Canadian Market Ups & Downs: Expect the Unexpected

Downtown Toronto astonished market watchers around the world when demand spiked in the wake of the devastating 2008 recession. At the time, 4.5 msf of office supply was under development, demand was expected to tank and vacancy was heading for the mid-teens. Instead, absorption reached an average of 330,000 sq. ft. per quarter between late 2009 and 2012, driven by surprisingly insatiable financial sector demand. By midway through 2013, vacancy had plummeted to 4.1 percent.

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U.S. Employment Update: January Jumble

U.S. employment growth remained weak in January 2014 as the economy added only 113,000 jobs, the second-smallest increase in the past 18 months. Only December 2013 experienced slower employment growth when just 75,000 jobs were added.

This back-to-back weakness follows six months when the average gain was slightly more than 200,000 per month, suggesting that the slowdown has been caused by bad weather in December and January rather than by a fundamental economic slowdown. An important positive point in the report was the significant upward revision in employment growth in both October and November, which are now estimated to have added an additional 70,000 jobs.

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The Lexicon of the European market changes

In a sure sign of a significant improvement in the outlook, the lexicon of the European market place has changed over the past year.

We still have “austerity” and “deleveraging” to cope with of course and “bad banks” are also still with us – albeit now more likely to be a specifically designated institution rather than a definition for the whole sector.

However in a sign of progress federal “deficit” gave way to federal “deadlock” and that now looks to be changing to federal “fudge”.  More notably, as the eurozone recession has ended and property values and activity have stabilized, “confidence” has clearly seeped back, and in some cases flooded back, into the system.

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Transformational Changes Occurring in Lower Manhattan Retail Landscape

New York City Manhattan

Change is constant in New York and retail is no exception.  Perhaps there’s no better example of a changing retail landscape than Lower Manhattan.  Once considered a business address and little else, Lower Manhattan has become a desirable place to live, work and visit.  The residential population has exploded over the last 10 years, tourist volumes are way up, and the number of hotel rooms available and in the development pipeline has grown dramatically.  Add to these changes an ever-diversifying employment base and you have all of the ingredients for a vibrant, growing 24/7 environment ripe for a retail renaissance.

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Defining Creative Space

Trying to follow a trend that isn’t clearly defined is challenging. We’ve read about the tech boom for a couple of years now and all the catchy names that have cropped up to delineate tech areas in numerous cities; however, the questions remain: Who is the creative user? What is the creative office? How do we predict the future of creative space?

First, we must look at the user. Traditional office users in industries such as finance, insurance, real estate and legal, with a few exceptions, are unlikely to move out of the high rise to a vintage low rise with exposed brick or an industrial building with 14 foot ceilings. These industries are steeped in history and generally have stricter dress codes and prefer to be located in structured, traditional office space.

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Global Economic Update: Improving Sentiment

Global Economic UpdateAs we enter the home stretch for 2013, indicators of business and consumer sentiment reflect growing optimism that 2014 will be a better year than 2013 in every region. In Europe, the transition from recession to recovery continues with mixed results depending on the country.

In the Asia/Pacific region both Japan and China continue to show improvement with signs of stronger manufacturing and, in Japan, healthy growth in consumer spending. The U.S. saw consumer confidence drop amidst other signs of continuing slow growth, however, this reflects the impact of the Government shutdown and should be reversed in the current month.

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Increased development in the industrial sector – E-commerce is a huge driver for big-box space.

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.

Can today’s buildings support tomorrow’s work environment?

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.

Building Momentum in Europe

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.

Growth Returns to Europe

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.