Cushman & Wakefield: Global Real Estate

The U.S. industrial market continued to show momentum with strong leasing velocity and absorption, as well as construction levels that have already surpassed last year’s total. The overall vacancy rate fell to 8.2% in the third quarter, 300 bps below its recessionary peak in the first quarter of 2010. The U.S. industrial sector has now absorbed 279.3 million square feet of space since year-end 2011 and the last three years from 2011-2013 will go down as the strongest period on record for net absorption.

While location has long been the most prominent driving force in real estate, e-commerce is redefining the meaning of “ideal location” for a fulfillment center. As retailers attack the “last mile” issue, the trend in technology is affecting the demand for warehouse space – not only in the amount of space, but also the location of the facilities. To meet demands being driven by e-commerce, technology and transportation costs, companies are actively streamlining their fulfillment processes – maximizing efficiencies in inventory, service time and delivery – which is driving demand for high-quality space. With next-day delivery required and same-day delivery becoming more popular, e-commerce fulfillment centers must be close to population centers.

In response to this new demand driver, we are seeing a significant amount of new development projects that are either exclusively or significantly catering to e-fulfillment—both e-commerce-only retailers like Amazon and multi-channel retailers such as Walmart, Target and others seeking to expand their e-commerce business. This year, Walmart signed a 1.2-msf deal in Lehigh Valley and another 788,000 square feet in Dallas. Nordstrom previously said its Iowa Distribution Center had abundant capacity – but now the chain is in the market looking for a new fulfillment center to support its e-commerce operations.

New industrial construction levels continue to rise, including a significant amount of speculative product. This trend is expected to remain , especially in port and intermodal markets. Construction completions totaled 60.0 msf through the third quarter, already surpassing 2012’s year-end total of 58.0 msf.  An additional 21.7 msf of speculative development is scheduled to be completed by year-end. The Inland Empire leads the nation in construction activity at the end of the third quarter, with 16.4 msf currently in development, followed by the Pennsylvania I-81/I-78 Corridor, with 8.3 msf.

The global economy is also having a profound effect on the location of distribution centers. The cities that are especially well-positioned to attract new distribution projects are those that link to the global economy through ports and airports.  Additionally, the expansion of the Panama Canal, set for completion in 2015, is already affecting distribution warehouse site selection. Container shipments are projected to increase tremendously at U.S. East Coast ports and  expansion of the Panama Canal could be a game changer for South Florida industrial real estate. Miami, which handles more traffic from Asia than any other Florida port, still gets 54% of its trade from Latin America and the Caribbean compared to 18% from China. Florida’s location is unique in the U.S. because of its position for east-west and north-south trade.

There is a coming crisis in many markets: the changing occupier needs can no longer be adequately supported by the majority of the already-built inventory. A review of the class A office buildings across the central business districts of Boston, New York, Washington DC, Chicago, Los Angeles and San Francisco reveals that over 53% of class A buildings in those markets were constructed prior to 1980. That’s 30-plus years ago! While many of these buildings have undergone renovations to modernize their infrastructure, today’s occupiers are working very differently than even five years ago. Corporations have clear goals from their workplace and they are focused on productivity, efficiency, flexibility and cost. Oh, and social responsibility as well! Occupiers are looking to do more with less and many corporations, through the use of technology that allows for remote work, open floor plate designs to provide collaboration, or built-to-suit projects, are increasing the per person density in their portfolios. This means that even though their businesses are growing they will need less space- some even as much as 20% less.

Many owners do not fully grasp the significance of these changes and what they may mean for their properties. They do not understand that these new requirements are firmly rooted in corporate real estate strategy and are here to stay. Owners, particularly those in markets with technology, life science, or finance concentrations, need to assess whether the buildings they own can support the new ways of working. Does a building have the infrastructure in place to handle higher densities? Can occupiers maximize space loss factors within the floor plates? Does the building have the right amenity mix to support a 24/7 work environment? Those properties that can’t address these issues may require significantly more capital investment than anticipated and run the risk of becoming uncompetitive, or even functionally obsolete.

Europe’s early summer gains appear to be consolidating as we head towards the run in to year-end, with August seeing a 3.3% increase in the EU’s Economic Sentiment Indicator and a near 12% increase on the year.

What is more this is broadly based: 22 out of the EU’s 28 countries saw a step up on the quarter while business surveys reported an improvement in production, orders and expectations. Consumer surveys surprised even more markedly on the upside, standing at their highest for over 2 years.

While these changes are from a low base and are still uneven, it does appear that some real momentum is building and, indeed, spreading, with even Europe’s “troubled fringe” seeing some measure of a bounce.

This firmer sentiment is also being mirrored in the property sector and values have responded, with prime yields/cap rates coming under pressure to fall and prime rents stabilizing or edging up.

Of course, activity in much of the market is still volatile and often constrained by limited levels of supply. Particularly for occupiers this may be slow to change, with construction indicators still weak in many areas, but even here the outlook is brightening, with more markets now improving than declining.

At the same time, more demand will emerge in the remainder of the year, with businesses and investors turning their thoughts away from merely surviving to shaping their strategy for the future.  Certainly among occupiers a lot of this activity will remain as much defensive as expansionary and we should also expect more business failures as banks relax support for the walking wounded. Among investors, strong interest in prime assets is still underpinning demand, but a spreading of interest beyond just the core is becoming more notable as more buyers get comfortable again with risk.

Overall therefore, the tide does appear to be turning and doing so quite quickly. As a result occupiers may need to assess their opportunities in today’s market more rapidly than they might have expected while investors will have to expand their horizons to access stock but at the same time must be realistic on pricing. They also of course need to stay tuned in to the risks that still persist due to debt imbalances and global geopolitics but which also now include market reactions to the end of QE and the normalisation of interest rates that will start at some point.

euro zone gdp

Last week, we talked about signs of stability in Europe. This week, we got even better news: Gross domestic product (GDP) for the 17 countries that use the euro as their currency increased at a 1.2% annual rate in the second quarter of 2013, the first increase in the region’s GDP since the third quarter of 2011. In addition, other European nations that do not use the euro, notably the United Kingdom, also recorded solid economic growth in the second quarter. The preliminary data for July in Europe and the U.S. were generally positive. Finally, in Asia, Japan’s second quarter GDP grew at a slower pace than in the first quarter.

The key economic statistics released this week included:

       •       Eurozone GDP grew at a 1.2% annual rate in the second quarter of 2013. This is the first quarter of growth since the third quarter of 2011, and the strongest growth in more than two years. The strongest economies in the region were Germany, where GDP expanded at a 2.8% annual rate and the United Kingdom, with 2.4% annually rated GDP growth. France, which had seen its GDP decline in three of the previous four quarters, recorded a 2.0% annual rate of growth.  

       •       Other European economic data released during the week were generally positive. In the U.K., employment data for the second quarter were also positive, as the nation added 69,000 jobs in the quarter and 330,000 from a year ago. July retail sales in the U.K. also increased sharply, up 1.1% for the month, as unusually warm weather boosted spending. In Germany, investor confidence increased in August, as measured by the ZEW indicator of economic sentiment. Finally, Eurozone industrial production surged 0.7% in June, led by a strong increase in German output.

       •       It’s not all positive in Europe, however. The industrial sector of Spain recorded a steep drop in orders in June, and French employment fell in the second quarter.

       •       Outside Europe, the U.S. economy saw continuing steady growth in retail sales and flat industrial production. But labor markets continue to improve as unemployment claims hit a near 6-year low.

The key story of the week is the mounting evidence of recovery in Europe. It now appears likely that most European nations will see their economies expand during the second half of 2013 and in 2014. This is a positive for the entire global economy. The 27 nations that make up the European Community are the largest economic bloc in the world, with a total GDP of approximately $17 trillion in 2012 (compared with $16.2 trillion in the U.S.). These nations are a critical component of global demand, and weakness in Europe has dampened demand for goods and services throughout the developing and developed world.  

In the U.S., for example, exports to the European Union fell steeply during the 2007-2009 recession, recovered in 2010, but fell again last year and are still well below their pre-recession level. Recovery in Europe will boost economic activity throughout the world.

However, we need to be cautious before declaring an end to the economic troubles in Europe. Although the larger economies expanded in the second quarter, the southern tier nations — Spain, Italy, and Greece — remain weak and fragile. Italy contracted in the second quarter, and, while there is no GDP data for Spain or Greece yet, other statistics suggest it is unlikely that these nations expanded in the spring. Further deterioration in these countries and/or new sovereign debt issues in any of the Eurozone nations could slow or reverse the nascent recovery. The recovery is not yet firmly entrenched and could be reversed in the event of another shock, financial or otherwise.

In addition, Germany, the largest economy in Europe, will hold Parliamentary elections on September 22. The current German government has been an important supporter of the current supportive policy of the Eurozone. If a new government is elected that is less inclined to support the current approach to the sovereign debt issue, it could be the kind of shock that would reverse the Eurozone recovery.

Conclusions. As we noted last week, the second half of 2013 is shaping up to be better than the first, as the global economy transitions to a stronger growth pace in 2014. Growth in Europe is a key piece to the 2014 story, and this week’s data suggest that is likely.

There are still significant risks in Europe and in the global economy overall. The major economies of the world are not yet robust enough to withstand a major shock. The events in the Middle East this week show us that those shocks can occur anywhere, at any time.

But for now, the data continue to support the cautious optimism that has been our fundamental position on the U.S. and global economies throughout 2013.

The biggest news in last Friday’s U.S. employment report wasn’t the stronger-than-expected 195,000 person increase in non-farm payrolls; it was the healthy upward revision of the data for April and May.  Job growth in April, first reported as +165,000 jobs, is now estimated at +199,000 and May’s increase was revised from +175,000 to +195,000.  The average increase in employment over the first six months of 2013 was 202,000 jobs per month, making this the best first half of the year since 2005.

•Employment in the key office-using sectors – financial, professional and business services, and information – increased by 65,000 jobs in June. Over the first half of the year, employment in office-using industries has increased an average of 77,000 jobs per month, the strongest six-month period since late 2005. Office-using employment is now within 235,000 of its pre-recession peak.  Among the three office-using sectors, the strongest growth, by far, has been in professional and business services, where employment today is well above pre-recession levels. •The unemployment rate remained unchanged at 7.6% as the number of unemployed persons rose for the second consecutive month. Significantly, the U-6 unemployment rate, which includes discouraged workers and those working part time because they cannot find full time work increased from 13.8% to 14.3%, suggesting that discouraged workers may be coming back into the labor force.  Another positive indicator is the share of the unemployed who left their job – an indicator of confidence in the labor market. In June 8.8% of the unemployed left their jobs, the largest share since December 2008.

The U.S. economy continues to generate jobs at a healthy, if unspectacular pace. The good news is the private sector continues to grow in the face of significant headwinds from the ongoing fiscal drag (higher taxes and Federal spending sequestration). This suggests that as the impact of the fiscal drag diminishes later this year the economy will be poised to grow even more strongly.  The bad news is that the fiscal cliff part II is still in front of us. The Federal Government is currently expected to reach the debt ceiling some time in the fall and the possibility of another debate over how to address the long term debt challenges faced by the U.S. will increase uncertainty and hold back growth.

The improvement in economic conditions that this report and other recent indicators point to has led to anxiety in financial markets, particularly the bond market, that the Federal Reserve will start to reduce its purchases of long term bonds. This concern has driven long term bond rates up sharply over the last two months, with the U.S. 10-year note yield rising from 1.66% in early May to 2.52% currently.  The healthy employment growth over the past six months is an important factor encouraging the Fed that the economy is improving steadily and will not require the continuing stimulus of massive bond market purchases.

As the economy improves, interest rates will rise. The good news is, the reason for the increase is a healthier economy and that is good for everyone.

It’s finally time to start talking about interest rates again. For the past five years interest rates have not even been in the economic conversation. But recent events in Europe, Asia and the US have brought interest rates and the interest rate policies of central banks around the world back to the forefront. Rising interest rates in the US will have an impact on the real estate sector most immediately in investment markets.

• In Asia, the efforts to stimulate growth via bond purchases in Japan-one part of the set of policies that have been dubbed “Abenomics” after Prime Minister Shinzo Abe-has led to increased volatility in equity and currency markets and more importantly appears to be having a positive impact on Japan’s economy which grew more strongly than expected in the first quarter of the year.
• In the US, recent indications by the Federal Reserve that it may start winding down it’s bond purchase program later this year has caused interest rates to abruptly increase leading to wide gyrations in equity markets and is forcing businesses and investors to start thinking about a world in which interest rates are no longer held artificially low.
• In Europe, the European Central Bank (ECB) dropped the interbank lending rate to a record low in May to counter continuing economic weakness. Economic improvement in Europe is likely to take more time to fully emerge.

For most of the past five years, official interest rates have been held at or near record low levels as central banks in the developed nations sought to counter first the most severe recession since the Great Depression and then the weakest recovery on record. Market driven interest rates, particularly for 10-year government bonds have trended lower. But it wasn’t until 2011, when the Federal Reserve began to aggressively purchase long term bonds that long term interest rates in the US, followed by the UK and Australia, began to decline substantially. In China long term interest rates have held steady at between 3.5% and 4.5% as the government first sought to stimulate during the recession but quickly switched to a more restrictive policy as growth accelerated and fear of inflation increased. In the Euro Zone it was in mid-2012 that ECB President Mario Draghi told the world that he will do “whatever it takes” to preserve the Euro and support the nations in the currency union. Since then long term interest rates in Europe have moved sharply lower.

After all these years of low short term interest rates with longer term rates trending lower, the environment has shifted in the last six weeks or so. That’s when the Federal Reserve fist mentioned the possibility of reducing the amount of long term securities purchases (Treasury bonds and Mortgage securities). Since then, US interest rates have spiked higher. Long term treasuries are up from approximately 1.60% to 2.40%. This has caused long term bond rates to move higher in just about every major economy throughout Europe and even in Japan and led to an increase in volatility in global equity markets.

We are now in uncharted territory. After unprecedented and unorthodox policies were initiated to address the most challenging economic conditions in decades, financial markets are now facing uncertainty about how those policies will be unwound or how much longer they will stay in place. The first country to be facing these questions appears to be the US where the Federal Reserve is signaling that US economic growth is likely to get stronger and the risks to growth are diminishing. How the Fed will ultimately unwind its massive easing and the impact that will have on the economy are not clear. Higher interest rates could threaten growth and could make investors shift their strategy away from fixed income and other yield driven investments. However, the underlying reason for the potential shift is an improving economy and the Fed has been very clear that it will not raise rates prematurely and that it will continue to monitor economic performance and ease off if the economy appears to be faltering. The result is likely to be choppy investment markets but an improving underlying economy.

Elsewhere in the world, different monetary policy challenges are occurring.

• In Europe, while there is some optimism that economic conditions will not deteriorate further, meaningful growth is unlikely until later this year. So the ECB is unlikely to make any changes in its policy for the foreseeable future. European financial markets will not be immune to volatility elsewhere in the world, but the challenges posed by the continuing weakness in the regional economy and the continuing debate/discussion about financial, banking and economic integration will likely result in a basically stable interest rate environment.
• In Asia, the Bank of Japan is most likely to continue buying securities to keep rates low as the government continues to move ahead with other policy measures designed to stimulate growth. In China, slower growth (note “slow” in China means 7%) will likely lead to stable interest rates in the near term as the government balances the need to keep the economy growing while at the same time trying to keep inflation from accelerating.

For the real estate sector, the most direct impact of higher interest rates in the US will be on investment markets. It is unclear how investment markets will react to an increase in interest rates. While they will tend to make some investors reassess their strategy, the improvement in leasing fundamentals that accompanies these changes can make properties more attractive.

For the first time in many years, interest rates are an important factor in the economy and in global investment markets. There is likely to be some turmoil in financial markets and in real estate investment markets as the adjustment takes place, especially because the Fed has never embarked on this program before. But the reason the Fed is shifting and the reason that rates are likely to rise in the future is that the US economy is in much better shape and is growing more strongly. From a leasing perspective, this means employment is rising and demand for space is likely increasing as well. Stronger economic growth in the US will benefit the global economy. US demand for goods and services across the world will accelerate helping to boost economies in Europe and Asia. Each region has its own challenges and opportunities and a stronger US economy by itself cannot carry the rest of the world, but it will be an important support for the global economy.

The emerging new interest rate environment will create challenges and there will be bumps in the road. But stronger economic growth will enable global financial and real estate markets to absorb the changes in fixed income markets that are coming in the US.

Despite a slow start to the year in U.S. office market fundamentals, construction activity has returned in the Northeast.  From Central New Jersey to Portland, Maine, new construction has reemerged, particularly in the major markets of Manhattan and Boston.  Nearly 38 percent of the 48.0 million square feet (msf) currently under construction in U.S. markets are located in the Northeast.  The Northeast represents nearly one-quarter of the total U.S. office stock (4.8 billion square feet) tracked by Cushman & Wakefield.

In 2008, U.S. office construction completions totaled 49.6 msf, which was the highest level of new construction completed since 2000.  The Northeast comprised 5.1 msf of this figure, just over 10 percent.  Over the past two years momentum has increased in the northeast with nearly 3.5 msf of new office space completed which was 63 percent pre-leased.   Most of this construction took place in the markets of Boston, New Jersey and Stamford.  Boston Properties, Mack Cali and Building & Land Technology represent some of the projects’ developers.  During the first quarter of 2013, three build-to-suits were delivered totaling just 320,000 square feet (sf) in New Jersey and Long Island.  However, through the balance of 2013, another 6.6 msf will be completed.  Nearly half of the construction to be completed this year is comprised of One World Trade Center being developed by The Port Authority of NY/NJ and the Durst Organization which is 55 percent preleased to Conde Nast, China Center and, the U.S. General Services Administration.

Of the nearly 18 msf of space currently under construction in the northeast corridor, 40 percent has been preleased.  The 2013 development pipeline represents 2 percent of the existing inventory in the northeast.  Some of the more significant projects under way are listed below with Manhattan comprising most of the space under construction (66%), followed by Boston (24%), Central and Northern New Jersey (7%) and Upstate New York (2%).

In total, there is an existing pipeline, including the 18 msf currently under construction, totaling 25.6 msf which is 33% committed to by tenants.   These are properties which are either under way or have the proper approvals in place to begin construction and are slated for delivery up to and including December 2016.  Ninety-three percent of these properties are located in the major markets of Manhattan and Boston.

The sluggish recovery lingers, and the new standard for most commercial real estate investments is lower returns.  Still, compared to stocks, bonds or cash, commercial real estate remains an attractive investment. RERC’s latest survey reports that ,on a scale of 1 to 10 (with 10 being the highest), commercial real estate scored a 6.7, the highest investment rating among investment alternatives at year-end 2012.

Although commercial real estate continues to be a good investment, to get a better sense of its true performance, it helps to look at some actual math behind this statement.  A good way to do this is by looking at the risk-adjusted metric (RAR Metric) that RERC produces. This is a metric that ranks property types based on their NCREIF returns relative to their standard deviations.

Although the apartment sector continues perform well, with an RAR metric near the top of the list, the sector is losing some of the momentum it had in 2011 and 2012, when the 1-year returns were notably higher than the other sectors.  This is likely due to stringent mortgage underwriting, which is keeping some potential buyers on the sidelines despite low interest rates.

The regional mall and neighborhood-community centers, as well as the industrial warehouse and R&D sectors currently have the same RAR Metric, while the office and hotel sectors round out the bottom of the list, as they did for the last half of 2012.  Adding to the strain of these two property sectors are the stubbornly high unemployment rate which is hindering small business growth.

Examining RERC’s RAR metric, it’s apparent that no property sector stands out more than any other from an investment perspective. This infers that a property-level study that incorporates a well-supported appraisal and a thoughtful and through accompanying analysis is essential to complete a successful property acquisition. And although market fundamentals continue to improve, as does appreciation, economic challenges continue to remain a threat to the commercial real estate investment market community in 2013.  An in-depth analysis of the market is the best way for investors to navigate through these times.

Jim Morrissey
Americas Regional Research Director, MD | New York | Americas Operations
Research, Valuation & Advisory

Developers are now in a race to build the next new addition to the San Francisco skyline. Over the past two years, strong tenant demand, especially from technology firms like Salesforce, Square and Twitter, has propelled San Francisco to outperform much of the US and global market. Vacancy rates have fallen below the 10% mark, the first time the rate has dipped that low since prior to the recession; rent growth has been robust, increasing more than 45% in the past two years.  Now, for the first time since 2008, developers have broken ground on projects that will have major impacts on the San Francisco market for years to come.

Before this focus on new construction, the influx of technology firms began to impact the local market with renovations of older buildings throughout the city. In 2011, the renovation began on 680 Folsom Street, formerly occupied by Pacific Bell, into a steel and glass building, as well as the renovation of the San Francisco Furniture Mart into the Twitter Building, which has become an  anchor in the city’s booming Mid-Market technology hub. The success of these high-profile renovations, along with the strong market, encouraged other owners and developers to begin transforming even more of the city’s older buildings into modern, open, technology-friendly spaces. Today, 2.6 million square feet of office space is currently being renovated. This includes notable renovations at 140 New Montgomery and 888 Brannan Street.

Alongside this focus on renovation, tight market conditions and rents approaching replacement cost levels have also spurred interest in constructing new buildings from the ground up.  In July 2012, Tishman Speyer began construction on Foundry Square III (505 Howard Street), the last remaining open site of the four properties that comprised the four-building Foundry Square “urban campus” development.  The developer jumped to take advantage of market conditions even ahead of lining up an anchor tenant and construction is underway with completion slated for the first quarter of 2014.  The owners of 350 Mission were set to begin construction around the same time as Foundry Square III, but at the last minute called an audible and rather than begin construction on the site, they sold it to Kilroy Realty in October 2012. Two months later, Kilroy lined up Salesforce to lease the entire building before the construction even began on the project, which is expected to come online in 2015.  The third building currently under way is Boston Properties’ development of 307,000 sf at 535 Mission.  Like Foundry Square III, this building is also under construction without a signed anchor tenant.  In total, more than 1.0 million square feet is presently under construction in San Francisco.

Developers are queued up to build an additional 2.4 msf during the next three to four years, including the Transbay Tower that will add 1.4 msf to the City’s skyline in 2016.  Tishman Speyer is also ready to start construction on another building at 222 Second Street.  In total, 6.1 msf of new space is expected to come online throughout San Francisco through 2016 of which 45% will be renovated space.  So far about 35% of it has been pre-leased.  Fortunately, San Francisco is projected to have strong employment growth of 2.7% per year during the next three years, far outpacing the U.S. average of 1.9%, which bodes well for the leasing of these new buildings.  Even with the higher levels of new construction expected over the next few years, we project the vacancy rate will stay below the 10% threshold with rent growth averaging 7.5% per year through 2016.

Caroline Green

Managing Director – Capital Markets | Northern California

Research