Office Market is Showing Signs of Life

One of the best barometers of an improving economy is reflected by a positive trend in office vacancy. As reported January 4, 2011 by the Wall Street Journal, the fourth quarter of 2010 was the first quarter since the end of 2007 that office properties in the U.S. registered an increase in occupied space (see chart below).



Other important tidbits from the article:

• Business vacated 138 million SF of office space between January 2008 and September 2010.


• The national office vacancy rate is 17.6%.


• Nationally, 2.5 million SF (net) were absorbed in the fourth quarter of 2010 after having negative absorption for the previous 11 consecutive quarters.

Portland is following the national trend, so says Gordon King of Collier's International. Mr. King is probably the closest thing we have to a "resident expert" when it comes to the Portland office market. In a recent conversation with me he had these interesting tidbits about Portland:

• Last year the Portland MSA had 600,000 SF of net absorption of office space, two-thirds of which occurred in the 4th quarter.


• The vacancy rate for the overall Portland market is in the 15% range with the downtown core being the lowest at 8% and th suburb office market the highest at around the mid- to high-20% range.


• Rents have not yet stabilized but the rate of decline is slowing. Mr. King estimates that rental rates will decline another 5% before bottoming out.


• In order to get the office vacancy rate in the 7 to 8% range, which is considered a stabilized market, 3,000,000 SF of office space would need to be absorbed. Assuming net absorption of 800,000 SF annually, it will take about 3 to 4 years to achieve a stabilized market.

The Portland office market is showing signs of improvement though it has a long way to go. However, it's just one more indication that the local economy in on the mend.

Sources: Preliminary Q4 Trends Announcement, ReisReports; Fresh Signs of Life in Office Market, Wall Street Journal, January 4, 2011; Light at the End of the Tunnel (It's Not Another Train), Ted Jones Blog, January 6, 2011.

My Crystal Ball Forecast for 2011 Commercial Real Estate

Doug Marshall, CCIM
Market Assesment


Back in December I asked my reading audience to give their opinions about what the commercial real estate market would look like in 2011.

I was pleasantly surprised by the number of people who responded. Thank you. Generally those who responded had similar thinking about the coming year as I did. So here goes:

· It’s the economy stupid! Everything hinges on what the economy ends up doing. The good news is that the economy is on the upswing. I know it doesn’t feel that way but the economy is on the rebound, albeit ever so slowly.

Believe it or not, we have had five consecutive quarters of positive growth in the GDP averaging just under 3% annually. Job growth is a different matter. There has been virtually no real improvement in the unemployment rate during this time period, currently stuck at 9.8% nationally.

The recent compromise tax bill maintaining the Bush era tax rates for another two years and lowering the payroll tax by 2 percent will have a positive impact on the economy. So I’m expecting a modest improvement in the overall economy by the end of the year.

· Rising interest rates. No one expects interest rates to stay at the current level. We are all predicting them to rise, the only question is how much. If they rise gradually over time we’ll be OK. If they rise dramatically over a short period of time, like they did from early October through mid December of 2010, it will shut down our industry until real estate prices adjust to the higher rates.

The consensus is that rates will rise slowly. Let’s hope we’re right. The alternative would be disastrous

· Will there be more lenders in the market? Yes. Absolutely. And their rates will be more competitive too. I am beginning to see this especially for apartment financing. I get calls from lenders saying that they plan to dramatically increase their loan volume in 2011 and asking what they need to do with their rates and terms to get more deals.

I also see a few lenders getting back in the retail side of the market. Lenders are showing more interest but underwriting will continue to be difficult. I think there will be more lenders in the market as their balance sheets improve. We are not over the banking crisis but we are beginning to see a light at the end of the tunnel.

· What property types will show increased sales in 2011 over the prior year? Everyone agrees there will be increased sales transactions in 2011. That’s probably because to be in commercial real estate you have to be a cockeyed optimist!

However there wasn’t a consensus as to which property types will show the most improvement. This is my take: I believe all property types except for land and hotels will show improved sales activity this year.

However for most property types, office, retail and industrial, the properties that are distressed with blood in the water will be in demand and those that are strong credit tenant properties will also be in demand. Everything in between will likely have very little sales activity.

Lenders have shown little appetite for properties that have any “hair” on them whatsoever, i.e., high vacancy, rental rates trending down, short lease terms, etc. Apartments, being the exception will do fine regardless of size, condition, and location as there are several lenders wanting to finance apartments with more recently coming into the market.

· Where are vacancy rates, concessions and rental rates heading? Improvement in vacancy rates, concessions and rental rates will be dependent on job growth, especially for office and industrial properties. Apartments and retail are less dependent on job growth but they too would show improved demand if the unemployment rate were to dip a bit.

The unemployment rates for Oregon and Washington, 10.6% and 8.9% respectively are not expected to improve significantly this year. At best I think we will see modest improvement in the unemployment rate, but probably not enough to affect real estate values.

· What will cap rates do? I think rising interest rates will stop any fall we might have seen in cap rates due to improving fundamentals and demand. They will counterbalance one another.

I believe it is possible that the top of the line properties may see some improvement in cap rates but all other properties will see either have a flat or slightly rising cap rate during the year.

A special thanks to Mike Baron, Mark Barry, Charles Conrow, Tom Davis, Alan Evans, Tom Hanacek, Cliff Hockley, Steve Morris, Marc Rogers, Dan Rodriguez, and Christian Trandum who gave valuable input for this article.

What’s Going On With Interest Rates?

by Doug Marshall, CCIM
Market Assessment

Over the past 60 days, the yields on 10-year Treasury notes have increased from 2.41% on October 8th to 3.53% as of December 15th, an increase of 1.12%.

What's going on?

Let's begin with a US Bonds 101 class. The 10-year Treasury note has become the security most frequently quoted when discussing the performance of the U.S. government bond market and is used to convey the market's take on longer-term macroeconomic expectations.

All of the marketable Treasury securities are very liquid and are heavily traded on the secondary market. The treasury yield expresses the relationship between the face value of the security and the amount of return the investor receives.

If there are more investors selling bonds then those who are buying bonds, the value of the bond declines (the law of supply and demand). A reduced price on the bond results in an increase in the yield or return on the bond.

Another name for “treasury yield” is “interest rate” which those of us in commercial real estate follow very closely. When US Treasury rates jump up significantly, like they have since early October, it means that investors are dumping their bonds in huge quantities. I can’t recall the last time I’ve seen interest rates jump so dramatically over such a short period of time.

So the $64,000 question is, “Why are bond holders selling off their bonds?” I have surfed the web for an answer to this question and unfortunately there is no agreement among the experts.

Depending on who you like to read there are a variety of answers. But being fearless and little bit stupid I am going to give you my opinion (take it for what it’s worth).

But before I give you my assessment of the situation let me muddy the waters a bit with some conflicting information.

Data released by the Treasury Department yesterday indicated that the Federal Reserve, China and Japan have recently been on a U.S. bond buying binge. The Fed is now owns $972 billion in Treasury holdings which surpasses China’s $906 billion (now the 2nd largest hold of U.S. treasuries).

And with more Quantitative Easing 2 purchases on the horizon it is highly probable that this lead will be greatly extended.

At the very same time, the debt crisis in Europe with what has happened in Greece and Ireland is continuing. Adding to the problem, on Tuesday Moody’s downgraded Spain’s sovereign debt causing further turmoil in the bond market. There is a very real debt crisis going on in Europe which is resulting in European investors transferring their wealth into (you guessed it) U.S. treasuries.

So in recent weeks bond purchases have been exceptionally strong by the major holders of U.S. debt and by the Europeans concerned with their own debt crisis but not nearly enough to offset all the little guys out there who own bonds and who are running scared.

Why are they running scared? There are two reasons that I think make the most sense

1. The Fed’s policy of QE2 is not working as planned. The printing of money by the U.S. Treasury and the purchase of these bonds by The Fed is perceived by the holders of bonds to be inflationary which makes their modest fixed yields less desirable if inflation is going to come roaring back
2. The other issue spooking bondholders that’s surfaced recently is the possible agreement by the Obama administration and Congress about extending the Bush era tax rates for another two years.
   

The compromise between the White House and Republicans included extending employment benefits for another 13 months which combined with extending the existing tax rates will increase the national debt by another trillion dollars. This means the U.S. Treasury will need to issue more bonds to cover the debt.

That being said, I believe that Ben Bernanke will do everything in his power to calm the bond market. What tricks he still has in his bag is anyone’s guess but he will do whatever he can to avoid runaway inflation.

Stay tuned. It’s beginning to get interesting.

Sources:
Fed Surpasses China in Treasury Binge, The Street by Eric Rosenbaum, December 15, 2010;
United States Treasury Securities, Wikipedia;
Bond Prices Fall Sharply after Federal Reserve Says It Will Continue to Boost Economy, The Associated Press, December 14, 2010.

What the heck is Quantitative Easing?

Doug Marshall, CCIM
Market Assessment

If you’ve listened to the news or read a newspaper in recent weeks there is a new buzz phrase being bandied about: Quantitative Easing. So what is it?

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

The Federal Reserve does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by “printing money.” It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.

The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy.

What is the purpose of Quantitative Easing?

The Federal Reserve has been given two mandates:

1. It is charged with ensuring full employment in the United States; and,

2. It is also charged with ensuring price stability. Inflation, in recent months, as measured by the CPI (Consumer Price Index), has declined to almost zero which is well below its target of two percent annually.

The Fed hopes that QE will stimulate the economy and thereby ease unemployment.

The Fed also hopes QE will bring the U.S. closer to its stated long-term inflation target.

The primary risk of QE is that it can spark inflation greater than desired or even hyperinflation. Or it could have no impact whatsoever.

Ben Bernanke, Chairman of the Federal Reserve, may be the “smartest guy in the room” but when he’s tweaking the largest economy in the world it is near impossible to really know what the impact The Fed policies will have on the economy.

What has been the impact of Quantitative Easing so far?

The first round of Quantitative Easing took place at the height of the financial crisis in late 2008 and early 2009. What impact did QE have on the economy and interest rates? Good question. I’m not sure anyone knows for sure.

Just recently the Federal Open Market Committee announced another round of Quantitative Easing called QE2. The Fed plans to purchase over $600 billion of long-dated Treasury securities over a period ending in June 2011.

Economists are debating what impact QE2 will have on interest rates. Ted Jones, PhD, Chief Economist for Stewart Title, says it has already significantly increased interest rates and uses the following table to support his position.

The table details the changes in constant-maturity Treasury rates since August 1, 2010. While rates are still comparably low, they have risen significantly in recent weeks.

As noted below in the table three-year Treasury yields are up 80 percent from the low just two weeks ago while two-year notes are up 60 percent. Even the 30-year Treasury yield has jumped 24+ percent since the end of August.

As convincing as this table is in supporting Dr. Jones’s opinion, I don’t think anyone can know for sure if the recent rise in interest rates can be directly attributed to the announced purchase of $600 billion of treasury securities over the next several months.

It seems to be too sharp of a rise in rates and it happened too quickly after The Fed announcement to be attributed to QE2.

But then again, who am I to disagree with such a distinguished and well qualified expert? We should know though in the next few months whether Dr. Jones is right or not. Let’s hope for all our sakes he’s not.

Sources:
Quantitative Easing by Wikipedia;
Does Quantitative Easing Work in Boosting the Real Ecomony? by Edward Harrison, November 4, 2010;
'Quantitative Easing': What Does It Really Mean for Investors?, Jeff Cox, CNBC.com, August 23, 2010;
Quantitative Easing Already Goosing Interest Rates, Ted Jones, Jones on Real Estate blog, November 14, 2010.

Why Interest Rates Will Rise

Doug Marshall, CCIM
Market Assessment

Shown below is an article written by Ted Jones, PhD who is the Senior Vice President-Chief Economist for Stewart Title Guaranty Company.

Mr. Jones opines about why interest rates will rise in the near term. He predicted back in August that rates would rise 100 basis point increase (1%) before the end of this year!


I wrote last month how a typical Japanese investor that had purchased a two-year Treasury note lost more than 10 percent per year on their investment – see post from September 27th – and that the only way they would keep coming back and buying U.S. Treasury instruments would be an increase (eventually) in interest rates.

Since then at the 17 economic forecast presentations I have given, the issue of rising rates seems to be most contemptuous by the audience. Simply stated, they believe that with no demand for money rates should not rise.

My response is that there is massive demand for money—but not in the typical avenues of home purchases, autos and other durable goods—and that is in record federal deficit financing and corresponding record-trade deficits.

Just look at the article link from the Wall Street Journal on Friday. The August trade deficit approached $50 billion ($46.3 billion to be exact) of which $28 billion was with China (and the $28 billion was an all-time record). Wow.

Add that to a massive Federal deficit in this past fiscal year of $1.3 trillion in 2010 and an a projection of $1.1 trillion in 2011 (that’s the off-budget surplus which reduces the deficit by estimated excess Social Security cash flows—with the 2011 on-budget deficit of $1.154 trillion) and you are looking at almost a couple of trillion of equivalent borrowing. Massive.

Looking at it another way, just contrast the Federal deficit of 2009 through 2011 to total commercial real estate lending in place and total first-lien residential loans in place.

Fannie Mae estimates that as of 2010 first-lien residential lending outstanding is $9.6 trillion and other sources tally total commercial real estate lending at $3.5 trillion. Total Federal deficits in 2009, 2010 and 2011 are estimated to be $1.4 trillion, $1.3 trillion and $1.1 trillion, respectively, for a total of $3.8 trillion.

That means that in just a 36 month period, the Federal government borrowed more money than all of the total commercial real estate loans outstanding. When comparing residential lending, that equates to 40 percent of the amount of the total first-lien lending outstanding on U.S. homes. Now you see that there is significant demand for borrowing.

Now throw in the inflation data contained in the linked Wall Street Journal article, and you might start being a believer in rising rates. Wholesale prices in the past three months jumped 1 percent (and yes—that includes energy and food, but unless you do not eat nor use any energy then that remains the appropriate factor) which annualizes to a potential 4 percent annual wholesale inflation rate.

The Fed released on Friday their expectations on inflation, but do not be surprised if they respond by stating they are going to increase the money supply by printing more money—which in the long run will be inflationary.

And that is my two cents. Or with inflation 2.08 cents……

I hope for all of our sakes that he is wrong about rising interest rates. What impact would a 1% rise in interest rates, over a short 3 month period, do to commercial real estate sales?

My guess is that everything would come to a stop until cap rates adjusted upward. And if you haven’t refinanced your properties, what are you waiting for?