Bill Gross Thumbs Nose at Bond Market

Last week Bill Gross, who runs the world's largest bond fund at Pacific Investment Management Co., sold all government related U.S. debt from PIMCO's $237 billion Total Return Fund.  You may be thinking, "Why is this tidbit of news important to us?"  Good question.  When someone who is as knowledgeable about the bond market as Mr. Gross decides to get out of U.S. bonds there's a good chance that something signficant is about to happen.  Gross is betting that the discontinuation of the Federal Reserve's Quantitative Easing program (QE2) in June will have a negative overall impact on the bond market. 

Let's back up for a minute and explain some things.  QE2 is the Federal Reserve program of buying U.S. government debt instruments for the purpose of stimulating the economy.  In a period of only 28 months the Federal Reserve has become the largest owner of U.S. Treasury Bonds ($972 billion as of December) surpassing both China and Japan who took decades to accumulate their bond holdings.  Yesterday, Mr. Bernanke, Chairman of the Federal Reserve confirmed that the Fed will discontinue QE2 as planned by the end of June.

Bill Gross wonders when the Fed stops buying bonds who will take their place?  The Federal Reserve is currently buying $75 billion in U.S. bonds a month.  That's a huge amount.  So what will be the impact when the Fed stops buying?  It all goes back to the law of supply and demand.  If the supply of U.S. treasuries remains the same but the #1 buyer of bonds is no longer buying, in order to get others to absorb the excess supply the market will demand a higher rate of return.  It's as simple as that.  Gross believes that the current interest rate on 10 year treasuries is at least 100 basis points below the historical average.

If Mr. Gross is correct the logical result will be a significant rise in interest rates and it should happen before the end of this year.  If true this could have a dramatic impact on the commercial real estate market.  Rising rates would require a re-adjustment in cap rates upward to offset the decline in investment returns due to higher interest rates.   

Years ago there was a TV ad by investment banking firm E.F. Hutton.  The ad shows an E.F. Hutton fiancial advisor about to give confidential investment advice to his client in a crowded, noisy room.  Before the advisor speaks the crowd stops talking and leans their ear to hear what he has to say.  The ad ends with the slogan, "When E.F. Hutton speaks people listen."  Mr. Gross has just spoken and his actions speak loud and clear.  Are we wise enough to follow his lead is the only question?  
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On a totally different note, treasury rates have plunged in the last few days.  The 10 Year Treasury rate at this moment is 3.20%, down 55 basis points since January.  On the surface this flies in the face of what is being predicted by Mr. Gross.  In reality this substantial dip in rates is being caused by the crisis in Japan.  Japan's stock market, has plunged 16% in the last couple of days and investors are taking their money out of their stock market and putting it into the safest investment they know: U.S. Treasurys.  How ironic.   

Sources: Gross Sees Trouble Ahead for Treasurys, The Oregonian, March 15, 2011; Pimco's Bet Against Treasurys Not Working (So Far), Wall Street Journal, March 15, 2011; Federal Reserve Enters Final Lap of Easing Policy, National Journal by Clifford Marks, March 15, 2011. 

A Picture's Worth a 1,000 Words

By Doug Marshall

I recently came across the following U.S. employment chart which got my attention and should get yours too. 

The chart shows U.S. employment growth by decade from 1940 through 2010.  Every decade from the 1940s through the 1990s showed positive job growth of at least 20 percent.  But the decade from 2000 to 2009 showed negative job growth.   In other words the Great Recession we are currently coming out of has wiped out all employment growth that has occurred during the past decade.  Yikes!  The chart also shows that we've had some employment growth last year and if it continues through the end of the decade at the same pace it would increase employment by 8.7%.

As revealing as that chart is, more important to us is the employment growth rate in the state of Oregon.  Does it follow the national trend or does it chart its own course?  As much as we like to pride ourselves that Oregon travels to the beat of a different drummer when it comes to employment growth over the past decade we follow the exact same drum beat as the national economy. 

Last week I had the opportunity to hear Tom Potiowsky, the State of Oregon Economist, at the Sperry Van Ness Economic Forum indicate that our current level of employment of about 1.6 million jobs is about where we were in January of 2000.  So Oregon is in the exact same situation as the national economy: no net new job growth during the past decade.  At the peak of employment, which occurred in the first quarter of 2008, Oregon had about 140,000 more jobs than it does today.  

Maybe more revealing is the following chart that compares this recession with previous recessions since World War II.  This graph shows the number of months it took for each recession to return to its peak employment.  For most recessions it took between 12 and 24 months for employment numbers to bounce back to pre-recession levels. 

Only the 1980 and 2001 recessions took longer, 86 months and 51 months respectively. The Great Recession of 2008 is currently in its 34 month and it is forecasted to rival the 1980 recession in length.

Why is this important to commercial real estate professionals?  Until the Oregon economy begins adding new jobs commercial real estate (with the exception of apartments) will be, for all intents and purposes, in the doldrums.  Employment growth fuels increases in office occupancy rates, it increases demand for industrial output and spurs retail sales.  They are all directly affected by job growth.  If Tom Pitiowsky's forecast for returning to pre-recession employment levels is accurate we have another 3 to 4 years to weather this economic storm. 

2010 Transaction Activity

By Doug Marshall, CCIM

Tanya Williamson in my office went through the laborious task of tabulating all of the transaction activity for the past five years.  Below is the criteria she used in compiling the data:

• Source - CoStar Group database
• Investment sales activity only, no owner occupied
• Property types included Office, Flex, Industrial, Retail, Mixed-Use and Multi-Family
• Transactions with a sales price of $1,000,000 or greater
• Arms length transactions only
• Properties were located along the I-5 corridor from Kelso, WA to Eugene, OR including Bend, OR

Based on this criteria, the annual transaction activity for the last 5 years is shown below:

As you can see, transaction activity for 2010 was slightly less than 2009, a decline of about 9% over the prior year.  Substantially more dramatic is the 65% decline in the number of transactions since the 2007 peak.  The good news is that it appears that we have leveled off and maybe we will actually see an increase in sales activity this year. 

As you can see from the graph below, multi-family properties closely followed by retail properties make up the bulk of the sales in 2010.  Combined these property types total 67% of all sales transactions last year.

The last tidbit we can glean from the data is the transaction broker representation.

Of the 153 sales transactions in 2010:

• 54% had both the buyer & seller represented by a real estate broker
• 27% had no buyer's broker
• 17% had no brokers involved for either the buyer or the seller
• 2% had no listing broker

That's the news from Lake Woebegone!  Let's hope that the market has bottomed out and 2011 will see a substantial increase in sales activity. 

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.