Wednesday, April 22, 2015

Commercial real estate booms

Updating my comments from January: U.S. housing starts have almost doubled in the past 5 years, and, according to Case-Shiller, housing prices have recovered 56% of their recession-era losses. But the recovery of the residential real estate market pales in comparison to the boom in commercial real estate, where prices have recovered substantially all of their recession-era losses, thanks to double-digit annual gains for the past 4-5 years.

Repeating the comments from this month's Co-Star report on commercial real estate:

COMMERCIAL REAL ESTATE PRICES CONTINUED TO CLIMB IN FEBRUARY. The two broadest measures of aggregate pricing for commercial properties within the CCRSI—the value-weighted U.S. Composite Index and the equal-weighted U.S. Composite Index— gained 1.5% and 1.4%, respectively, for the month of February 2015. Both indices have increased by more than 13% over the 12 months ending February 2015 as the pricing recovery for commercial property expanded into smaller markets and secondary property types.

HIGH LEVEL OF INVESTMENT ACTIVITY SUGGESTS COMMERCIAL REAL ESTATE WILL CONTINUE TO BE A SOUGHT-AFTER ASSET CLASS IN 2015. ... transaction activity through February 2015 suggests this will be another active year for commercial real estate acquisitions. The U.S. composite sales pair count of 2,357 and sales volume of $18.9 billion in the first two months of 2015 exceeded totals from the same period in 2014. Meanwhile, the share of commercial property selling at distressed prices fell from 32% in 2011 to less than 10% for the 12 months ended February 2015. 

The strength of commercial real estate belies the fact that this continues to be the weakest economic recovery on record. That's a conundrum which in turn suggests that 1) the economic fundamentals are arguably stronger than most people realize, 2) very low borrowing costs (i.e., easy money) are artificially boosting property values, and/or 3) commercial real estate never experienced a bubble of the magnitude that residential real estate did. I think government meddling in the mortgage market was a significant factor contributing to the overbuilding, overpricing, and eventual crash (think Fannie Mae, Freddie Mac, no-down payment loans, stated income qualifications, government guarantees, and interest-only loans). Things never got so carried away in the commercial real estate sector, where market forces were still operating to keep things more or less rational. 

In any event, a vibrant commercial real estate market is at the very least a source of comfort for us bulls. Things can't be that bad if commercial real estate values are increasing more than 10% per year.


Benjamin Cole said...

Actually U.S. commercial real estate prices fell by about the same amount as residential real estate prices in the 2008 bust.
I am a little concerned by what I see in institutional quality commercial real estate today. I see some of what we saw in 2008. That is, every time a trophy office tower or shoppong mall is purchased it is explained that the tower will be refurbished and higher rents garnered in the future and that justifies the extremely rich purchase price.

In 2008 we saw a commercial buyers of real estate go high in the capital stack. That is, they would secure a first loan from commercial bank and then mezzanine financing from others, often up to 98 and 99 percent of the total purchase price.
On residential real estate, it may be worth pondering an elimination of the home mortgage interest tax deduction, as well as elimination of Fannie and Freddie.

William said...
This comment has been removed by the author.
D Brown said...

I have trouble reconciling the high amount of commercial vacancies in my area with the fact that sales prices have not declined. Logically I can only think of two possible explainations. As noted by Mr Cole, buyers may be trying to force up rents to offset the high prices they paid for the property. Unfortunately, with a slow growth economy and stagnant incomes, the tenants either downsize space or close, resulting in higher vacancies. Alternatively the low interest rates enable the owners to carry the vacant space at a low cost (at least relative to the upside of eventually renting the space). In that case I would presume that a lot of sellers will all hit the market when interest rates rise.

Unknown said...

Given the lousy employment recovery, Mr. Cole's theory appears to be right on. Looks like a bubble.

Unknown said...

Obamacare. It has completely wrecked the economy. Bubbles, stagnation, inflation - it is a total mess now.

This is exactly what the opponents of Obamacare predicted would happen.

Benjamin Cole said...

D Brown: Your comment is interesting. I do not know what city you live in.

Certainly, real estate is prone to over supply. In fact, today many industries are prone to over supply such as autos computer making, clothing, even food.

Abd, there is today capital gluts. Money looking for a home.

It is not PC to say so, but I think the problem today is not on the supply side, it is on the demand side.

William said...

At last the reputal to Benjamin Cole's pleadings for more action from the Federal Reserve!!

Jim Paulsen of Wells Capital Management and Lakshman Achuthan of ECRI agree on the causes of the slow U. S. economic recovery: supply-side constraints. One, aging demographics have reduced the growth of the labor supply and two, remarkably weak productivity performance.

Paulsen: "At only 0.73% annualized growth in the contemporary recovery, the U.S. labor supply has grown
less than half its average pace in the seven prior recoveries since 1960 and about 40% slower than it grew during the last three recoveries."

Paulsen: "Annualized labor productivity has risen by only 1.24% in the current recovery compared to about a 3% postwar average and at a pace which is only about one-half the experience during the last three recoveries."

Paulsen explains: "Chart 3 strongly suggests the disappointing contemporary recovery is not due primarily to high debt burdens, low savings rates, or muted risk-taking behaviors (i.e., demand-side
constraints) as many believe. Rather, this irregularly slow recovery seems more likely tied to a watershed slowing in the growth of the U.S. labor supply and its productivity
performance (i.e., supply-side constraints)."

Achuthan summarizes:
"a. Productivity growth has averaged half a percent a year for the past four years
b. Potential labor force growth has averaged half a percent a year for the past four years, and will remain there for the next decade, according to the CBO
c. Since productivity and labor force growth add up to about one percent, even if the Fed's 2% inflation target is met, nominal GDP growth is still likely to trend down towards 3%"

Primary references are these .pdf docs

William said...

Jim Paulsen's Solutions to the Supply Side Problems Described Above

"Ultimately to “speed up” the U.S. economy in this or future recoveries, attention needs to shift from treating weak demand to boosting supply capacity....Certainly reopening Ellis Island would help boost labor supply growth and raise the speed of future recoveries. However, while we believe this will
eventually be accomplished, politically it will likely take several more years before a new more liberal immigration policy is

"More immediately, we are hopeful the second half of this recovery will see improved productivity performance. This will require faster investment spending from both the private
and public sectors adding technologies and infrastructure
which will allow our slow growing labor supply to become more effective. Indeed, as we have argued elsewhere (see the
March 20, 2015 Economic & Market Perspective), success or
failure in finally boosting productivity during the next few years may well prove to be the most important factor shaping the rest of this economic and stock market recovery."

Scott Grannis said...

Weak productivity growth is by definition the reason the recovery has been so weak. The real question is why productivity growth has been so weak. Is it because of a lack of money? Interest rates that are too high? I don't think so. The more obvious answers are burdensome regulations (e.g., Obamacare, Dodd-Frank), high marginal tax rates, and general, lingering risk aversion. Investment, in turn, has been weak because of those factors, not because of anything the Fed has or hasn't done. Those things can be fixed with appropriate fiscal policies.

Benjamin Cole said...

William: I am more than on board with all sorts of supply-side improvements. Lesser unemployment benefits, elimination of the VA, wipe out food stamps, eliminate the USDA, cut the Defense Department in half, much lower business and worker taxes. The GOP would turn pale face at the pro-business rules I would implement.

Every nation must invest in infrastructure, plant and equipment, education, work ethics and contractual honesty.

But today every industry I can think of over-supply demand easily. Is there an industry you can mention that is running full-bore?

If so tell me. I want to invest in an ETF related to that industry.

Productivity tends to surge when there is strong demand. See the 1990s in the USA.

William said...

@ Benjamin

The .pdfs are short and well worth reading because both authors note that the supply side issues are shared by all developed economies, most much worse off than the US because of their economies' structural problems and even worse demographics.

Paulsen refers to a "misdiagnosis" of our economic problem and Achuthan describes it as "a longstanding misunderstanding". Central banks are prescribing a monetary treatment (extremely low interest rates and QE) designed to treat demand side weakness when the real problems are on the labor supply side.

This is why the massive QE has not been more effective the past couple of years - and will have only a limited effect in Japan and Europe as well.

We most desperately need an accurate diagnosis of the US and global economic problems; and politicians who can persuade the electorates of the validity of the treatment. This applies to Euroland and Japan too.

ROGER49 said...

Commercial Real Estate values vary greatly from location to location. In hot markets sales prices reflect zero rate Fed policy. We won't know for several years whether or not these prices are justified. The rubber will meet the road when properties need to be refinanced at higher interest rates. Some lenders such as community banks and credit unions now have loan portfolios with a % of commercial real estate greater than 50%. Loan terms have been quite aggressive and getting more so. Zero rates are pushing lenders to take on additional risk. Should the economy more to a higher rate environment without rent growth, there will be problems.

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Ba Xoáy said...

iven the lousy employment recovery, Mr. Cole's theory appears to be right on. Looks like a bubble.

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