Job Stagnation Should Prompt Property Sector Risk Assessment

August’s job report confirmed our position that the economy entered a period of stagnation a few months back and continues to struggle through the cloud of uncertainty.  As I mentioned in the past two blogs addressing the current state of the economy and commercial real estate, the most likely outlook calls for a prolonged stagnation or moderate economic contraction as opposed to a repeat of the free fall in 2008-09. I also voiced concern about the heightened risk and vulnerability to another shock and the importance of factoring all this into investment performance expectations in the short to mid term. However, the macro drivers that make investing in commercial real estate in this environment favorable remain intact even with August’s disappointing job report for several reasons.

For starters, it seems companies are being cautious in their hiring but they are not panicking. Consumers are being careful but they are not pulling back on spending in a pattern that would resemble a “total fear” status. Data readings are likely to get worse before they get better but the notion of hoards of tenants giving space back, declaring bankruptcy or simply going dark does not seem to be a threat around the corner. If anything, commercial property markets have stabilized, some are in recovery and may stagnate as a mirror image of the stall in job growth.

August’s volatile economic ride and its subsequent rattling of the consumer’s psyche did not generally disrupt commercial property deal pipelines. Some larger transactions that had not gone under contract were pushed back a bit, most of which involved foreign buyers, but unlike various periods in 2008 and 2009, there is no panic on behalf of buyers and lenders. If anything, there is increasing anecdotal evidence that commercial property capital flows and transaction activity will increase for three major reasons: 1) Historically low interest rates, locked in before the eventual improvement in property fundamentals, provide a major advantage for investors. 2) The stabilization, and in many cases, rise in values is enabling many owners to sell assets they otherwise could not dispose of in the past 18 months to 24 months. More properties that don’t fit a long-term portfolio strategy or the owners’ situation or needs can now be upgraded through a trade or simply sold. 3) Volatility in the stock market and financial markets in general bodes well for commercial real estate as a hard asset without the threat of over-building any time soon, and an asset class that has clearly reached the bottom in terms of fundamentals. The Dow Jones Industrial Average had the most 400-point-plus swings in August on record, and September is off to being the one of the worst months in equities markets globally. Commercial real estate has emerged as competitive investment alternative with a 4% to 6% yield range for lower risk, high-quality assets; 6% to 7% yields on average properties; and 7.5% to 8.5% yield for lower-grade but not junk assets.

Within commercial real estate the risk/reward spectrum continues to evolve. Apartments, the clear leader in the recovery, will continue to outperform thanks to renter demand that has expanded beyond the simple link to job growth. Unlike every other commercial property sector, which has a direct-demand correlation with net job creation within a few months’ lag, apartments are benefiting from favorable baseline demographics, release of pent up demand, weakness in the for-sale housing market, falling home ownership and lack of new supply. The pace of absorption is certainly due to cool off further and job growth still matters, but the overall trend of improving occupancies and rent growth, albeit slower, should continue for the foreseeable future. Apartments have registered price gains and cap rate re-compression as a result, especially at the top tier of the market. Therefore, the apartment sector is clearly the lower-risk, lower-return choice; however, it should be noted that Class B and B- properties in primary and secondary markets have not experienced same run up in values as the Class A segment and still offer attractive returns, especially with a value-add component.

Retail, which stabilized and began to improve faster than most projections, is currently the most vulnerable of all property types given its direct link to consumer sentiment and exposure to small tenants whose finances and access to capital have not improved much. If job stagnation turns into losses and if the political gridlock does not ease, consumers are likely to retrench further and put new pressure on smaller to mid-sized retailers. It should be noted that core retail sales, excluding auto and gas, were up 6.5% in July over last year, which is a surprisingly strong indicator pointing to consumer resilience. However, the first cracks could show up in the back-to-school shopping season which unfortunately coincided with Hurricane Irene and the Washington, D.C.- and EU-induced bout of uncertainty. Core, neighborhood, community centers, Class A malls and discount retailers are bound to show continued improvement since the new construction pipeline has come to a virtual standstill but investors need to be mindful of shaking consumer confidence.

We will share our latest views on the office and industrial sectors in our next blog.

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.