12th Fed District issues 3q report
Greenfield is a global firm (albeit mostly in the U.S.), and even though we’re headquartered in Seattle, we try to focus our attention broadly rather than locally. That said, the 12th Federal Reserve District just released First Glance 12L (3Q15) which takes an early cut at the data from the nine western states. It’s very telling data — the “left coast” as I like to call it tends to suffer worse when times are bad and boom better when times are good. Thus, there are some interesting facts and figures to be gleaned from this well-written report.
Naturally, the report is focused on the health of the member banks in the region, but the macro-econ factors driving that health are of much broader importance. Nationally, unemployment stood at 5.1% at the end of the 3rd quarter. Western states tended to be a bit worse off, with 3 states (Idaho, Utah, and Hawaii) recording lower unemployment rates and the rest showing higher numbers, ranging from Washington’s 5.2% up to Nevada’s 6.7%. California, always the thousand pound gorilla in the room, came in at 5.9%.
However, job growth in the western states is well above the national average — 3% annually for the region versus 2% for the U.S. as a whole. However, the west is digging out of a deeper hole — while job growth nationally hit a trough of -4.9% at the peak of the recession, it bottomed out at -6.7% in the west. Generally, job growth in the west over the past 20 years had held steady at about one percentage point above the national trend during “boom” years.
Housing starts in the west are well below the pre-recession peaks. As of September, 2015, the seasonally adjusted annual rate (SAAR) of housing starts stood at 161,000, with 107,000 of that in 2+ family units. This compares with a peak of 449,000 SAAR in the 2005-2006 period, at a time when 2+ unit housing only made up 85,000 of the starts. Arguably, the market in the west is still absorbing the huge shadow inventory built up during the boom days.
Commercial vacancy rates in the west have been drifting down for the past few years in the office, industrial, and retail sectors. Apartments, however, seem to have plateaued around 4.3% at the end of the 3rd quarter, and are forecast to rise a bit to 4.7% a year from now. I might posit that historically, profit-maximizing apartment vacancy rates have been found to be somewhat higher than these numbers, so apartment managers and owners may have some lee-way to continue building.
The 5 western maritime states are very export-driven, and the strength of the U.S. dollar (up about 18% against major currencies since 2014) has been rough news for those markets. While western state exports rebounded nicely from the trough of the recession (up about 17% from 2009 to 2010), export growth has flat-lined since 2012. Regionally, exports declined about 2.5% since last year, with positive growth reported in only four states (Arizona, Hawaii, Nevada, and Utah). Bellweather California saw exports decline 3.6%. Note that in Washington, my semi-home state, exports make up 21.2% of the gross state product. (We export things like big trucks, big airplanes, software, and agricultural products.) Hence, this is critically important stuff.
The remainder of the report focuses on the health of the regions banks. I’ll leave that up to the reader if you care to download your own copy. Short answer, though, is that the region has seen loan growth accelerate even while the nation as a whole has flattened. Further, the regions banks tend to be a bit more efficient in terms of expenses and staff, both compared to the nation as a whole and compared to the “boom days” pre-recession. Both small and large commercial borrowers generally reported tightening credit standards at the end of the 3rd quarter, which is a change from previous reports. However, consumer borrowers (residential mortgage, credit cards, and auto loans) generally reported easier standards. The bulk of loan growth for small banks (under $10B) came from non-farm non-residential, while for large banks the biggest growth sector was in consumer lending. The percentage non-performing assets (the “Texas Ratio”) in the region, which peaked at 38.9% in 2009, is now down to 5.4%, although still higher than in the 2004-2007 period. By comparison, the national peak hit in 2010 at 19%, and is now standing at 7%, also higher than pre-recession levels.
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PWC’s Emerging Trends in Real Estate for 2016
Ever since PWC acquired Peter Korpacz’s excellent quarterly commercial real estate survey, they have really leveraged that theme into a great regular read. Along with my subscription, their annual Emerging Trends just landed in my in-box, and it’s a really excellent read. (To access a copy, just click on the link above.) The report is a must-read for anyone in real estate, particularly in the investment or finance side. I’ll skip to two of the summaries — one they call “expected best bets” as well as the capital market summary, to give you a flavor of their report.
Expected Best Bets — PWC recommends, “Go to the secondary markets”. They note that gateway markets have pricing problems, while the “18-hour cities” are “…emerging as great relative value propositions.” They particularly cite Austin, Portland, Nashville, and Charlotte.
PWC also discusses “middle-income multifamily housing,” and notes the solid business opportunities providing creative answers for what they call the “excluded middle” households. PWC also encourages planners to re-think parking needs, in light of the changing demands of “live/work/play downtowns.”
On the securities side, PWC notes that many REITs are priced well below net asset value, providing an interesting arbitrage opportunity in 2016.
Capital Markets — PWC opens by noting, “In many ways, it appears that worldwide capital accumulation has rebounded fully from the global financial crisis. The recovery of capital around the globe has been extremely uneven. And the sorting-out process has favored the United States and the real estate industry, affecting prices, yields, and risk management for all participants in the market.”
Whew…. I’m usually loathe to quote so much from another’s work, but I simply could not have said that any better. PWC quotes one of their survey respondents, a Wall Street investment advisor, who says, “There is going to be a long wayve of continued capital allocation toward our business….”
Survey respondents largely were split on short-term inflation, with about 40% predicting modest increases and 60% looking for stability at current rates. However, when they look down the road 5 years, 80% of respondents look for modest increases in inflation. Coupled with that, over 60% of respondents think both short term interest rates and mortgage rates in specific will rise next year, and nearly 80% think such rises will occur over the next 5 years. Intriguingly, a small but significant minority — about 20%, believe rates will rise substantially over the next 5 years. Almost no one believes rates will fall, either in the short-term or the long-term.
To sum up the capital markets view, PWC says the general spirit of the industry is positive, albeit with an eye toward risk. Many are calling for a “long top” to this recovery, but many are also taking defensive postures by shortening investment horizons, paying more attention to the income component of total return rather than the capital appreciation component, and moving down the leverage scale.
As always, I would stress that I am citing a 3rd party source here, and nothing in this review should be construed as investment advise. That said, PWC’s Emerging Trends is an excellent read, and I highly recommend it.
Have I written about Thomas Bayes yet?
I had the very real pleasure of speaking at the Appraisal Institute’s annual meeting this past July in Dallas, and indeed I’ve been asked to speak there 3 of the past 4 years — a great group and a very well-done conference. My topic this year was on “Practical Statistics for Practicing Appraisers”, and given the need for continuing education credit, my talk was scheduled for two hours. Unfortunately, two hours is either w-a-a-a-a-a-y too much time, or not nearly enough, depending on what you want to do with it.
About the only thing I could do was touch base on a dozen or so different useful topics, talk about the highs and lows of each, and point the audience in the right direction to get more information. One topic I wish I’d spent more time on was Bayesian Statistics, a little-known and under-appreciated branch of statistical inference which, in fact, has significant every-day impacts on how we analyze (or at least SHOULD analyze) data. For example, let’s say that I want to determine the house price trend in a particular town, and have no idea what that trend looks like. I’ll want to construct some sort of “best linear unbiased estimator” (such as a time-series regression) to help me sort all that out.
However, what if afterwards, in that same town, I’ve already measured the overall property trends, but now I’m told that half of the town is known to be contaminated. Do I still want to use the same estimators, or should my methodology be informed by what is now “prior knowledge” about both the existence of the contamination and the overall price trend in the town?
This use of prior knowledge falls into the category of “Bayesian Statistics”, or “Bayesian Inference”, developed by early-18th century theologian and mathematician Sir Thomas Bayes. In short, Bayes noted that our inferences could be improved by the existence of prior knowledge. What’s more, when we’re conducting a Bayesian investigation, our data gathering is anything but random, since we’re seeking data based on our prior knowledge of the situation. In the contamination matter, I may want to look at price trends for homes in the contaminated neighborhood versus price trends for homes in the non-contaminated neighborhood. Naturally, I’ll only focus my attention on properties that have actually transacted, which leads to a common problem in this sort of analysis where properties that have not transacted (which may contain different information) are not part of the data set.
Unfortunately, a lot of practical appraisal — particularly in the residential setting — is heuristic, and over-reliance on “prior knowledge” can lead to a level of sloppiness. That said, a rigorous application of Bayes’ principles, and careful analytical techniques, can allow appraisers to actually develop statistical measures for their valuation work.
Why I’m not that worried about Greece
Pundits (and yes, to a degree, I’m one) have taken every position possible over the Greek debt crisis. I’ll toss in my 2 cents, and hopefully I’ll add a bit to the debate.
First, I’ve never been to Greece, but one of my colleagues from Greenfield just came back and brought me a bottle of Ouzo (than you, U.S. Customs Service). Also, I had a nice lunch at a Greek restaurant a few days ago. As economists go, that must count for something.
Here is Greece’s problem in a nutshell — as a stand-alone economy they suck. Their people are old, the bright young folks go somewhere more productive as soon as they are old enough to read a map, other than feta cheese they don’t export much of anything, and there simply isn’t enough austerity to balance the budget. Hence, they’ve hocked everything worth hocking right down to the scrap value of the Parthenon to pay for social services and little things like food and medicine. Additional austerity (demanded from what passes for the right in Europe) will salve the wounds for a while, and additional high living (essentially a non-starter, but none-the-less demanded from the left) simply isn’t in the cards. The credit cards are maxed out and the repo man is backing up into the driveway.
By the way, Greece has roughly the same population as Ohio. Greece’s most important industry is tourism, which accounts for 20% of Greece’s GDP and employs one out of five people who actually have jobs. In 2014, tourism was an estimated $12 Billion slice of the economy. However, to put that in perspective, Ohio’s tourism is estimated at $40 Billion per year. You see? The most important thing in Greece is about a 4th the size of one of the least important things in Ohio.
We don’t really think about it here in America, but if the 50 states tried to exist as separate nations, some would die on the vine and others would prosper very nicely. (Although, to be fare, the worst unemployment in America, West Virginia at 7.2%, sits right in the middle between the two healthiest economies in Europe, France and Germany.) We don’t think about that because of the crucible of the Civil War, which you may have read about in your history books. Not withstanding some of the news from South Carolina lately, the Civil War was about several things. Slavery was at the top of the list, for sure, but southern “heritage” types (and yes, I was born and reared in the South) would posit that it was all about states rights versus the central authority of Washington. Let’s go with that for a minute, just for the sake of argument. Let’s assume that was the central theme of the war. How did that turn out? Huh? Turns out, the north won. America was one nation, undivided, period, exclamation point. Along the way, we’ve made numerous economic decisions which would not be rational if we were 50 separate nations, but make perfectly good sense in the long shadow of the Civil War. Hence, some states don’t pull their own weight, economically, but we drag them along, sometimes kicking and screaming, as the rest of us march forward into the economic future.
Europe also had a recent crucible. Indeed, one might think of the 20th Century as one long, amazingly painful period. It essentially started with the “War to End All Wars”, and then a massively painful depression, followed by, “War, the Sequel”, and then followed by, “Let’s all count down to nuclear Armageddon” as the superpowers stared each other down across Germany’s Fulda Gap. By the time the Eurozone was created, thinking people in Europe were willing to do whatever it took to unite the continent and make sure that the casus belli of the past no longer existed.
So, that takes us to Greece. One might not think of Greece as being a focal point, but that would be short-sighted in the extreme. Of course, anyone who has studied anything about western civilization thinks of Greece as the fountain of democracy. That said, it is right at the crossroad of Europe and Asia, and has been central to pretty much every argument in that part of the world in the past two or three thousand years. More to the point, the reasonably solid economies of Europe look at the laggards with pity but also with fear, because a splintering of the Eurozone removes the warm blanket of unity that staves off the kinds of wars that Europe is all too familiar with.
So, like it or not, Europe will hold their noses and cut a check to help pay for Grandma Greece’s hospice bills. They will probably make her move to from a private room to a semi-private one, and she’ll have to settle for generic medicines from now on, and eat in the cafeteria like all the other folks, but she won’t be allowed to starve, and she’ll get a card every Christmas, as long as anyone remembers the 20th century.
American Real Estate Society Annual Meetings
For many years, Greenfield had been privileged to participate in the annual American Real Estate Society meetings, held in late April and typically in a warm, waterfront location. This year’s meeting was at the Sanibel Harbor Marriott Resort, on the bay near Sanibel Island, Florida.
Of the major academic real estate organizations, ARES has the unique mission of bridging academia and practitioners, and as such draws a large contingent of Ph.D.-types (and others) from organizations like Greenfield. Somewhat surprisingly for an organization which bridges academia and practice, ARES publishes the largest number of scholarly real estate publications, and has the top-ranked academic journal in the real estate, insurance, and banking fields (the Journal of Real Estate Research, edited by my good friend, Dr. Ko Wang of Johns Hopkins University).
Various researchers at Greenfield authored several papers accepted for presentation at the ARES meetings, including:
- The Impact of Fracking Sites on Brownfield Funding (Dr. Clifford Lipscomb)
- Can We Forecast the Next Bubble? (Kilpatrick and Lipscomb)
- A Primer on Cleaning Residential Real Estate Data (Lipscomb and Dr. Andy Krause of U. Melbourne)
- Using a Random Forest Process in an Automated Valuation Model (Lipscomb, Kilpatrick, Jessica Kenyon of Greenfield and Dan Tetrick of Greenfield)
- The Impact of the NAREIT Light Awards on REIT Performance (Kilpatrick and Lipscomb)
Additionally, I had the pleasure of serving as co-chair (with the esteemed Dr. Stephen Roulac of U. Ulster and Roulac Global Research) for one of the sessions where doctoral students presented their research. Dr. Roulac and I heard presentations from students from Yale, from Royal Agricultural University and U. Aberdeen in the U.K, and U. Regensburg in Germany.
I’ll conclude with a big “shout-out” to Dr. Arthur Schwartz, who despite having been retired for quite a few years, serves as the volunteer Meeting Planner for ARES (at no small personal expense) and manages to secure world-class warm-water resorts for these spectacular meetings. Sadly, he is taking a sabbatical for 2016, and the meeting will be in chilly Denver. However, I’m pleased that the meeting will return to San Diego in April, 2017, and to Estero, Fl (near Ft. Myers) in 2018.
21st Century Valuation Problems
Did everyone have a great holiday? It’s been nearly 3 months since I’ve darkened the door of this blog. Between the holiday season, a couple of very interesting conferences (more on those later) and heading for warmer climates for the winter (MUCH more on that later!), I’ve been terrifically distracted since November.
The trigger to get me off my duff and writing again was a complex Federal Court trial in Missouri last week. Yes, I was the testifying expert, and yes, my clients prevailed, but that’s not exactly the point. The point is WHY I was testifying and WHY my clients ultimately prevailed, at least in my humble observation. The case was a class action concerning the value of a fiber optic telecommunications transmission easement. For a variety of reasons, this case only concerned 789 miles of the easement crossing about 3,250 properties, but the very important lessons learned from this case apply broadly to a variety of modern-day corridor easements.
Earlier in the litigation, the class action had been certified and the Court had held that the responsible party did not have the right to enjoy the easement without compensating the property owners. The court had held that the defendants had unjustly enriched themselves, and so this trial was narrowly focused on compensation. That compensation, it was held, would be the fair market value of the easement, and that’s where Greenfield came in.
The defendants proffered a valuation theory called “across the fence”, or “ATF” for short. ATF models were developed many years ago for easements like railroads and power lines when data on such easements were difficult to come by, and when the change in highest-and-best-use of the property resulting from the easement was minimal, at best. The ATF theory basically says that the value of the easement is equal to the value of the land taken (usually farmland or forests) plus an “enhancement factor” to equate the more valuable use of the railroad or power line easement. This enhancement factor would range from 1X for an easement which was no more valuable than the surrounding land to 10X or more for a very valuable easement. Note that the enhancement factor can be a matter of judgment on the part of the appraiser. It is supposed to be determined by looking at sales or leases similar easements and similar surrounding properties, but with a dearth of data, the enhancement factor was often just a matter of conjecture.
In addition, ATF valuation required individualized “before-and-after” appraisals of every affected property. In testimony in Missouri last week, the defendants’ appraiser acknowledged that each “before-and-after” appraisal would cost about $10,000, more or less. Given that there are 3,250 properties affected by this one easement, that translates into $32.5 million in appraisal fees. Ahem…..
In addition, the defendants’ appraiser applied a fractional enhancement factor, which he basically simply made up with no data or analysis to support it. He said that the land devoted to a fiber optic cable telecommunications easement was worth 25% of the value of surrounding pasture and grazing land. Again, ahem….
Greenfield was called in because modern valuation problems call for modern solutions. In 2002, the U.S. Fish and Wildlife Service (“FWS”) was faced with the challenge of determining the fair market value of fiber optic cable easements in National Marine Sanctuaries. Specifically, there were two such easements in the Olympic Marine Sanctuary in Washington State (one each headed to Japan and Alaska) and one in New England. Faced with the likelihood that Federal land would be used for such easements in the future, and the mandate that private users of public property pay fair market value for such uses, the U.S. Government undertook an extensive review of payments for similar easements, and found that prices ranged from $40,000 per mile to $100,000 per mile. (In the Missouri case, the defendants’ appraiser, applying pastureland values, a fractional enhancement factor, and a number of other adjustments, arrived at a value of $3.44 per mile. Ahem, yet again…..)
Shortly after the FWS report, Greenfield undertook our own analysis of telecommunications corridor easement transactions across the U.S. We gathered over 1,000 transactions dating back to the early 1970’s, with a particular focus on easements where both the grantor and grantee were operating on a level playing field (i.e. — telecom companies versus railroads). Our findings were solidly supported. Telecommunications easements are typically valued in America using corridor theory models. The values of the easements are unrelated to the values of the surrounding land (thus relegating ATF models to the history books). Corridor easements should (and indeed must) be valued with simple per-foot or per-mile data in a straightforward, easily understood, 21st century model.
The jury in Missouri deliberated about as long as it took to pick a fore-person to affirm the efficacy of corridor valuation models. The evidence and testimony could not have been more starkly different from the two sides.
The downside? I would love to have had a piece of that $32.5 million project they proposed.
REITWorld 2014
REITWorld is the principal annual meeting of the National Association of Real Estate Investment Trusts (NAREIT), held this past week in Atlanta. I had the privilege of representing Greenfield, meeting with many of the top leaders in the securitized real estate field. The tone was generally upbeat, not surprising given the great run that REITs have enjoyed the past few years.
The gathering was a mix of very specific information on individual REITs, provided in small group briefings by the leaders of those REITs, along with several large group meetings with briefings on the industry as a whole. As expected, many of the service providers to the REIT industry were there, such as the research firm SNL Financial, with whom I had several great meetings.
The biggest concern in the meeting was matching past performance. REIT investors have enjoyed unprecedented gains since the trough of the recession, and even though most sectors of the market look stable and solid going forward, no one believes that returns for the next few years will equal those of the past few years.
Leading economists presented two of the five featured programs — Jeffrey Rosensweig, Director of the Global Perspectives Program at Emory U., and Robert Zoellick, currently a Senior Fellow at Harvard’s Kennedy School and former President of the World Bank. In addition, the Board of Governors dinner speaker was former Secretary of State Madeleine Albright. The focus and attention of REIT leaders is clearly on the global scene.
In other news, the death notices for traditional retail may be premature. As noted by Sandeep Mathrani, CEO of General Growth Properties, malls today can really be divided between “A” and “B” properties. The “A” properties are in high demand by in-line tenants, who have much stronger balance sheets than in the past. Right now, occupancies in the high-90% range with strong rent growth is the norm for “A” retail properties. As such, this sector is looking for continued strong growth in the near term.
Europe is projected to be an interesting market in the intermediate term for REITs looking for global expansion and choice properties. About 80% of the commercial real estate debt in Europe is scheduled to mature in the next 5 years, and many if not most of the debt holders are in no position to renew or “roll” that debt. As such, cash-rich investors may have some cherry picking opportunities soon.
Finally, the closing session speaker was Mark Halperin, Managing Editor of Bloomberg Politics. He shared intimate insights on the Washington political scene for the next few years, with a particular emphasis on the presidential campaign (which, if you didn’t notice, started last Wednesday morning).
Scotland Independence and U.S. Real Estate
If you haven’t been keeping up, about 4 million voters in Scotland will go to the polls tomorrow (Thursday, Sept 18) to decide one simple question, “Should Scotland be an independent country?” If a majority vote no (the “unionist” position), then the question of Scotland’s independence should be put to rest for a long time to come. If a simple majority votes “yes”, then Scotland and the United Kingdom will sever most of the ties that bind. Scotland will apparently remain part of the British Commonwealth, but with the same relationship to London and the Crown that Australia, New Zealand, and Pakistan have. (Yes, folks, Elizabeth is the Queen of Pakistan. Betcha didn’t know that.) As of this writing (Wednesday afternoon here in the states), it is reported by the Washington Post that the independence movement is slightly ahead.
So what are the implications, other than for scotch and haggis? As with any such major event, the unknowns outnumber the knowns, and the negatives may be overblown. However, from the perspective of global finance and European stability, no one can discern a plus and the minuses seem to be having a field day.
One thing is obvious — Scotland is the heartland of liberalism in the U.K. Independence means the remaining components of the U.K. (England, Northern Ireland, and Wales) will be governed by the conservatives for the foreseeable future. More to the point, Scotland’s indigenous political parties range from left of center to further left of center. Proponents of independence hope for a Scandinavian-style socialist state free of meddling from the Tories in the south. Of course, exactly how Scotland plans to pay for this isn’t quite clear just yet.
Oh, did we mention oil? Britain’s oil comes mainly from the North Sea. However, those reserves are being pumped by firms with names like BRITISH Petroleum, not SCOTTISH Petroleum. However, actual ownership of the oil revenues is a matter which has yet to be discussed, much less decided. Indeed, the Institute for Fiscal Studies indicates that Scotland will actually have to cut social spending by about $9.9 Billion per year.
Then there’s the issue of currency. Scotland benefits by using the pound, which is a globally accepted reserve currency. London is adamant that the pound will not be shared with Scotland, any more than it is shared with any other commonwealth state. (Note that Australia, Canada, Lesotho, and the like may have the Queen on their currency, but have to print their own money. As a result, many Scotland based businesses have threatened to de-camp to the south. Will Royal Bank of Scotland become Royal Bank of…… East Northumberland? (In fairness, Scotland could unofficially use the pound the same way Equator uses the U.S. dollar.)
How about nuclear weapons? Currently, Scotland is where the U.K. keeps theirs. Scotland has declared that they will be a nuclear-free zone. Further, Scotland’s chances of joining NATO or the European Union appear slim.
All of this has some very real implications for one of the world’s anchor currencies and 6th largest economy ($2.8 T estimated 2014 GDP, according to CNN.com). To suggest that this wouldn’t have implications for global real estate investment would be short sighted in the extreme.
Retail Real Estate
The current common wisdom (such that it is) about retail real estate is that the Amazons of the world will crush retail real estate. Add to that the pressures of retrenchment among traditional shopping mall anchors such as Sears and JC Penney (neither of whom have figured out how to make “on-line” work), as well as the changing shopping habits of the millennial generation and the “halt” of suburban sprawl, and it comes as no surprise that only three traditional enclosed malls have been completed in the last decade, compared with 19 in the 1990’s (according to the International Council of Shopping Centers).
A neat article in the current edition of Real Estate Investment Today (REIT) published by the National Association of Real Estate Investment Trusts, illustrated both the challenges and the potential solutions for real estate investors. The principle focus of the article was on Macerich, one of the nation’s premier retail trusts. While the article does a great job of illustrating how this one firm is addressing today’s challenging retail landscape, the underpinnings of the article were even more interesting for projecting the future of this important property sector.
Among other ways to address the issues, Macerich is targeting its top performing malls for significant redevelopment. For example, the Tysons Corner Center in Fairfax, VA, is slated for a $525 million expansion. In addition, many top-tier malls are being multi-purposed, with hotels and office space added for synergy and operational leverage. Much of the redevelopment has been aimed at making properties in densely populated markets more up-scale or even “luxury” branding. Macerich also has a technology program, including social media, aimed at the millennial shopper. Finally, the outlet mall product continues to be strong, and Macerich intends to build a few of those in the near term.
On the flip side, Macerich sold about $1 Billion in assets over the past 14 months, and has another $250 million slated for disposal during the rest of 2014. Lower quality assets and properties in secondary markets are largely on the chopping block.
What does this mean for the industry? In some ways, the news isn’t all that bad. The lack of new construction favors existing properties, particularly those with good fundamentals and solid (and growing) customer bases. On the down-side, mid-grade properties are going to become “malls people USED to shop at”, and retail is extraordinarily hard to reposition. Thus, while there are bright spots in retail sector, there are certainly players who won’t survive the next cycle.
From a small northwestern observatory... 