Texas Tea & CRE: The Commodities Rout & Its Implications For U.S. Commercial Real Estate
By Hans Nordby, Managing Director, and Adrian Ponsen, Senior Real Estate Economist, CoStar Portfolio Strategy
Regular NAREIM meeting attendees are very familiar with Hans Nordby and his colleagues’ fascinating perspectives on markets, demographics, and the quirks of our economy. Hans leads CoStar Portfolio Strategy, (formerly Property & Portfolio Analytics), and is a frequent speaker on economic topics. Adrian’s writings on macro-economic impacts on the real estate space are particularly insightful.
Commodities and commercial real estate are joined at the hip in more ways than one. Commodities such as iron ore, aluminum, and copper are, literally, the building blocks of the commercial real estate sector. Over 85% of American workers use the world’s most heavily traded commodity (oil) to drive to the office, retail, or industrial buildings where they work. For owners of U.S. commercial real estate, the implications of today’s changing tides in the commodities sector (and lower long-term prices for raw materials) will stretch beyond just resource-rich regions of the country such as Texas and North Dakota. This piece begins with an overview of where commodity markets stand in early 2016, followed by an analysis of the commercial real estate sector’s winners and losers from lower-for-longer prices of raw materials.
Deeply Discounted Commodity Prices Are Here To Stay
Of all the commodities whose values have sunk recently, the downturn in oil markets has been the most well-publicized and with good reason. Energy is a major line item in the average American consumer’s budget and also a key input in the processing of other commodities, such as iron ore and limestone into steel and cement. As a result, low commodity prices act as a tax break for most consumers, as well as a discount on construction cost for builders. And a substantial subsidy it is—at the time of this writing, WTI crude oil prices are $37/per barrel, down about 65% from 2014 highs. The current supply and demand balance in energy markets suggest that a major price spike (one that would be enough to wipe out most of the recent declines) is a long way off. Top OPEC producers, such as Iran and Iraq, intend to increase production this year. Meanwhile, economic growth (which drives oil demand) is slowing in China, the U.S., and Europe.
The most bearish signal for oil prices is the current level of oil stockpiles, which is well into record highs and still rising. During the energy market downturn of the 1980s, it took more than 20 years of working off oil stockpiles before inflation-adjusted oil prices could hold above $40 per barrel. During that downturn, many of the factors at play were similar to those seen in oil markets today, including a strengthening dollar, elevated U.S. production, and Saudi Arabia pumping aggressively to defend its share of oil market revenues. Another 20-year stretch of low oil prices seems unlikely, but with prices over $40/barrel, the vast majority of today’s producers can continue to make money pumping oil. This suggests that prices will again need to stay below this benchmark for an extended period of time to bring down the global supply glut.
Oil Inventory Gluts Take Years To Work Off
U.S. Oil Stocks & WTI Prices
Houston, We Have A Problem
The U.S. metropolitan areas hurt most by the downturn in commodity prices are those with economies driven by extraction of oil, natural gas, coal, or iron ore. The chart below highlights some of the U.S. metropolitan areas most exposed to natural resources and mining employment. Most of these are relatively small markets, off the radar of institutional investors. Only four have populations over two million: Pittsburgh, Denver, Dallas-Fort Worth, and Houston.
Most U.S. Commodity Markets Driven By Oil & Natural Gas
A prolonged downturn in commodity prices would do some damage to the Pittsburgh, Denver, and Dallas-Fort Worth economies. But these metros are fairly diversified, with Denver and Dallas having particularly strong growth drivers, enough so that the fallout will likely be limited to specific submarkets. Examples of energy firms making layoffs in Dallas are few and far between today, as oil firms have shifted operations to Houston in recent decades, leaving behind smaller offices (mostly in Fort Worth and Irving) for executives hoping to remain in the metroplex. Meanwhile, corporate relocations by companies like Toyota and Liberty Mutual continue to power the economy in Dallas, where employment growth was an impressive 3% in 2015. Companies such as Linn Energy and WPX Energy have recently vacated office space in Denver’s CBD, but job growth in the Denver metro overall also remains above 3% and office vacancies are continuing to decline.
Houston is the lone major U.S. market with massive exposure to energy-related firms. Its concentration of employment in the natural resources and mining sector is more than six times the U.S. average. The Greater Houston Partnership estimates that the energy sector accounts for 40% of the metro’s employment base. Houston’s total employment growth has slowed from an average annual pace of 3.8% from 2012–14 to less than 1% in 2015.
Of course, economic drivers (and the demand for space they generate) only account for half of the equation; supply matters as well. Houston commercial real estate landlords also have to contend with record levels of new construction in the apartment and office sectors. During 2015, 12.8 million SF of office space (akin to about 4.3% of the metro’s total office market) completed, amounting to the most office year-over-year supply growth in over 25 years. Another 6.8 million SF remains under construction today (52% of which hasn’t yet been leased) and on track to complete over the next two years. Within Houston’s apartment market 32,000 apartment units are under construction, about 21,000 of which are expected to complete in 2016 (amounting to 3.8% growth in the metro’s apartment stock), making for a high not seen in three decades.
Provided that the U.S. economy can avoid recession (our base case implies GDP growth averaging 2%–3% from 2016–18), the decline in Houston rents expected in both property types should be comparable to what the market experienced in 2009–10. However, with the current economic expansion now entering its seventh year, there are risks of another recession taking hold at some point over the next three years. Such a scenario would pull the rug out from under oil demand and oil prices, doing further damage to Houston’s economy. Under a mild recession (with U.S. GDP falling by 1.6% in 2017), CoStar’s models suggest Houston apartment and office rents will fall by 13% and 12% respectively from current levels before bottoming out and beginning a recovery.
If The U.S. Stays Out Of Recession During 2017–18
Houston Can Avoid Extreme Rent Losses
Consumers and Developers Stand To Gain
Despite Houston’s woes, most U.S. metros will benefit from commodity prices remaining low. The U.S. Energy Information Administration (IEA) estimated in late 2015 that lower gasoline prices would save the average U.S. consumer $700 in 2015. A recent study of credit card activity by JPMorgan Chase Institute shows that 80% of those savings are being put toward discretionary spending, mostly dining out, entertainment, groceries, clothes, electronics, and appliances. This recent cash injection into consumers’ pockets is making its way into the registers of malls, power centers, and grocery-anchored centers nationwide, benefiting retail landlords.
The oil dividend is not paid equally in all cities. Urbanistas in San Francisco and New York take public transportation and live in apartment buildings—they don’t feel love coming from cheap gasoline. Avid drivers get the savings at the pump, and they live in markets such as Baltimore, Atlanta, Inland Empire, and Nashville, where commute times are 20% higher than the national average. Based on the IEA estimate of $700 saved annually by the average U.S. consumers, two- or three-person households in these gas-guzzling metros are likely saving $1,500–$2,500 per year. Apartment landlords appear to be capturing some of these consumers’ newfound savings as well, with some of the nation’s strongest rent growth surfacing in these long-commute metros. To wit, apartment rent growth in Atlanta and Inland Empire accelerated during the second half of 2015, ending the year above 7.5% in both markets.
Gas-Guzzling Markets Benefit Most
From Lower Oil Prices
Falling commodity prices have also translated into a much needed slowdown in the growth of construction costs. Going forward, slowing global economic growth (particularly in Asia) means less demand for building-related materials over the medium term at least, as China fills up its ghost cities. Cheaper oil also means cheaper coal—and lower costs manufacturing materials key to the construction process, such as steel and cement. In fact, aside from the depths of the recession in 2009, construction price growth in 2015 was the slowest in 14 years. As the development cycle ramps up nationwide, falling costs of raw materials and transportation are partially offsetting rapid increases in the costs of construction labor and equipment, ultimately helping to preserve developers’ bottom line. This is a benefit to those getting underway on new buildings today but perhaps a net loss for owners of existing buildings, as they are now less insulated from new construction
Steel: Buy Yours On Sale In 2016
Construction Costs Vs. Commodity Prices