Property Performance to Diverge Further; Job Stagnation Continues

The recent stagnation in jobs and barely positive economic momentum has caused the Obama Administration to take another stab at a more targeted stimuli plan and stirred much speculation about the Fed’s options. While the proposed $450 billion jobs plan outlined by the President last week could add 1.5 million jobs and 1.5 percentage points to economic growth in 2012, it is likely to face many obstacles. The Fed’s primary options are to lower or eliminate the 0.25% interest rates it pays banks for keeping their cash in reserve to encourage more lending and to rotate short-dated Treasury debt in favor of holding more long-term Treasury debt, thereby reducing long-term interest rates even further.

With interest rates already at historic lows, the rate is not the challenge holding back the velocity of capital. Weak loan demand by consumers and businesses still in the midst of de-leveraging, coupled with tight underwriting by cautious lenders, are the major obstacles. This dynamic has improved over the past six months but not nearly to the point of propelling the recovery. Further stimulus and additional measures by the Fed, if implemented, will have a short-term positive effect but will not be sufficient to break the current job trend out of its flat line pattern for some time. Nothing can replace private-sector expansion and corporate innovation, which require some level of economic certainty and confidence.

This undesirable situation is far better than severe job losses, which appear unlikely and provides a baseline expectation of relative stability for commercial real estate property fundamentals. Nevertheless, caution still rules as reflected in the dominance of property sales within the top-tier, best-quality assets in primary markets. As I mentioned in my last blog, apartments, having proven capable of staging a recovery in real demand even with modest job growth, will continue to top the list as the lowest-risk property sector. At the other end of the spectrum, the fragile recovery in retail appears to be the most vulnerable to the recent drop in consumer sentiment, lack of job creation and income stagnation. 

Just as strength and confidence was building among retailers ready to expand and new concepts ready to take form and occupy space, renewed uncertainty is impacting leasing decisions among retailers faster than any other sector. It should be noted that even within the retail property sector, the divergence between well-anchored neighborhood/community centers and Class A malls is quite wide compared to high-vacancy power centers, specialty centers and new developments in outlying areas that took the brunt of the housing overdevelopment. Renewed pressure on small to mid-size retailers that do not benefit from the scale, pricing power and access to cheap capital of larger, multi-market retailers is of particular concern.

At a macro level, office and industrial properties fall somewhere in between the safety of apartments and elevated risk of retail. While corporate profits have recaptured their 2006 peak levels, net absorption of both office and industrial space have been positive for a few quarters and global trade levels have rebounded considerably from their recession trough, space consumption is hampered by an emerging “wait and see” attitude.  However, the regained footing of companies and the economy as a whole reduce the possibility of major space givebacks and sublease space surge. 

Between the two sectors, industrial has once again emerged as the safest choice thanks to its direct correlation to the movement of goods, which has returned to normal levels. An economic stagnation and drop in retail sales would certainly hurt industrial as well but the sheer size of the U.S. economy and normalized trade volumes bode well, even with a minor contraction or prolonged stagnation. From an investment point of view, relatively good quality industrial assets with financially stable tenants trade in the 6.5% to 7.5% cap rate range, offering somewhat of a margin of error against economic risk. Industrial speculative construction has come to a virtual halt and obsolescence is resulting in the removal of a fair volume of stock. Market and specific asset selection naturally rule but these drivers put industrial as the second sector of choice in terms of current risk/reward. 

The best news for office properties is the more than 500,000 business and professional services jobs that were created over the past 12 months. Typically, these levels of job creation would lead to much stronger net absorption than what has been observed over the past year, but this disconnect is a natural result of companies still having too much excess space. Once this space is burned off, a stronger tie between jobs and absorption will emerge but given the stall in job creation, the office recovery is likely to take a break for at least a couple of quarters. From an investment perspective, high quality, well-located office properties are in high demand with values rising and cap rates falling, particularly in CBDs that are in the center of the urban renewal. Suburban office and older B- and C assets have yet to experience a recovery in demand by tenants, buyers and lenders alike. The biggest hold back here – which will not be overcome any time soon – is the weakness among small to mid-sized companies emanating from weak balance sheets and a general lack of confidence. The great divide between the strength of large, multi-national firms and bread-and-butter small to mid-sized office tenants is directly reflected in the performance of Class A and B+ assets vs. everything else.

Investors have much to gain by looking under the surface for B and B- assets in relatively stable geographic areas that may be just outside the core, high-demand locations to find attractive yields, light value-add opportunities and the chance to take advantage of higher yields without entering “junk” territory. Once again, low interest rates and local expertise can provide the safety net that can translate to value creation opportunities. 

Hessam Nadji is managing director, research and advisory services, for Marcus & Millichap Real Estate Investment Services and interim director of the firm’s Institutional Property Advisors division.  Contact him at hessam.nadji@marcusmillichap.com.