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4Q 2014 EDITION
© 2014 TRANSWESTERN transwestern.com
Transwestern is a privately held real estate firm specializing in agency leasing, property and facilities management, tenant advisory, capital markets, research and sustainability. The fully integrated global enterprise leverages competencies in office, industrial, retail, multifamily and healthcare properties to add value for investors, owners and occupiers of real estate. As a member of the Transwestern family of companies, the firm capitalizes on market insights and operational expertise of independent affiliates specializing in development, real estate investment management and research. Transwestern has 34 U.S. offices and assists clients through more than 180 offices in 38 countries as part of a strategic alliance with Paris-based BNP Paribas Real Estate.
ARE YOU READY FOR 2015? A Message from Mark Doran, Chief Operating Officer
WHAT INVESTORS SHOULD DO BEFORE INTEREST RATES RISE By Gerry Trainor Executive Managing Director Capital Markets Transwestern
THE HEALTH OF THE U.S. CONSUMER AND COMMERCIAL REAL ESTATE By Rachelle Sarmiento Associate Delta Associates
NEW TENANT IN DOWNTOWN, U.S.A. Phil Utigard Executive Vice President and Education Advisory Group Leader Tenant Advisory Services Transwestern
MULTIFAMILY GREEN LIGHT By Mark Culwell Managing Director, Multifamily Development Transwestern Development Company
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
Transwestern is pleased to share its observations on the latest market and economic developments impacting commercial real estate in this final 2014 edition of Insights + Trends + Opportunities. In this issue, our experts provide insights into the economy, pending monetary policy changes and several property sectors while offering their perspectives on what to expect in the period ahead.
We begin with the mindset of the U.S. consumer and an improving labor market, both of which bode well for commercial real estate, according to Delta Associates, Transwestern’s research affiliate. The Thomson Reuters/University of Michigan overall index shows consumer confidence on the rise, reaching the highest index level since July 2007. That sentiment tracks with the third-quarter 2014 Gross Domestic Product estimates of the Bureau of Economic Analysis. The growth rate in U.S. output in the second and third quarters combined produced the best six-month growth period for the economy since late 2003. The retail and industrial segments are well-positioned to benefit from the uptick, which industry watchers hope will carry through the holiday season.
Turning to the Federal Reserve and expected policy changes, Gerry Trainor, executive managing director of Capital Markets at Transwestern, offers suggestions on what owners and investors should do before interest rates rise. Trainor examines the historical correlation between interest rates and cap rates along with the impact of continued economic improvement. This includes commentary on the impact on leveraged buyers and a prediction that unleveraged buyers will emerge as a more significant force during this period.
Multifamily development is a hot topic for debate throughout the industry, and Mark Culwell, managing director at Transwestern Development Co., shares his insights on the supply/demand equilibrium. Culwell explains there is still strong pent-up demand for residential units, enough to fuel up to six more years of sustainable production.
And finally, tenants in Central Business Districts around the U.S. may find themselves in competition for office space from an unlikely source. Phil Utigard, executive vice president of Tenant Advisory Services at Transwestern, discusses industry dynamics in higher education and graduate-level professional education that are attracting these providers to urban settings.
Transwestern hopes you find value in these articles and insights. To our trusted clients, friends of the firm and colleagues in the industry, best wishes for a strong finish to 2014 and a prosperous 2015.
Very truly yours,
Mark Doran Chief Operating Officer
ARE YOU READY FOR 2015? Be Prepared for Near-Term Changes Impacting Real Estate
A message from Mark Doran, Chief Operating Officer
THE HEALTH OF THE U.S. CONSUMER AND COMMERCIAL REAL ESTATEBy Rachelle Sarmiento Associate Delta Associates
The current economic recovery has been anemic partly because of the erosion of consumer confidence after the 2008 financial crisis. Spending less increasingly became the consumer’s mantra as the nation faced additional economic uncertainties driven in part by federal austerity measures. As of late, however, consumer sentiment is making a comeback.
The Thomson Reuters/University of Michigan overall index on consumer sentiment peaked at 86.4 as of October 2014, continuing the upward progression since 2011 and reaching the highest index level since July 2007. This compares to an index value of 73.2 in October of last year, when consumers – whose spending comprises about 70 percent of the national economy – felt vulnerable from the 16-day federal government shutdown.
We are already seeing this consumer optimism act in harmony with the slow and steady revival of the national economy. It particularly echoes third-quarter 2014 Real Gross Domestic Product (GDP) estimates of the Bureau of Economic Analysis. Overall U.S. output grew at a 3.5 percent annualized rate. Although this marks a slowdown from the 4.6 percent growth rate last quarter, the combined growth in the recent two quarters produced the best six-month period for the economy since late 2003.
Among other measures, improvement in personal consumption expenditures contributed to this recent increase in GDP. Personal consumption rose 1.8 percent for the 12 months ending at third-quarter 2014. And while the increase in consumption is slightly lower than many economists anticipated, it remains a marked improvement from the negative annual growth rates of personal spending during the worst days of the Great Recession.
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
An improving labor market is one of the main factors driving this rise in consumption and consumer sentiment. A total of 8.4 million payroll positions on a seasonally-adjusted basis have been added to the national economy during the past five years. This year alone national payroll job change is averaging +227,000 a month. Consequently, the jobless rate has fallen. The national unemployment rate stood at 5.9 percent as of September 2014, slipping below 6 percent for the first time since July 2008. Although wage growth has remained stagnant during the current economic recovery, falling unemployment should slowly increase competition for talent, eventually accelerating income growth.
The upbeat news on GDP and the labor market brings good news for the commercial real estate industry. Two asset types – retail and industrial – are especially poised to benefit from consumers’ improving take on the national economy.
Retail sales increased 2.6 percent in September 2014 year-over-year. A tightening labor market will continue to increase overall disposable income, in turn increasing retail sales. This job growth trend combined with the upward progression of consumer sentiment could increase demand for retail space in the year ahead. More specifically, pockets of strong demand for new or renovated space blended into mixed-use centers with a more fast-casual or urban feel will largely be generated by two emerging customer segments: Baby Boomers and Millennials.
Notwithstanding the recent optimism on consumer sentiment, retail sales growth remains tepid – for now – as it continues to adjust to the after-effects of the Great Recession and the e-commerce boom. As a result, brick-and-mortar retailers have been cautious about expanding and construction activity remains moderate. Although double-digit vacancy rates have kept rent growth for shopping centers at a measured pace, their vacancy rate has been declining. The national vacancy rate for neighborhood and community shopping centers stood at 10.3 percent as of the third-quarter 2014. The decline in vacancy plus gains in retail employment over the past five years – totaling 819,400 jobs – are signs of the retail sector’s resiliency despite economic headwinds.
Comparison price shopping plus one-click buying from mobile applications and websites have limited sales growth at brick-and-mortar stores. However, as a growing portion of consumer spending is conducted through e-commerce, the need for seamless distribution services will continue to trigger e-retailers’ demand for warehouse and distribution space. Consequently, the
60
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1984 1988 1992 1996 2000 2004 2008 2012 2014*
HOUSEHOLD CONSUMER SENTIMENTUnited States | 1984 – 2014
Source: University of Michigan, Thomson Reuters, Delta Associates; November 2014. *As of October 2014.
Cons
umer
Sen
timen
t Ind
ex
PERCENT CHANGE IN REAL GDP AND PERSONAL CONSUMPTION EXPENDITURES
United States | 2002 – 2014
Source: Bureau of Economic Analysis, Delta Associates; November 2014. *As of 3Q 2014.
Perc
ent C
hang
e Fr
om P
rece
ding
Per
iod,
Ann
ualiz
ed Real GDP Personal Consumption Expenditures
-3%
0%
3%
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014*
2%
4%
1%
-1%
-2%
Source: Census Bureau, Delta Associates; November 2014. Note: Sales are 12 monthsending September of each year.
RETAIL SALES GROWTHUnited States | 2005 – 2014
-8%
-6%
-4%
-2%
0%
2%
4%
6%
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Perc
ent C
hang
e in
Ret
ail a
nd F
ood
Serv
ices S
ales
“ALTHOUGH THE IMPROVING FINANCIAL HEALTH OF THE U.S. CONSUMER BODES
WELL FOR SHOPPING AND DISTRIBUTION CENTERS, IT COMES AT A TIME WHEN
CONSUMERS ARE REDEFINING THE BUYER EXPERIENCE.”
estate footprints. Although some large retailers have been slow to adopt evolving technologies, they must accommodate the shopping tendencies of a growing number of consumers who demand a highly mobile buying experience. Tenants could further tap into the advantages of rising consumer sentiment by enhancing the customer experience and deploying databases of products, prices and promotions for consumers to access on digital channels such as web and mobile platforms, even within brick-and-mortar stores. The immediate communication of product information to consumers through these channels can boost in-store conversion rates – moving consumers from shoppers to buyers. Not all tenants can afford these investments, but some may be able to use the capital they have saved from negotiating reduced rents and substantial tenant improvement allowances to fund these new initiatives.
Rachelle [email protected] 703.299.6360
“ALTHOUGH THE IMPROVING FINANCIAL HEALTH OF THE U.S. CONSUMER BODES
WELL FOR SHOPPING AND DISTRIBUTION CENTERS, IT COMES AT A TIME WHEN
CONSUMERS ARE REDEFINING THE BUYER EXPERIENCE.”
national vacancy rate for warehouse and distribution space declined 40 basis points during the first three quarters of 2014, to 11.2 percent, the lowest level of the current cycle.
Consumer sentiment may continue its rise as the U.S. economic recovery continues on a bumpy but positive course. Although the improving financial health of the U.S. consumer bodes well for shopping and distribution centers, it comes at a time when consumers are redefining the buyer experience. Now more than ever, consumer spending behavior is constantly being influenced by multiple digital channels even while customers navigate their way through a physical store.
These shifts in consumer spending habits should prompt owners to take action. Owners should be willing to negotiate shorter lease terms for retail tenants, especially those who need to remain flexible as they reconfigure their real estate portfolios. As some tenants right-size and renovate, developers also should consider investing in physical and technological infrastructure that would allow brick-and-mortar stores to easily connect tenants to their increasingly wired customers and to tailor the tenant’s brand for specific population segments and the “experience” economy.
The rising tide of e-commerce will continue to affect some retail chains, and affected tenants should reconfigure space and plan the future of their real
Source: REIS, Delta Associates; November 2014. *As of 3Q 2014.
VACANCY RATESUnited States | 2010 – 2014
2010 2011 2012 2013 2014*10%
11%
12%
13%
14%
15%
Warehouse/Distribution Centers Neighborhood and Community Shopping Centers
Vaca
ncy
Rate
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
NEW TENANT IN DOWNTOWN, U.S.A. Change in Education Delivery System Increases Competition for Urban Spaces Phil Utigard Executive Vice President and Education Advisory Group Leader Tenant Advisory Services Transwestern
While urban office buildings typically have attracted financial institutions and professional services firms, a new type of tenant is emerging as an important part of the downtown mix. Higher education institutions and graduate-level professional schools are contributing to urban renewal by relocating from suburban and standalone campuses to Central Business Districts (CBDs). Driving this trend is a desire to be closer to their targeted student population. For example, the Chicago Loop is home to the largest concentration of higher education in the country, with approximately two dozen institutions in a 1.65-mile area that is easily accessed by their more than 200,000 students living and/or working downtown, as well as those commuting from the suburbs.
The situation is taking place in CBDs around the country as higher education institutions move closer to students who work full time. According to Forbes, 60 percent of students graduate from four-year universities without the skills necessary to work in their chosen field. Subsequently, enrollment is increasing in post-graduate programs for industries such as teaching, nursing, information technology and psychology. That’s despite the recent reduction in undergraduate enrollment as people begin to question the value of a high-priced education. Students who enroll in post-graduate programs typically take classes at night to get qualified for a different career than the one in which they currently work. For students who already work in their chosen profession, many pursue advanced degrees to increase their chance for promotion. To meet these lifetime learning needs of working students, schools have realized that they need to be located in close proximity to business centers and public transportation.
Just as today’s progressive companies select office space that appeals to younger employees, schools want to locate in highly visible buildings in 24/7 environments that meet their students’ desire to live, work and play in a central location. As a result of this cultural shift, educational providers are competing with traditional CBD tenants for office and retail space in the urban core. This has required higher education institutions to revisit, and in many cases transform, their real estate strategies to accommodate where people learn. Also, some educational institutions have
downsized or merged with other providers, which has triggered relocations, consolidations and workplace reconfigurations in an effort to drive greater value from real estate.
In addition to changes in where people learn, educational institutions are also navigating changes in how people learn. Driven primarily by advances in technology, many professional and masters-level classes are being offered online instead of through lectures in large classrooms. In some cases, students learn facts online and then gather at the school or in neighborhood practicums to apply and discuss what they’ve learned. To accommodate this new delivery model, higher education providers are leasing space with fewer and smaller classrooms and more collaborative areas.
Providers also configure space to encourage students to linger, extending discussion and learning between classes. To achieve this objective, the physical space must be high-tech and have comfortable furniture in flexible settings. From a real estate perspective, we’ve found that a creative, disciplined approach can pay off. A professional college in Chicago worked with Transwestern to apply these strategies in a new 100,000-square-foot space; now, students spend two-and-a-half times more time at school than they did at the previous location. In Boston, our firm helped the Massachusetts School of Professional Psychology relocate from insufficient space to a larger facility with plenty of gathering places for students, policy makers, practitioners and mental health advocates. According to the school’s president, the move and space design that inspires learning resulted in a substantial increase in enrollment and decrease in operating costs.
The urbanization movement within the education sector may endure for yet another reason: once higher education providers enter a CBD setting, they could be less likely to leave than typical office tenants. Whether it’s a traditional office building, vacant big-box space or strip shopping center, higher education institutions and vocational schools that need state-of-the-art technology throughout their space may spend $130 to $150 per square foot on build-out, creating a financial incentive to maintain the facility for as long as possible. As the education relocation trend continues, expect to see more suburban campuses closing and additional competition for prime urban real estate.
Phil [email protected]
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
"JUST AS TODAY’S PROGRESSIVE COMPANIES SELECT OFFICE SPACE THAT APPEALS TO YOUNGER EMPLOYEES, SCHOOLS WANT TO LOCATE IN HIGHLY VISIBLE BUILDINGS IN 24/7 ENVIRONMENTS THAT MEET THEIR STUDENTS’ DESIRE TO LIVE, WORK AND PLAY IN A CENTRAL LOCATION."
WHAT INVESTORS SHOULD DO BEFORE INTEREST RATES RISE Gerry Trainor Executive Managing Director Capital Markets Transwestern
The Federal Reserve announced the end to Quantitative Easing during its September meeting, thereby concluding its bond buying program. As the economy nears full recovery from the Great Recession, Fed officials are debating when to begin raising short-term interest rates. Many want to connect the rate rise to progress in the employment rate and the pace of inflation. Economists now forecast an initial rise in interest rates in mid-2015, with additional increases over the next couple of years. Real estate investors have become accustomed to low interest rates, which the Fed artificially held near zero since December 2008, but the time has come to formulate strategies based on a new interest rate environment.
Movement in interest rates will not immediately impact capitalization rates. While there is a direct correlation between the interest rate on the 10-year Treasury bond and cap rates, interest rates are historically more volatile than cap rates, rising and falling more quickly. Cap rates will rise at a slower pace, typically lagging six months behind interest rate movement. For example, 10-year Treasuries peaked in 1981 at 15.8 percent and trended downward until 2012, when they bottomed out at 1.3 percent. Meanwhile, the average cap rate on core product peaked in 1982 at 10.5 percent and dropped to 5.5 percent in 2013, only a 5 percent drop versus a 14.5 percent drop in the 10-year Treasury. The historical trend is depicted in the chart to the right and demonstrates how interest rate fluctuation compares to that of cap rates for Class A buildings in downtown Washington, D.C.
Institutional owners and other investors that rely on leverage have the most to gain from taking action before interest rates rise. Investors that have a hold strategy on core real estate are advised to lock in longer-term debt at today’s lower rates. Likewise, today is an excellent time for short-term holders of core assets to sell if the property is stabilized and the strategy is to sell within the next three years. It is also a good time to sell core assets because they continue to be in high demand in markets across the United States. An imbalance between supply and demand,
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
combined with more institutional investors increasing capital allocations for real estate, have driven down cap rates on core assets across the country to historic lows.
In a rising interest rate environment, leveraged investors will find it harder to compete against unleveraged buyers. Initially cap rates will remain flat as the unleveraged buyers fill their coffers. Once the unleveraged buyers fulfill their allocations, cap rates will start to rise until it becomes economically feasible for the leveraged buyers to step in. Furthermore, cap rates will likely rise more slowly in gateway markets, where
unleveraged investors prefer to shop for core assets. Cap rates in second-tier markets may rise at a slightly faster pace.
Fluctuating interest rates are not expected to prompt a meaningful decrease in U.S. sales volume. However, as rates rise, it will become more difficult to finalize transactions. More deals will fall out of contract during the due diligence period as interest rates rise and change the underwriting economics.
As the U.S. economy continues to improve and more companies expand operations, expect occupancy rates to rise and markets to tighten. Transwestern is projecting a shift from a tenant to a landlord market across most major U.S. markets by 2016; in fact, many gateway markets have already shifted. As more markets change over, rental rates are forecast to increase, which will soften the impact of higher cap rates. Real estate owners and investors are advised to diligently reassess property strategies as our country moves into a new financial environment with higher interest rates.
Gerry Trainor [email protected] 202.775.7091
"TRANSWESTERN IS PROJECTING A SHIFT FROM A TENANT TO A LANDLORD MARKET ACROSS MOST MAJOR U.S. MARKETS BY 2016."
Source: US Treasury, Market Maker Survey, Transwestern. *Data is for Downtown DC Class A office.
INTEREST RATES VS. CAP RATES1973 – 2013
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2%
4%
6%
8%
10%
12%
14%
16%
1973 1978 1983 1988 1993 1998 2003 2008 2013
10-Year Treasury Capitalization Rate*
MULTIFAMILY GREEN LIGHTU.S. Development Pace is Sustainable for Years to ComeMark Culwell Managing Director, Multifamily Development Transwestern Development Company
Forecasters have begun to warn of potential overbuilding in the multifamily sector, but concerns from pundits are premature. Multifamily development in the U.S. has yet to meet pent-up demand, and annualized effective rent growth was 4.1 percent in August 2014, the highest since October 2011. At the current rate of development, we anticipate production capacity and demand will reach equilibrium by mid-2015. Subsequently, the industry could enjoy up to six additional years of sustainable production, if developers and lenders carefully monitor demand and modify deliveries accordingly. It has been said that multifamily is in the middle innings of an extra inning game.
Statistics on the U.S. supply of multifamily units clearly show the sector is not in danger of being overbuilt, although a few markets are the exceptions. Even areas such as Northern Virginia, which recently experienced oversupply conditions, are showing signs of improvement. Here are notable signs of a robust multifamily sector:
� The national multifamily occupancy rate rose to 95.2 percent in August 2014 after being at 95 percent since May, according to research firm Axiometrics. Occupancy rates are holding steady despite the new supply from developers.
� There is fresh demand each year for 400,000 to 450,000 units, but developers are completing only 325,000 units a year.
� 1 to 1.25 percent of the existing multifamily inventory in this country is demolished each year, a metric that when not taken into consideration, skews perception of demand. With considerable attention currently on urban development, the trend will continue in the near term.
Fundamentals remain strong on the demand side as the need for rental units continues to rise. In the top 100 U.S. markets, demand for apartments was more than double that of the number of units delivered, with 55,561 units completed and 129,162 units absorbed, according to a second-quarter 2014 report from MPF Research. Job growth is expected to continue for the next five years, according to economists at Axiometrics, barring an unforeseen shock to the economy. Job growth will drive demand for multifamily projects, and as more job formation drifts to the suburbs, so will rental demand. In a somewhat surprising observation, the National Multifamily Housing Council reports that almost 50 percent of new renters are Baby Boomers, rivaling Millennials as the biggest driver of demand.
transwestern.com 4Q2014 INSIGHTS + TRENDS + OPPORTUNITIES
Baby Boomers are becoming “renters by choice” who trade house and yard maintenance for convenient live/work/play environments.
For the time being, several factors are holding the supply/demand ratio in check. The number of Millennials entering the renter pool continues to increase − a circumstance that will not change in the near term. Millennials will constitute 24 million new households between 2015 and 2025, thus driving up demand for rentals and starter homes, according to “The State of the Nation’s Housing 2014,” a report by the Joint Center for Housing Studies of Harvard University. Immigration is also driving additional household formation in ever-increasing numbers. Renter growth in 2013 remained well above the 400,000 average annual absorption rates of the last few decades, the study reports. In addition, stringent mortgage underwriting and growing student debt push homeownership further out for many young individuals and families.
Also curtailing supply are barriers to entry, which exist in coastal markets as a result of the high costs of land and construction. Artificial barriers in other U.S. markets are a consequence of zoning restrictions and public opposition to higher density projects that are necessary to make some deals financially feasible.
Finally, the lack of skilled labor is putting stress on construction capacity, driving up labor costs and lengthening construction timetables. Many former and
“IN THE TOP 100 U.S. MARKETS, DEMAND FOR APARTMENTS
WAS MORE THAN DOUBLE THAT OF THE NUMBER OF
UNITS DELIVERED.”
would-be construction workers have been lured to the oil and gas industry by higher wages, leaving the development community without enough tradespeople. While commodity prices are increasing moderately, contractors are pushing up margins to recoup losses incurred during the recession, and the additional costs will price some projects outside the realm of feasibility. The same labor dynamic is slowing the building of homes, which, consequently, also adds to the number of people in need of rental units.
Opportunity still abounds in the robust multifamily sector, but future projects will face greater scrutiny from debt and equity sources, particularly as interest rates begin to rise. The “easy” opportunities are largely completed and developers must be creative in originating the next round of development opportunities. As long as developers exercise constraint, it appears we will have a number of years of positive investment environment for multifamily.
Mark Culwell [email protected] 214.534.1458
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