Ninety-nine percent of the failures come from people who have the habit of making excuses.
George Washington Carver
by Kevin J. Thorpe
Midway through 2015 — year six of the current U.S. expansion — the economic data is once again making some real estate investors nervous.
Midway through 2015 — year six of the current U.S. expansion — the economic data is once again making some real estate investors nervous. First-quarter real gross domestic product, originally estimated at a meager 0.25 percent growth rate, actually fell 0.7 percent, according to the second estimate from the Bureau of Economic Analysis in late May.
On top of the weak GDP numbers, we have had to endure lousy manufacturing trends, lousy consumer spending trends, lousy office absorption numbers, increased stock market volatility, and bumpy employment data for the first 100 days of the year. Indeed, based on the steady string of weak data, the U.S. economy looks tired. And in the back of our minds, we know the average length of an expansion post-World War II is just under five years. So is the U.S. expansion running out of juice?
Is a Weak 1Q the Norm?
For the last seven years, the data in the first quarter has generally been quirky and weak; however, that initial weakness has meant diddly-squat for the remainder of the year. Since 2009, first-quarter GDP growth has averaged -0.39 percent — brutal — versus 2.67 percent of solid growth for other quarters.
This time around the weakness was caused by three primary factors. First, the unseasonably cold and snowy weather — the coldest in more than 20 years in certain places — played a major role. People probably are sick of hearing about the weather from economists, but its economic impact is real. Severe weather delays consumption, investment, travel and tourism, and construction and will artificially make the economy appear weaker than it actually is.
Second, labor disputes at various West Coast ports jammed the U.S. economy in certain spots. For example, container traffic at the Port of Los Angeles was down 26 percent in January and another 10 percent in February compared to a year ago. There is clear evidence that when the supply chain is disrupted in this manner it drags down both consumer spending and trade.
Third, the plunge in oil prices curtailed new energy-related investment in the first quarter, at a -23.1 percent annualized rate, which directly hit the “nonresidential structures investment” component of the GDP calculation. This drag will ultimately be more than offset by the positive multiplier low oil prices have on consumer spending — but that multiplier hasn’t kicked in quite yet.
In addition to the temporary drags, one has to be mindful of the soaring U.S. dollar and the weakened global economy. In its current state, neither the dollar nor the choppiness overseas will sink the U.S. expansion, but a dramatic move in either one could certainly cause problems.
Looking past the temporary drags, the core of the U.S. economy remains strong. Both households and businesses have done a tremendous job healing their balance sheets, as evidenced by low debt-service ratios, plunging delinquency rates on monthly mortgage payments, and near-record corporate profits. Consumer confidence, which correlates well with occupancy levels, has been inching its way back over 100 — as robust as it was during the strong real estate years of 2004–2007.
With lower gas prices effectively stuffing an extra $100 billion into Americans’ pockets this year and with the onset of warmer weather, consumer spending is poised to drive stronger economic growth. The signs of pushing past the first-quarter blues are already appearing. Retail sales in March were better (+0.9 percent over February), existing home sales in March were better (+6.1 percent year-over-year), job growth in April was better (223,000 net new nonfarm jobs versus 85,000 the month before). In summary, the strong economic DNA that has been driving the improvement in commercial real estate fundamentals for the past several years remains firmly intact.
Widespread Rent Growth Is Upon Us
For most owners, the bulk of this commercial real estate recovery has been less about growing rents and more about finding a way to lease up an empty building in what seemed like an endless fleet of empty buildings. There were a few exceptions, of course. Tech- and energy-fueled markets, such as San Francisco and Houston, began observing meaningful office rent growth in early 2011. Apartment rents have also been appreciating at decent clip in most cities since 2011. In general, high quality space across all sectors has seen some mild upward movements. But those were the aberrations. It was not widespread; just a few one-offs here and there. That is all about change. Let’s take the office and industrial sectors as examples.
Office. The U.S. office sector hasn’t had a robust recovery, but it has been consistent. Net absorption has been positive for four straight years, averaging 13 million square feet per quarter. Not great, but good enough to drive vacancy down almost 300 basis points to 14.4 percent as of 1Q 2015 from 17.1 percent in 2Q 2010. For context, vacancy is now lower than it was in 2005. In 2005, office rents grew by a solid 2.5 percent.
The rent growth story is no longer limited to tech and energy hubs or gateway cities. For example, asking rents in Atlanta grew by nearly 10 percent in 1Q15. Fort Lauderdale, Fla., Louisville, Ky., Nashville, Tenn., and Oakland, Calif., all have 5 percent rent growth or better.
Yes, tech markets are still leading the way. San Francisco put another 17 percent rent growth number on the board in 1Q15. And no, not every single market is going to see rental appreciation. Houston, which has led many markets in commercial real estate for the past five years, will be negatively impacted by the plunge in oil prices. Northern Virginia, the core of the private defense industry, is still recovering from the sharp federal budget cuts. But with new development across the country still 30 percent below its 2005 peak, and with office-using job growth the strongest it has been in 15 years, more than 80 percent of the U.S. office markets DTZ tracks will observe rent growth by the end of 2015.
Industrial. If there is any sector that can rival the top performer — the multifamily sector in this recovery — it is the industrial sector. Industrial is flat out booming. Last year the industrial sector absorbed 162 msf of space — the second highest pace on record dating back to 1990. Not even the unseasonably cold weather was able to slow industrial absorption in the first quarter — which registered another 38.8 msf of demand. U.S. vacancy currently stands at 7.6 percent and is 5 percent or less in nearly one-third of the country. Asking rents are starting to feel the pressure from this demand. Seven markets posted double-digit rent growth in the 1Q15 and another 12 saw 6 percent YOY growth or better.
A Record Year for Investment Sales?
So far this year, the U.S. is on pace to complete $618 billion in transaction volume, which would eclipse the 2007 high mark. Sales volume is up across all product types compared to a year ago, with 20 percent or higher gains in all product types except retail. Thus far, the composition of domestic buyers mirrors what we observed in 2014 with institutional investors, public real estate investment trusts, and private investors accounting for roughly the same share.
Despite a stronger U.S. dollar, foreign investors continue to place big bets on U.S. real estate. Throughout April, foreign investment in U.S. commercial real estate was up 90 percent compared to the same period one year ago. This foreign capital primarily targets the six global gateway cities (New York, Boston, Washington, D.C., San Francisco, Los Angeles, and Chicago) and office and multifamily assets.
Likewise, commercial real estate values continue to aggressively increase. In 1Q15, capitalization rates fell across all property types. That being said, six years into the recovery, there are still signs of unevenness in the capital markets. For instance, the multifamily sector and CBD office have both blown past pre-recession peak pricing. Per square foot pricing for apartments is up 26 percent from the 2007 peak, and CBD office is up 22 percent. Meanwhile, suburban office, retail (outside of downtown prime space), industrial (outside of bulk and built-to-suit) are still down from their peak highs.
Will these strong trends end anytime soon? That is unlikely. There is simply more capital in the global economy than there is real estate product to buy. The global central banks, through various forms of quantitative easing, have injected $9 trillion into the global economy since 2009. They have effectively printed the equivalent of China’s GDP and dropped it into the world economy. Thus far, only a small percentage of these capital injections have made their way to U.S. commercial real estate. Barring something unforeseeable, that alone suggests that there is still a tremendous amount of runaway left in the capital markets.
Plenty of Juice
There are still threats to global economic growth. Here in the U.S., we have yet to normalize monetary policy, and we will be doing so while other central banks continue their own quantitative easing policies. Oil prices, though stable now, could fall and rise rapidly given the right shock. And, despite the U.S. dollar’s slow appreciation rate, combined with another oil price shock, we could still see some harm to the U.S. economy.
But make no mistake, shocks are not the norm, and the Federal Reserve is being notably careful about its decision of when to raise interest rates. The underlying U.S. economic fundamentals are as solid as ever, suggesting there is still plenty of juice left in the current expansion. The average length of a business cycle should be perceived as nothing more than that: It is just an average.
Perhaps, given the slow developing nature of this recovery, and the unprecedented moves made by the central banks in shoring up the financial system, we are in the midst of the longest expansion in the history of the U.S. The longest post-WW II expansion was the 10-year growth cycle that spanned from 1991 to 2001. Midway through 2015, six years in, there is little evidence to suggest that this one can’t be longer.
Kevin J. Thorpe is chief economist, the Americas, for DTZ, based in Washington, D.C. Contact him at firstname.lastname@example.org.
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