut to the goal of higher lending volume and profit.
But most people in the investment management business had not considered the impact that the LIBOR shakeup may have on existing loans. Phil Weller of DLA Piper surprised many audience members by explaining that loan documents often state that, in the absence of a LIBOR standard, interest rates may revert to base rates that are 200 to 300 basis points higher. The sudden jump in rates would be painful for borrowers, and lenders are not expecting to get the higher rate, Weller said. But without direction from regulators, lenders may be at a loss to determine how to calculate interest rates if LIBOR is suspended.
Whither the Market?
The range of challenges and opportunities add up to a big question mark for investment managers’ primary concern: Are building values headed up, down or sideways? The continuing uncertainty could be seen by the audience response to a call for a show of hands on three successive questions: Over the next couple of years, do you expect your company to be a net seller of property, a net buyer, or are you most likely to follow a hold strategy? The audience appeared evenly split among the three camps, with many in the “net hold” group agreeing that there are not many clear arbitrage opportunities on the buy or the sell side.
The lack of clear consensus is actually a good sign for our industry. Markets function best when there are many potential buyers and many potential sellers. When everyone agrees that it’s time for a sell-off, there aren’t enough buyers to meet the supply; and if everyone is looking to buy but no one is selling, deals aren’t likely to happen. The fact that the best and brightest minds in the real estate investment management business are not all locked into the same mind-set means the market may be ripe for win-win transactions. It may not be easy, but in the words of Hamlet, those with “cause, and will, and strength, and means to do’t” are likely to find opportunity.
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