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Finance and economics generally focused on real estate

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PWC’s Quarterly CRE Review

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PwC’s quarterly commercial real estate review just hit my desk.  I have a particular affinity for this survey-based review — it was founded about 30 years ago by Peter Korpacz, MAI, an alumni of the Real Estate Counseling Group of America and an acquaintance of mine.  PwC took it over a few years ago, and have done wonderfully with it.

The entire report, at 106 pages, is far too robust for a simple summary.  However, a key metric is the review of capitalization rate changes by property type (e.g. — warehouse, apartments) and offices by region (e.g. — Manhattan, DC, San Francisco).  A cap rate, of course, is the ratio of a property’s net operating income to its sales price.  Declining cap rates on a broad front can indicate the onset of a recession, but differential cap rate changes (rising in one market, declining in another) may suggest differing sector views by real estate investors.  By property type, this is what we appear to have today.

For example, warehouse cap rates currently average 5.27% nationally, but this represents a decline by 10 basis points just in the 2nd quarter.  Generally, this points to a favorable view of warehouses by investors — they’re willing to pay a bit more for each dollar of prospective income.  Conversely, offices in the central business district saw increases of 13 basis points, suggesting a softening of CBD office prospects.

Across various regions of the country, offices in general (both CBD and others) showed either no change or declines in cap rates, with the biggest cap rate declines occurring in Phoenix and Philadelphia.  Only Denver and Atlanta showed increases in office cap rates.

Overall, investors expect cap rates to hold steady or increase over the coming six months.  Indeed, only among CBD offices and power centers was there any sentiment for cap rate decreases.  100% of investors expect net lease properties to show cap rate increases in the coming 6 months, which portends value softening in that property sector.

We’ve used the nasty “R” word (ahem… “recession”) on occasion here at Greenfield, and PwC seems to agree with us.  They expect that the office sector will peak by the end of this year, and a large number of metro areas are expected to move into contraction during 2018 and 2019.  They expect 61% of cities in their survey to show retail property recession by the end of this year, but with some limited exceptions (Austin and Charleston).

Industrial properties, on the other hand, should fare well, with only Houston headed for recession during 2017.  They also expect 15 other markets, including Los Angeles and Atlanta, to face industrial recession by the end of this year.  Further, a large supply of industrial property is expected to come to market during the near term, suggesting an industrial over-supply for the next four years.

One bright spot is multi-family, which continues to “benefit from the unaffordability of single family homes”.  Two markets need to play catch-up (Charlotte and Denver) but other markets should fare well, with 40% of markets headed for expansion.

Demand & Supply

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I just read a nice piece by Deloitte’s Robert T. O’Brien, their Global and U.S. Real Estate and Construction Leader, titled Commercial Real Estate Outlook 2017.  It’s far too interesting and too packed with info to summarize here, so have a glance for yourself.  However, I’ll point out a couple of things I believe stand out in his analysis.

First, homebuilders are under pressure due to what he calls the “demand-supply dichotomy.”  I’ve been concerned about this for a while.  During the recession — which admittedly was several years ago — big chunks of the housing infrastructure collapsed, including acquisition-development-construction (ADC) finance, skilled labor, permanent finance securitization, and local government permitting capabilities.  As such, we now actually have a bit of a housing shortage in hot areas (think “Seattle”).  Mr. O’Brien worries that homebuilders’ financial projections may be dampened.  I’m a bit more concerned with the upward price pressure on houses, which could put us back in a bubble situation.  Deloitte believes interest rates hikes by the FED may temper some of the demand side.

He believes private equity fundraising will decline this year, “…as managers focus on deploying existing funds.”  He believes managers will face increasing competition looking for good investments.  I would add that new managers or managers with a new story to tell will find 2017 a bit easier for fundraising than 2016.

O’Brien also sees slowing in the commercial construction arena, and so slugging financial performance for engineering and construction firms.  REITs should do well, though, albeit with continued portfolio repositioning.

Deloitte sees GDP growing about 2.5% this year and unemployment below 5%, which is in line with metrics we see here at Greenfield.  They also see several things disrupting the economy both this year and in out years.  The “collaborative economy” will certainly have implications for the way new start-ups use and lease commercial real estate.  The internet is rapidly disintermediating brokerage and leasing services, with implications for traditional brokers.  A shortage of talent in the STEM area and other shifts in the way millennials view the workplace have implications for location strategies.  Speed and mode of retail delivery — the “last mile” disruptions of Amazon — are still being sorted out.

Trump’s Tax “Reform”

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Mark Twain is usually — and incorrectly — quoted with the phrase “No man and his money are safe while Congress is in session.  (The actually quote goes to 19th century NY politico Gideon Tucker, but I digress.)  There’s little to be said, in general, about TheDonald’s proposals yesterday, simply because there’s little substance to analyze.  However, I’m old enough to remember the last tax overhaul, in the early stages of the Reagan administration, and perhaps I can offer a few observations.  I’ll limit my mental meanderings to real estate for now.

First, the Reagan tax re-hab (the 1986 Tax Act) was a disaster for real estate investing, particularly at the individual, atomistic investor level.  One of the “loopholes” to be cured was the elimination of deductibility of passive losses on real estate investments.  The real estate community reluctantly supported the tax act, in trade for increases in the deductibility of home mortgage interest and a guarantee that passive losses on then-existing real estate deals would be grandfathered.  Indeed, in the run-up to passage, there was a flurry of investing (by Main Street USA folks — the kind of folks who still, amazingly, support Trump) in just such “grandfathered” investments.  At the last minute, the grandfathering was removed, costing Main Street USA investors tons of alternative minimum tax payments on now-sour investments.  Some pundits suggest that this grandfathering-revocation, alone, led to the downfall of the Savings and Loan industry, but that excuse is a bit to simplistic.  It did, however, shut down the time share industry for a while.

Today, according to news reports, single family residences are enjoying record demand (which may or may not be good news).  The hottest market is among first-time buyers, and the demand is greatest among starter homes.  The Trump proposals would double the standard deduction for a married couple filing jointly.  While, on the surface this seems like a good idea, it will drastically shrink the number of tax payers who itemize mortgage interest and property taxes.  In short, for the biggest tranche of homebuyers, the biggest differentiation between ownership and renting would be effectively removed.  As a guy who invests in rental property, that’s nice, but the home building industry won’t react well.

Otherwise, I don’t see lowering the marginal tax rate on corporations as having much of an effect on real estate investing.  For one, most of those projects are either done thru tax-advantaged REITs or thru other pass-thru entities, like partnerships and LLCs.  Even if it did, the demand / supply of investment grade real estate depends on other factors, and slight changes in the tax rate may have an impact on the debt/equity mix, but not on the aggregate output of new commercial construction.  The ONE area most affected will be low income housing, which is funding in no small part by tax credits.  The value of those credits will be slashed, requiring a complete re-thinking in the finance side of low income housing.  The last time such a tax cut went into effect, it was a real mess for low income housing.

If I was the government, and I wanted to create good paying construction jobs, I’d embark on a long-term infrastructure redevelopment plan.  That would probably require actually raising tax rates a bit, but would have marvelous returns on investment for middle America.  But that’s just me….

Thus Spoke Janet

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Yeah, who else tried to slug their way thru Thus Spoke Zarathustra back in their halcyon days?  Now that the storms of autumn breath over my career, I find the pronouncements of Janet Yellen every bit as obtuse as Nietzsche.

I’ll try to make it simple. CNBC had an excellent piece this afternoon.  If you borrow money, you’re going to pay more.  If you invest in debt instruments, you’re not going to get paid more.  Simple?

So what does this mean for real estate?  I’ll posit a few axioms.

  1.  If you have a home equity loan and a first mortgage, and you have positive equity, you need to rush to your friendly banker and refinance all that into a fixed rate loan before happy hour this evening.
  2. If you’ve been planning to buy a house with a loan (as most people do) then yesterday was the day.  Today maybe.  Tomorrow… eh…..
  3. If you can invest in rental property, look for “equity positive” locations.  These are cities with solid economics, but the cost of construction is disconnected to the local rental rates.  Existing rental houses sell for a discount to new construction.  Buy all you can grab.
  4. There are three different explanations for the shape of the yield curve — rational expectations, debt stratification, and liquidity preference.  Today, liquidity preference trumps the other three.

Written by johnkilpatrick

March 15, 2017 at 1:08 pm

Dreams of GDP growth

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Paul Krugman and I don’t necessarily agree on everything, either in politics or economics, but I respect his research (and yes, envy his Nobel Prize).  That said, he has an insightful piece on his blog about The Donald’s economic projections, which both Paul and I find probably untenable.  I encourage you to read it here.

In short, The Donald projects 3% to 3.5% GDP growth throughout his tenure in the White House.  Under Reagan, it was at the lower end of this scale, and under Clinton it hit 3.7%.  Remember that both of those presidents inherited crappy economies, and so  a pendulum bounce in GDP would have been expected.  The Donald is inheriting a healthy overall economy (admittedly, with pockets of problems).  As such, growth in the 2+% range is more likely. So why are they projecting such glossy numbers?  In short, they back into what they need to say in order to fit their rosy projections.

I would note that the Chair of the Council of Economic Advisors sits vacant as of this writing, with no nominee in the offing.  This Council serves the president, among other ways, by putting a reasonableness test on just such projections.  Truly excellent economists have served on this Council thru the years, from all sides of the economic spectrum (and yes, there are more than two).  In the absence of trained, academic economists in this role, these projections are left up to whim.

Unlike Paul K, I have some hope that Paul Ryan may be a voice of sanity here.  He seems to understand that balance sheets need to balance.  Let’s see how that works out.

Written by johnkilpatrick

February 21, 2017 at 12:00 pm

Well THAT’S interesting…

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Most of the conversations I’ve had about real estate and The Donald focus on housing, and particularly the storm clouds forming over low-income housing.  However, while The Donald is one of the luckiest income presidents in history in terms of inheriting a great economy, his Achilles heel may be the commercial real estate sector.

cbre-graphic

CBRE was kind enough to tweet the accompanying chart this morning, which is pretty self explanatory.  (Of course, I’ll go ahead and explain it anyway.)  After the real estate storm that Obama inherited, commercial transactions have regained lost ground in the past several years.  Note that we peaked in 2015 with total commercial transactions of nearly $1 Trillion for the year.  However, the market backed-off considerably, with the first three quarters of 2016 coming in a bit lower than the previous year, and then the 4th quarter coming in nearly $50 billion lower than the same period in 2015.

Did we just see a trend line break?  One wonders.  Commercial real estate feeds a lot of other sectors of the economy.  For example, new construction employs lots of the sorts of jobs The Donald is promising.  We need to keep our finger on this particular pulse.

 

Written by johnkilpatrick

February 14, 2017 at 9:41 am

…and the next thing…

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I’ve been critical of the current occupants of the White House, and particularly their apparent naivity about the economy.  One might falsely surmise from my criticism that I’m a raging lefty.  I would rejoinder that competence knows no political stripes.  That said, I would note this morning that an economist from two leading conservative think tanks also expresses skepticism over The Donald’s trade policies.

The conservative bona fides of the Club for Growth and the Heritage Foundation are beyond question.  The former bills itself as, “…the leading free-enterprise advocacy group in the nation,” while the latter is lead by former GOP Congressman and Tea Party stalwart Jim DeMint, from my former home state of South Carolina.   Stephen Moore, a Heritage economist and co-founder of the Club for Growth, appeared on CNN’s Party People podcast, and said, “On trade, I think he’s playing with fire here.”  He went on to say, “And I think the idea of a tariff against Mexico is a terrible idea.  I think it would hurt Mexico a lot, and I think it would hurt American consumers as well.  We don’t need a trade war with Mexico.”  He did, however, give a tentative pass to The Donald’s attitude toward China, noting  “I kind of approve of some of the things he’s doing on China.”

Full disclosure here — I don’t necessarily agree with Moore on every point he makes.  Moore invokes the legacy of Harry Truman, and says that Truman got off to a rocky start but learned the Presidency quickly.  I would beg to differ on the validity of Moore’s analogy.  Truman had held significant local office in Missouri, was an Army Reserve Colonel, and was late in his second term as a Senator when the nod for the VP job came along.  The Truman Committee in the Senate, during the war years, provided extraordinary oversight to the conduct of the war and investigated every aspect of government management during the several years he was chair. As such, Truman was probably the most prepared person to assume the presidency available at the time.  (Many would have preferred South Carolina’s Jimmy Byrnes, but Byrne’s record on segregation would have made him a tough sell.)

Any “rough start” to the Truman presidency had to be taken in the context of inheriting a 2-front war, an atomic bomb, the beginnings of the cold war, massive demobilization, turning the American economy from war production to consumption, open rebellion from two wings of his own party (the Dixiecrats under Thurmond and the Progressives under Wallace) and devastation around the world.  The Donald, on the other hand, has inherited a stable, growing economy, no inflation, low unemployment, and a loyal majority in both houses of congress.

Ahem….  If The Donald screws this one up, it’s all on him.

Written by johnkilpatrick

February 14, 2017 at 7:19 am