The economy remains in slow growth mode and will be for some time—I believe for another three to four years. Debt overhang and ongoing deleveraging on the part of firms and households are the main culprits as well as higher structural unemployment and the stultifying double entendre of more or less permanently high taxes and excessive regulation relative to our economic competitors.
Many firms and consumers lack confidence about the U.S. and global economic prospects. Firms are playing it safe and are hoarding over $1.5 trillion on their balance sheets. Consumers began to spend last year, but have recently pulled back in the second quarter of 2012. Global volatility and uncertainty will continue along with the ongoing E.U. debt crisis and the specter of various geopolitical risks such as Iran. Most industrialized economies have mismanaged their balance sheets spending more than they take in, while raising taxes steadily over the years.
The cure (austerity/spending cuts) threatens to kill the patient, but at the very least will contribute to slowing growth in the near-term. Volatility is something we have grown used to for in an increasingly global economy, there are more risk factors introduced into a globally integrated economy. With growing economic and specifically financial sector integration, the network effect is all too evident in the chain reaction of Greece’s crisis ripples through the global financial system.
Uncertainty is also heightened by our poor political governance. Political stalemate and the belief that progress is not really possible have sapped confidence in our ability to make the much-needed structural changes. The rules of the game are uncertain—Dodd Frank, the Volker Rule, and national medical insurance are just three profound regulatory changes that, at the very least, portend more regulation and a higher cost of doing business. We lack concrete plans for seriously reducing our chronic overspending. Despite this negative backdrop, commercial real estate has been resurgent since 2010 on the back of increasing capital flows in search of yield and lower volatility and gradually improving fundamentals.
Returns to private equity real estate have made it the best performing asset class over the last year. The recovery has been characterized by bifurcation of demand with significant capital flowing to core markets for high-quality assets and much less so for secondary and tertiary markets and class-B and -C assets. Risk aversion still rules the day as many secondary and tertiary markets lack the economic vibrancy of global gateway markets and lag in job growth. The U.S. is becoming an economy of two markets—global gateway cities and all the rest.
The global gateway markets are gaining jobs, capital investment and exhibit improving fundamentals while most of the secondary markets languish. Global gateway markets are successfully competing in the global market place and often have globally dominant positions in industries such as the Bay Area for high-tech, Los Angeles for media, New York for finance and fashion, Boston for biotech and Houston for energy. Talented and educated people flock to these markets for economic opportunity. Firms and jobs are following them.
This recovery—in terms of both the general economy and real estate—has been anything but typical. I list five notable surprises.
The popularity of core
I have been surprised, along with many others, at how popular core real estate has remained in the face of cap rates that are now matching or below cap rate records set at the height of the last cycle in 2007. There is serious danger of rapid value erosion if cap rates decompress as they did in 2008 and 2009.
One of the rationales that does make sense when buying core assets at these low cap rates is that spreads are at historic highs over 10-year treasuries and interest rates face no upward pressure due to a moribund economy that shows no sign of returning to normal growth and an accommodative Fed. In addition, one might argue that NOIs are generally expected to increase. I expect core properties will remain in high demand despite nosebleed prices.
Relative paucity of distress
Though I predicted it at the onset of the downturn, I’m still somewhat surprised that there has not been more distressed selling by now. Lenders and borrowers, aided by historically low rates, accommodative regulation (no mark-to-market) and more experienced players (having learned from the real estate downturn of the early 1990s) have averted a rapid fire sale and are making this a long, slow-motion picture. Moreover, values of many core properties have come up significantly, giving further impetus to “pretend and extend.”
Though I called a robust rebound in multifamily fundamentals in 2009, the strength of the rebound is surprising. I predicted strong multifamily fundamentals because of large numbers of homeowner defections (including foreclosures), the high cost of home ownership, labor mobility favoring renting and massive Echo Boomer demographics creating millions of additional households over the next decade. Fundamentals continue to be favorable with strong rent growth and low vacancies, particular in metros with strong job growth. I expect 2013 will begin to see the start of the erosion of some of these favorable fundamentals as some markets will begin to be oversupplied.
Very low supply
Though I have been documenting this for quite some time, I am still surprised by the low level of supply for all sectors except for multifamily. Supply was below historical levels (as measured as a percentage of existing stock) through most of the last decade, but fell off a cliff at the start of the Great Recession. Since the onset of the recession, supply levels are at a fraction of their long-term historical levels with no sign of attaining those levels, again with the exception of multifamily. Lenders are reluctant to lend to most developers, particularly on speculative projects in secondary and tertiary markets. Supply of new office is so low that it matches levels not seen in the U.S. since the late 19th century when we were just a fraction of our current size. Even if the economy stages a miraculous resurgence, I don’t expect supply levels to revert to historical levels. This low supply is a unique feature of this real estate recovery (as opposed to all past recoveries) and has helped to bolster fundamentals and is behind the fairly quick recovery in commercial real estate fundamentals despite anemic demand factors.
Nodes of economic and real estate vibrancy
Not every aspect of the economy is gloomy. I am surprised that there are bright spots in the economy. I am surprised at the strength in the knowledge industries (tech, bio-tech and engineering) as well as energy, media, education, agriculture, and mining. Most of these industries are concentrated in the top six to eight global gateway cities, and that’s part of the reason why these metros are seeing a strong rebound in capital values, rents and occupancies.
The U.S. has suffered in some ways from being increasingly exposed to brutal global competition, but in these industries, which are characterized by a high degree of value-added labor and capital input, the U.S. competes very well and, in fact, a larger global market has facilitated the growth and success of these sectors. These industries require high skills and education.
Interestingly Americans with higher skills (those with a Bachelors degree or higher as a proxy) are faring much better in the job market (4.2 percent unemployment rate) and have an unemployment rate far below the national average of 8.3 percent. Those with lower skill levels have an unemployment rate in the mid-teens.
Dr. David Lynn is CEO and Founder of Lynn Capital Management and Portfolio Manager of the LCM Total Return Fund.