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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….

Economics of Climate Change

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To give credit right up front where credit is due, today’s post was stimulated in no small part by an excellent piece written for NPR last month by Angus Chen titled 1,000 Years Ago, Corn Made This Society Big.  Then, A Changing Climate Destroyed It.

In “all my spare time”, I’ve wondered a bit about the dichotomy of North American natives versus Europeans.  The latter developed a relatively advanced society by the time of Columbus, while the former seemed to be living in the bronze age.  I’ve really not had the time, effort, or inclination to study it much, and the few pieces I’ve read didn’t seem to be very robust, from a scholarship perspective.  One stream of research notes that pre-Columbian Europe, in the crossroads of trade among three continents, had more complex influences.  However, North American tribes traded among themselves, and before the Europeans brought gifts of small pox and syphilis, the population of this continent was certainly at a critical mass.

One of the less convincing arguments stemmed from lack of wheat.  In short, a population needs a robust agriculture in order to sustain modern civilization.  One farmer needs to be able to feed more than him or herself.  To me, this was also suspect — I’d been taught as a grade schooler that east coast natives actually demonstrated advanced cultivation techniques to European immigrants.  Chen’s article turns all this on its head by noting the Mississippian American Indian culture, a group of farming societies ranging from north of St. Louis down to present day Louisiana and Georgia.  The most prominent of these was the city of Cahokia, about 15 miles east of present-day St. Louis.  Around the 9th and 10th centuries AD, this society was fairly robust and successful, with large cities, complex agriculture, and trade.  In the absence of wheat, their principle row crop was corn, and apparently this contributed their diets in the same way wheat contributed to Europeans.

However, by the time Europeans came in the 15th century, these cities had already been abandoned.  Modern research now pins the failure of this civilized society on climate change.  The rains which sustained the corn crops for hundreds of years dried up, and by 1350 AD the region faced profound drought that lasted up to 500 years.

Climate change and crop failures led to destabilization of society and government.  Current archeology points to construction of palisades, burned villages, and skeletal injuries consistent with warfare beginning around 1250 AD.  Scientists are reluctant to blame the  entire collapse on climate change, but rather that climate change was probably one of a series of problems that brought down this remarkable American civilization.

The vast majority of scientists today concur that climate change is real.  Something on the order of 97% of recently published peer-reviewed empirical studies support this.  Admittedly, there is less concurrence regarding the impact of human factors, such as CO2 emissions, but the majority of scientists still seem to agree that at the very least, human intervention has probably accelerated existing trends.  That said, speaking as an economist, this all has implications for societal change which must be addressed in an organized, cogent manner.

Written by johnkilpatrick

March 9, 2017 at 1:37 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

The long lost shopping mall?

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Common wisdom holds that the shopping mall is on life support.  I venture into maybe one or two a year, and my most recent ventures weren’t very encouraging.  Two recent Wall Street Journal articles illustrate the complexity of repurposing.

First, in a January 24th article by Ester Fung, “Mall Owners Rush to Get Out of the Mall Business”, the Journal notes that even the big-names in the biz are making use of strategic default to get rid of underwater properties.  Citing data from Morningstar, the story detailed that from January to November 314 loans secured by retail property were liquidated, totaling about $3.5 billion.  According to the story, these liquidations resulted in losses of $1.68 billion. Washington Prime, CBL and Simon have all sent properties back to lenders in recent months.  Ironically, these big players have seen no dings to their credit ratings, and the equity market in fact views these put-backs as evidence of financial discipline.  On the downside, surrounding properties, such as out-parcels and other nearby retailers, such as restaurants, that depend on spillover from the mall, are suffering from the loss of shopper attraction.

One alternative to strategic default is a revamping of the real estate itself.  This often includes attracting a new or new type of anchor tenant or demolishing the mall entirely to make way for offices or apartments.  Unfortunately, as detailed in a February 14 WSJ piece by Suzanne Kapner, existing tenants often have covenants or restrictions standing in the way of such revamping.  In “Race to Revamp Shopping Malls Takes a Nasty Turn”, Ms. Kapner outlines how many department stores want to protect existing parking or existing exclusivity through “reciprocal easement agreements”.  For example, large swaths of unused parking space have value for repositioning.  However, as Gar Herring, chief executive of the MGHerring Group, a regional mall developer, put it, “But if you want to put a snow cone shack in a parking space furthest from the mall, you need the agreement of every department-store anchor.”  Currently, for example, Sears is suing a mall developer in Florida to prevent it from adding a Dicks Sporting Goods as an anchor. Lord & Taylor filed suite in 2013 to stop a Maryland mall’s demolition to make way for offices, residential properties and a hotel.  The retailer claimed violated an agreement signed in 1975 that prevents the landlord from making changes to the property without its consent.

The shopping mall is three different things.  From a consumer perspective, it’s a place of gathering and  consumption.  Indeed, the loss of the shopping mall, which replaced Main Street, has sociological implications as well.  Does Amazon.com now become a place of gathering as well as consumption?  That’s an interesting subject for another day.  Second, from a business perspective, the mall is a bundle of contracts, and sorting through those contracts will keep lawyers and real estate experts busy for some years to come.  Finally, a shopping mall may be, in some circumstances, a valuable piece of real estate.  Repositioning that real estate, either as retail with different tenants and focus, or as something other than retail, will be an interesting story in the coming years.

Strong vs weak dollar

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Ahem…. this may or may not be the truth, but in the words of my fellow Low-Country South Carolina expat, Stephen Colbert, it’s certainly “truthy”.  Reportedly, according to Huffington Post, The Donald called his national security advisor, Flynn, at 3am, to ask whether a strong dollar or a weak dollar was good for the economy.  Reportedly, Flynn told The Donald to ask an economist.  Since then, economists of all stripes have offered advice, because, well, this is important stuff for a President to know, along with “war is bad” and “full employment is good” and stuff like that.

So, here we go.  I’ll take a stab at it.  Whenever the world roils, investors of all stripes look for stable currencies in which to invest, and the dollar is the “mother of all stable currencies”.  Until Brexit, the same could be said of the Euro and the Pound.  Now, not so much.  Anyway, paradoxically, the election of The Donald roiled the world’s zeitgeist, causing investors to seek the dollar, and thus strengthening our currency.  Now, what’s the impact?  Well, a strong dollar makes it tough to export stuff, but it makes it easy to import stuff.  That wrecks the trade imbalance, and costs jobs in exportive industries.  Conversely, a weak dollar suggests lack of faith in the American economy, but helps with American jobs, albeit makes American consumption more expensive.

ALSO, a strong dollar makes it easy to borrow.  As America runs deficits (both fiscal and trade), we have to borrow and much of this borrowing occurs in foreign markets.  Conversely, a weak dollar drives up the cost of borrowing.

In short, if The Donald wants to bring American jobs home, he’ll opt for a weak dollar, but that will inevitably drive up the cost of consumption as well as the cost of borrowing.  Ironically, the way to achieve a weak (or lets say, “less strong”) dollar is to achieve some sort of stability in the world, and that doesn’t seem to be in the offing.

Written by johnkilpatrick

February 10, 2017 at 11:12 am