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Net Lease Economic Report Semi-Annual Edition | August 2018 Sage Policy Group, Inc.
Net Lease Economic Report
Semi-Annual Edition | August 2018
Sage PolicyGroup, Inc.
2Page 2
Sage PolicyGroup, Inc.
OverviewThe story of the economy has been akin to a Cadillac meeting a series of jolting potholes. It’s an uncomfortable ride, but the vehicle continues to progress, and it’s not clear whether or not any of the road imperfections are producing lasting damage.
If one were to spend one’s time watching CNN, MSNBC, or any number of other media outlets, they would be pounded by news of chemical warfare, late-night bombings, tariffs on steel and aluminum, a burgeoning trade war between the world’s two largest economies, indictments, investigations, sentencing of presidential allies, and an ongoing set of inquiries that threatens the presidency itself. This deluge of unsettling news would appear to be enough to soften economic performance, but to date there’s little evidence that all this negativity has done much damage. Here’s what we know about the U.S. economy half way through the year.
Economic growth continues to be brisk. During the final three quarters of 2017, the U.S. economy expanded at roughly a 3 percent rate. During 2018’s initial quarter, the economy expanded at a 2 percent annualized rate, impressive by first quarter standards.
Exhibit 1. U.S. Real Gross Domestic Product, Annualized Percentage Growth, Q1 1993–Q1 2018*
Source: Bureau of Economic Analysis *Q1 2018 Third Estimate
The U.S. economy has added jobs for 93 consecutive months, an unprecedented winning streak. Since employment hit a cyclical nadir in February 2010, the nation has added approximately 19.1 million net new jobs. The nation added another 213,000 net new jobs in June according to the preliminary estimate from the Bureau of Labor Statistics. Stalwarts like professional and health services continue to chip in a disproportion share of newly created jobs. The construction sector has added nearly 300,000 net new positions over the past year, a phenomenal tally given how difficult it has been to secure electricians, roofers, carpenters, HVAC technicians, and project managers among others.
-10%-8%-6%-4%-2%0%2%4%6%8%
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Q1Per
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US Economy Continues to Soar
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AUGUST 2018 | Net Lease Economic Report
Unemployment broke the 4 percent threshold in April, falling to 3.9 percent. It fell again in May, to 3.8 percent, an 18-year low, before rising to 4 percent in June due to a wave of entry into the workforce. A recent survey of economists indicates that unemployment will decline to a half century low by mid-2019.
That rate of unemployment is now below what the Federal Reserve Bank of the United States deems to be the natural rate of unemployment, suggesting that there will continue to be upward pressure on wages, inflation and interest rates. Indeed, there is evidence that wage growth is accelerating. Average hourly earnings for all employees on private nonfarm payrolls rose by 5 cents to $26.98 in June, which puts the change in average hourly earnings over the past year at +72 cents or 2.7 percent. The much-watched Employment Cost Index indicates that wages are rising at their fastest level in about six years.
Exhibit 2. Number of Unemployed Persons per Job Opening (SA), January 2002–May 2018
Source: Bureau of Labor Statistics
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Recent data indicates that there are presently more available job openings in America than unemployed individuals. As the economy continues to expand, the pressure to secure enough workers to permit enterprises to grow will become increasingly acute. It seems almost inconceivable that wage inflation will fail to manifest itself more acutely for the balance of 2018 and into 2019.
Other inflationary pressures are emerging, including those related to construction materials, fuel, healthcare, tuition, and housing. Meanwhile, cellular services deflation has finally stabilized. The latest report from the National Federation of Independent Business indicates that small businesses have begun to hike prices. The result is that U.S. Core Producer Price Index is up 3.4 percent since June 2017. Those higher producer prices will eventually translate into higher prices for consumers.
In short, the picture is of an economy that is steadily overheating. An analysis of the components of the Conference Board’s Leading Economic Index (LEI) is instructive. The index embodies ten indicators that lead the economy, including initial unemployment claims. At the year’s onset, initial unemployment claims were running around 240,000. As of this writing, the number of unemployment claims is 207,000. This is the lowest it’s been in more than 48 years.
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Rank MSA UR Rank MSA UR1 Denver-Aurora-Lakewood, CO 2.3 11 Dallas-Fort Worth-Arlington, TX 3.4
1 Minneapolis-St. Paul-Bloomington, MN-WI 2.3 11 Phoenix-Mesa-Scottsdale, AZ 3.4
3 San Francisco-Oakland-Hayward, CA 2.4 11 Portland-Vancouver-Hillsboro, OR-WA 3.4
4 San Diego-Carlsbad, CA 2.9 17 Miami-Fort Lauderdale-West Palm Beach, FL 3.5
5 Orlando-Kissimmee-Sanford, FL 3.0 17 New York-Newark-Jersey City, NY-NJ-PA 3.5
6 Boston-Cambridge-Nashua, MA-NH 3.1 19 Detroit-Warren-Dearborn, MI 3.7
7 Washington-Arlington-Alexandria, DC-VA-MD-WV 3.2 19 Los Angeles-Long Beach-Anaheim, CA 3.7
7 San Antonio-New Braunfels, TX 3.2 19 Philadelphia-Camden-Wilmington, PA-NJ-DE-MD 3.7
9 St. Louis, MO-IL 3.3 21 Houston-The Woodlands-Sugar Land, TX MSA 4.3
9 Tampa-St. Petersburg-Clearwater, FL 3.3 19 Riverside-San Bernardino-Ontario, CA 3.7
11 Atlanta-Sandy Springs-Roswell, GA 3.4 23 Seattle-Tacoma-Bellevue, WA 3.8
11 Charlotte-Concord-Gastonia, NC-SC 3.4 24 Baltimore-Columbia-Towson, MD 4.0
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Net
Ch
ange
(00
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)
June 2018: +213K
The Commercial Real Estate OutlookThis is a state of affairs that renders it quite easy to distinguish glass half-full types versus their glass half-empty counterparts. In the near-term, strong economic performance remains a blessing to developers and owners of commercial real estate. Occupancy rises and vacancy declines as employment expands. Consumer spending is enhanced with each and every net new job created, which has particular salience in the single tenant net lease market. Consumer and business confidence also tend to drift higher, inducing further household and enterprise outlays into the economy.
Exhibit 3. National Monthly Job Growth, June 2003–June 2018, SA
Source: Bureau of Labor Statistics
On the other hand, a strong, tax cut-fueled economy also makes life more expensive, including in ways that render it more difficult for developers to make their pro-formas work. Many are familiar with the recent run-up in construction materials prices, which according to government data jumped nearly 10 percent during a recent 12-month period. Petroleum, softwood lumber, and steel are among the categories that have experienced the most inflation.
Exhibit 4. Unemployment Rates, 24 Largest MSA (Not Seasonally Adjusted), May 2018
Source: Bureau of Labor Statistics
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AUGUST 2018 | Net Lease Economic Report
Additional data indicate that it has also become much more expensive to transport materials to jobsites. The Cass Truckload Linehaul Index is a measure of market fluctuations in per-mile truckload linehaul rates. Between March 2016 and March 2017, the index had been negative for 13 consecutive months, a reflection of the industrial recession that took place in 2015 and 2016 in the wake of a precipitous decline in energy prices that commenced in mid-2014.
But since April 2017, the index has posted 15 consecutive positive months. Donald Broughton, a Cass Truckload Index analyst, indicated in a recent release, “We are increasing our realized contract pricing forecast for 2018 from a range of 6 to 8 percent to a range of 6 to 12 percent, and current data is clearly signaling that the risk to our estimate may be to the upside.” Because of the crucial role trucking plays in the overall economy, the dearth of truckers and mechanics
coupled with increasing demand for inputs and outputs will serve to create additional supply chain bottlenecks, driving shipping costs higher. Presumably, this will be even more impactful in communities associated with the lowest unemployment rates.
Then there is that pesky issue of tariffs and trade wars. On June 1, 2018, the White House released two Presidential Proclamations that imposed a 25 percent tariff on steel imports and a 10 percent tariff on aluminum imports. Prior to that, tariffs were placed on solar panels and washing machines imported from China. In response, the Chinese government proposed a 25 percent duty on 106 U.S.-produced items. These include output such as automobiles, soybeans, and aircraft. President Trump then instructed U.S. trade officials to consider another round of tariffs on $100 billion in Chinese production.
Exhibit 5. State-by-State Unemployment Rates, June 2018
Source: Bureau of Labor Statistics
At present, we find ourselves in the midst of an escalating tit-for-tat trade war. While we have heretofore been in the foothills of such a conflict, the economic impact is beginning to be felt with particular intensity in the Midwest, home to much of America’s industrial and agricultural production. While some prices (e.g. soybeans) have declined, the more likely impact of back-and-forth tariffs is to drive costs higher globally. These dynamics will leave the Federal Reserve with little choice but to keep driving short-term rates higher, even in the context of presidential critiques.
Rank State % Rank State % Rank State %1 Hawaii 2.1 17 Missouri 3.5 34 Illinois 4.3
2 North Dakota 2.6 17 Tennessee 3.5 34 New Jersey 4.3
3 Colorado 2.7 20 Wyoming 3.7 34 Pennsylvania 4.3
3 Iowa 2.7 21 Arkansas 3.8 34 Rhode Island 4.3
3 New Hampshire 2.7 21 Florida 3.8 39 Connecticut 4.4
6 Vermont 2.8 21 Montana 3.8 40 Michigan 4.5
7 Idaho 2.9 21 South Carolina 3.8 40 New York 4.5
7 Maine 2.9 25 Delaware 3.9 40 Ohio 4.5
7 Nebraska 2.9 25 Oklahoma 3.9 43 Arizona 4.7
7 Wisconsin 2.9 27 Oregon 4.0 43 Louisiana 4.7
11 Utah 3.0 27 Texas 4.0 43 Mississippi 4.7
12 Minnesota 3.1 29 Alabama 4.1 43 Nevada 4.7
13 South Dakota 3.2 29 Georgia 4.1 43 Washington 4.7
13 Virginia 3.2 31 California 4.2 48 New Mexico 4.9
15 Indiana 3.3 31 Kentucky 4.2 49 West Virginia 5.3
16 Kansas 3.4 31 North Carolina 4.2 50 District of Columbia 5.6
17 Massachusetts 3.5 34 Maryland 4.3 51 Alaska 7.1
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Change in Treasury Note Yields
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2-Year 10-Year Spread
Source: Federal Reserve Bank of St. Louis
To date, long-term rates have not moved in conjunction with short-term rates. As of this writing, the difference between the yield on the 2-year Treasury and the 10-year Treasury is in the range of just 24 basis points. According to the Federal Reserve Bank of St Louis, the last time the spread was this small was in early-August 2007, four months before the onset of the Great Recession.
If one presumes two more Federal Reserve rate hikes later this year, the yield curve could easily be inverted by year’s end. Often, that signifies substantial slowing in economic activity, but this time could be different. Many economists agree that long-term U.S. rates haven’t risen in part because they are already quite high relative to long-term rates in other advanced economies, including German and Japanese long-term rates.
Occasional Setbacks – I’m No Longer a Toys ‘R Us KidJune 29th was a sad day for millions of American children.Toys ‘R’ Us, the venerable toy, clothing, and video game store, officially closed its last stores in the U.S. Toys ‘R’ Us continues to operate stores elsewhere the world.
For other retailers looking to expand their operations, these properties present a possible investment if current landlords are willing to cooperate. Possible suitors for the former Toys ‘R’ Us stores include Big Lots!, a discount chain store, and Raymond & Flanigan, a furniture seller based in New York.
The Positive Performance of Net Lease PropertiesGenerally speaking, net lease properties continue to be among the best performing investment vehicles in the U.S., even as the economy hums along in the 10th year of the latest economic expansion. Buyers have plenty of choice, or at least more than they have had.
The average capitalization (cap) rates rose in nine of eleven net lease subsectors when compared to the same timeframe in 2017. Between the second quarters of 2017 and 2018, the largest increases were registered in the Automotive (6.19 to 6.93 percent) and Pharmacy (6.25 to 6.90 percent) property categories.
0.28%
2.59%
2.88%
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AUGUST 2018 | Net Lease Economic Report
Average Cap Rate by Sector
Source: Calkain Research
Educational and QSR (quick service restaurants) experienced cap rate declines. Convenience stores and Other Retail both experienced a minuscule increase of 0.1 percentage points. Rising consumer confidence is associated with an increase in meals supplied outside of the home, which helps explain the compression of cap rates associated with quick service restaurants. That said, the change in cap rates in this category was rather minimal.
Change in Annual Average Cap Rate by Sector from Q2 2017 to Q2 2018
Source: Calkain Research
Q2 2017
Q2 2018
Change
6.19%
5.45%
6.89%
6.17%
5.56%
6.98%
7.42%
6.71%
6.25%
5.84%
6.38%
6.93%
6.03%
7.17%
6.46%
5.66%
7.25% 7.19%7.02% 6.90%
5.67%
6.50%
4.50%
5.00%
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6.00%
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0.74%
0.59%
0.29% 0.29%
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0.65%
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-0.40%
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Banking continues to be impacted by a combination of mergers/acquisitions and the growing impact of online banking. The result has been a dwindling number of bank branches. According to the Federal Reserve Bank of St Louis, the number of bank branches declined from 36 per 100,000 adults in 2009 to 32 per 100,000 adults by 2014. Thereafter, the number of bank branches began to trend higher, but it is conceivable that the number of branches will never attain its previous peak.
National Average Cap Rates: Bank Sector
Source: Calkain Research
Nationally, average annual cap rates among Big Box properties rose 28 basis points (bps) to 7.17 percent. Three featured companies experienced increases in their respective cap rates over that period of time. Among this group, Hobby Lobby saw the largest increase, rising from 6.04 percent at the end of Q2 2017 to 6.52 percent. Average cap rates for Aaron’s Inc., a lease-to-own retailer, rose 24 bps. Tractor Supply Co. experienced an increase of 23 bps. The average sale price in the sector was $5.6 million for the quarter, while the average net operating income was $375,760.
The increase in cap rates for Hobby Lobby and the other Big Box retailers should be put into context. Inflationary pressures are rising, consumer prices rose nearly 3 percent during a recent 12-month period. Viewed from that perspective, the increase in cap rates is smaller than expected.
National Average Cap Rates: Big Box Sector
Source: Calkain Research
5.45%
4.50% 4.45%
6.79%6.03%
5.30% 5.00%4.55%
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5.00%
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Sector: Bank Bank of America Chase Bank Citizen's Bank
Q2 2017
Q2 2018
Q2 2017
Q2 2018
6.89%6.04%
8.12%
6.26%7.17%
6.52%
8.36%
6.49%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
Sector: Big Box Hobby Lobby Aaron's Tractor Supply Co.
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AUGUST 2018 | Net Lease Economic Report
6.19%6.44% 6.56%
5.76%
6.93%
7.76%
5.82% 5.68%
4.50%
5.50%
6.50%
7.50%
8.50%
Sector: Automotive Advance Auto Parts Jiffy Lube O'Reilly Auto Parts
Average cap rates in the automotive sector rose 74 bps over the past year. Advance Auto Parts experienced an average cap rate increase of approximately 140 bps on a year-ago basis, while Jiffy Lube experienced a 74 bps decline. The average cap rate associated with O’Reilly Auto Parts dipped slightly to 5.68 percent from 5.76 percent.
It is not surprising that cap rates have been rising in the automotive sector. After all, most sectors experienced an increase in cap rates over the past year. Moreover, there is evidence that auto sales have peaked for this cycle and that a meaningful share of recent purchasers are now behind on their auto loan payments. Elevated delinquency rates have a tendency to result in tighter lending standards, which in turn constrains new car purchases. This could provide a boost to auto parts and auto service centers in the near future and lead to cap rates increasing at a slower pace.
National Average Cap Rates: Automotive Sector
Source: Calkain Research
Average cap rates also expanded in the pharmacy sector (65 bps between Q2 2017 and Q2 2018). A key sector event was Walgreens’ announced plans to purchase 1,932 of Rite-Aid stores. Albertson’s a grocery store chain, had been in the process of acquiring the remaining Rite Aid locations, approximately 2,500 stores. This merger is now off.
An arguably more significant source of cap rate movement came from Amazon, which continues to express an interest in entering the pharmacy space. In late-June, Amazon announced an acquisition of PillPack, an online pharmacy that permits users to purchase medications in pre-made doses. While terms were not immediately disclosed, media reports indicate that the deal was for just under $1 billion. With online growing as a threat to traditional pharmacy operations, cap rates in this segment may continue to rise. CVS, Rite-Aid, and Walgreens experienced cap rate growth over the past year.
National Average Cap Rates: Pharmacy Sector
Source: Calkain Research
Q2 2017
Q2 2018
6.25% 5.93% 6.04%
7.98%6.90% 6.37%
7.01%
8.54%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
Sector: Pharmacy CVS Walgreens Rite Aid
Q2 2017
Q2 2018
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Rosy Outlook Near-Term, Murkier in the Longer-TermBack in 2009, economists tended to forecast that the economy would be problematic in the near-term, but that things would get better over the intermediate- to long-term. They were right. America now finds itself in the 10th year of economic recovery, with GDP growing around 3 percent per year and nation is currently at or above full employment.The global economy has also improved over time. Markets around the world have performed well in recent years, including U.S. equity markets. With tax cuts now in place and just now beginning to impact the economy, including in the form of stepped up capital expenditures, there would appear to be little reason for concern.
That is true in the short-run. Economic momentum should see us through the balance of 2018 and into 2019. Thereafter, the clouds presently forming on the horizon could begin to deliver some rain.
The logic of this scenario is defined by inflation and rising interest rates. Increasingly, solid economic growth is bumping up against human capital, materials, shipping and other constraints. Price levels are set to rise. On top of that are the impacts of tariffs, which may easily worsen with time as trade disputes drag on in a spreading global game of chicken.
Rising inflation and interest rates are not particularly good for a number of asset classes, such as stocks, bonds and commercial real estate.
On top of that is the specter of rising indebtedness around the world, whether among emerging-nation governments or private U.S. corporations that have been driving their respective debt-to-equity ratios higher through ongoing stock repurchases. Interest rate increases in the context of this rampant indebtedness ($247 trillion globally in Q1 2018 according to the International Institute of Finance) could trigger a host of possible consequences, including a sharp slowdown in global economic performance.
That in turn could trigger broad-scale selloffs of equities, which in turn would truncate global liquidity and compromise investor/business confidence. Eventually, that would translate into slower job growth, softer consumer confidence, reduced bank lending, and less liquidity. This scenario is neatly associated with rising capitalization rates.
Of course, this entire set of conjectures could prove faulty. Many economists dismiss the 2017 tax reform as largely having temporary effects. Conceivably, the tax reform could alter the structure of the U.S. economy by inducing more capital investment and meaningfully faster productivity growth. Under those circumstances, inflation could be held at bay while worker incomes expand more quickly. This type of dynamic could extend the current economic recovery, already the second longest in American history.
However, that is not the predominant view. Many economists predict the next recession will begin in 2020. A recent survey of fund managers suggests that many believe the next downturn will begin late next year.
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AUGUST 2018 | Net Lease Economic Report
Calkain Companies is a boutique commercial real estate firm with a passion for the net lease market. In 2005, Jonathan Hipp, President and CEO, took the initiative to build upon his experience and left a large, international brokerage firm to become an independent and innovative leader within the net lease investment community. Armed with a sole employee and a single office, the firm has grown exponentially.
Our services include Asset Management, Research, Advisory and Capital Markets. Solid relationships have been the cornerstone throughout Calkain’s decades of experience in the industry. They approach their clients’ risk tolerance with foresight and enthusiasm, forging long term partnerships by identifying the right people, investment criteria and innovation. Whether private or institutional investors, Calkain prides itself on providing real estate solutions that maximize client value and build wealth for your future.
Jonathan Hipp | President & CEOJon Hipp began his career in real estate over 25 years ago. In his early years as a broker, he ventured into the net lease industry and quickly began leading the US net lease market, closing over $3 billion in transactions. Jon was a Senior Vice President for Grubb & Ellis in Tysons Corner. With his “make it happen” mentality, Jon was honored with the #1 Producer Award for three consecutive years in his local office and was amongst the Top 10 Producers nationwide throughout his tenure at Grubb & Ellis.
In 2005, Jon co-founded Calkain Companies and as President and CEO, Jon has been instrumental in building the firm into one of the leading Net Lease real estate companies, transacting over $12 billion of net lease deal volume over the past 12 years.
Sage Policy Group, Inc., was established in 2004 by Anirban Basu. Sage is an economic and policy consulting firm specializing in economic, fiscal and legislative analysis, program evaluation, and organizational and strategic development. The firm’s clients include public agencies, law firms, developers, money managers and an array of nonprofit organizations. As experts in research methods, their corporate focus is to utilize sound, widely accepted analytical techniques that provide their clients and stakeholders with valid and reliable information to support critical organization requirements.
Sage’s clients appreciate the firm’s capacity and willingness to go beyond trend forecasts and to envision likely scenarios and their impacts on key variables, including revenues and expenditures. One of their principal strengths is the capacity to predict real estate and construction-related variables, which is important along both economic and fiscal dimensions.
Anirban Basu | Chairman & CEOAnirban is a study in contradictions. He has been called an economist with a personality, or alternatively, one with a sense of humor. He has twice been recognized as one of Maryland’s 50 most influential people. He has also been named one of the Baltimore region’s 20 most powerful business leaders.
Anirban serves as Chairman of the Maryland Economic Development Commission, teaches global strategy at Johns Hopkins University, and serves the Chief Economist function for a number of organizations around the country. He has read every one of Agatha Christie’s novels, is obsessed with James Bond, English football, Indian cricket, all Baltimore teams, and with his wife and two daughters, Kimaya and Kohena.
About The AuthorsThis report was produced by Calkain Companies research department in conjunction with Sage Policy Group, Inc.
Sage PolicyGroup, Inc.
Sage PolicyGroup, Inc.
Calkain Companies LLC12930 Worldgate Dr, Suite 150Herndon, VA 20170703.787.4714calkain.com
Sage Policy Group, Inc.575 S Charles St, Suite 505Baltimore, MD 21201410.522.7243sagepolicygroup.com
DISCLOSURES: As part of our market research, we collect sales price, cap rate, and lease years remaining for all publicly advertised and sold STNL properties. a) We are not able to capture 100% of the off-market transactions that occur; however the nature of off-market typically limits their value as true market comps. b) Sources include public records, sales announcements, Calkain sales, and appraiser obtained sales amongst others. c) Our collection process, while thorough, is not all encompassing and there may be biases in the data as it relates to geography, tenancy, or brokers involved in the transaction. d) Public records often lag behind when transactions actually close, months in some cases. Consequently the data supplied here for any given quarter is likely to miss a material amount of transactions that actually closed in it.
