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UNDERSTANDING CURRENT ECONOMIC INDICATORS AND THEIR IMPACT UPON COMMERCIAL INVESTMENT REAL ESTATE February 28, 2012
The relationship between various economic indicators and their impact upon commercial real estate investments can be complex. It helps to understand these relationships with a an illustration of Commercial Real Estate Drivers.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Let s start with analyzing consumers.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Although it has rebounded from the decline last summer, overall consumer sentiment remains fairly weak compared to prior levels.
Why isn t current consumer confidence higher?
Overall unemployment remains high, especially for lower educated workers. Construction workers have been particularly hard hit during the most recent downturn.
The overhang of the housing market decline remains a significant drag on our economy as national home prices have declined to a post economic bubble low.
Consumer confidence impacts consumer expenditures. In the U.S. consumer expenditures account for approximately 70% of total economic output (as measured by GDP).
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Retail sales continue to show steady growth as and are now up 20.7% from the bottom, and now 6.1% above the pre-recession peak, which is a positive sign for our economy.
The U. S. Federal Reserve monetary policy has also a significant impact upon total economic. Their goal is to provide economic stimulus but not so much that higher inflation becomes a problem.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Over the past year, the median CPI rose 2.4%, and core PCE (excluding food and energy) increased 1.85%. These measures show inflation is still above the Fed's 2.0% target.
Although year-over-year inflation has trended higher, the Fed has continued to maintain a highly simulative monetary policy, resulting in exceptionally low interest rate levels. Their stated policy is to keep rates low through late 2014.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
During their most recent meeting on Jan. 23rd, the Federal Reserve Bank directors stated that they expected only moderate growth over the coming quarters. The directors remain concerned about the elevated rate of unemployment. They also cited the downside risks posed by ongoing uncertainty about global financial markets. With the expectations of stable longerterm inflation, the directors recommended that the current primary credit rate be maintained.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
The Federal Funds Rate (the interest rate which banks with surplus balances lend to banks in need of funds) remains at historically low levels - this is positive for economic growth.
It s important to understand the impact that low interest rates have upon the overall economy.
The Yield Curve is the relationship between interest rates for shorter term 3 month treasury bills and longer term treasury bonds. The curve is normal, which is a positive sign.
The TED spread is the difference between interbank (LIBOR) loan rates and 3 month treasury bills. It has trended downward, indicating that the risk of bank loan defaults is considered to be decreasing, another positive sign.
Commercial lending to fuel business growth has been increasing but remains below prior peak levels, as banks continue to deal with problem loans in their portfolios.
What impact has increased consumer expenditures and low interest rates had upon the U.S. economy?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Real gross domestic product, the output of goods and services produced by labor and property in the U.S., increased at an annual rate of 2.8 percent in 4Q-2011. GDP has now grown for 10 consecutive quarters and appears to be accelerating.
The Conference Board s January LEI indicates improving economic conditions for early 2012. The positive outlook for the U.S. is at odds with a global economy that is losing steam.
So if the Fed is keeping rates historically low to stimulate our economy and the supply of capital to fund business growth is increasing, what impact has this had upon corporate profits?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Corporate profits are currently at record high levels.
Over time, profitable business owners will expand their workforce if they are confident that prospects for revenue growth can be sustained.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
In the 4Q-2011 Grant Thornton survey, U.S. business leaders have indicated an increased optimism about the future U.S. economy, business growth and their hiring expectations another positive sign.
Now let s examine the current U.S. employment situation?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
The impact of employment losses during the recent recession remain much worst than during any other post-war recovery period. The delay in hiring and the slow recovery is a result of the housing bust and resulting financial crisis.
Total U.S. employment continues to recover slowly with positive year-over-year gains through January 2012 but there are still 12.8 million unemployed workers (8.3%).
Let s examine the impact that the slow employment recovery is having upon the commercial real estate markets? Let s start with office-using employment demand.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Office-using demand in the U.S. also continues to recover led by an increase in the Professional & Business Services sector.
Overall U.S. office markets are at a cyclical trough and are beginning to recover.
What are the trends with industrial-using demand?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Economic activity in the industrial-using manufacturing sector expanded in January for the 30th consecutive month
Industrial markets across the U.S. are in the early recovery phase as absorption trends are tied closely to GDP growth.
Adults aged 25-65 choose where to live primarily for employment related reasons. Therefore, employment growth fuels population growth and household formations.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Household formations declined during the recession but have trended upward again a positive sign for residential demand.
What are the trends with multifamily residential demand?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
With a fragile labor market recovery and a weak housing market, post recession homeownership rates continue to decline as renter households have increased substantially.
Apartment markets are having a strong recovery but rising rents are attracting construction capital and many markets will enter the expansion phase within the next 12-months.
More workers with jobs creates more disposable income.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Real disposable income levels have increased since the recession ended but the growth trends have been very moderate.
Finally, what impact does household formations and disposable income have upon hospitality and retail markets?
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
Domestic and international travel had a big boost coming out of the recession and hotel demand is expected to continue to increase but a more moderate levels.
Hotel markets across the U.S. are mostly in the mid-to-late recovery phase with a few entering the expansion phase.
Commercial Real Estate Cycle Consumer Confidence Consumer Expenditures Inflation GDP Output Interest Rates Federal Monetary Policy Corporate Profits Business Confidence Employment Growth Leading Indicator Office Population Growth Industrial Coincident Indicator Lagging Indicator Residential Disposable Income Hospitality CRE Retail
All retail sales segments are now expanding but housing related purchases continue to lag.
Retail occupancies are improving, especially for national chains as most U.S. markets are in the early recovery phase.
Conclusions Consumer spending has recovered, which contributes to positive economic growth. Corporate profits are strong, capital for business expansion is increasing and business optimism has returned. Market fundamentals indicate moderate price inflation longer term. Interest rates are expected to remain near historic lows for the foreseeable future as the economy continues to recover.
Outlook for Commercial Real Estate Barring an economic shock, indicators are pointing to a continued slow recovery, leading to increasing real estate demand in all sectors. Investment performance by market and property type will continue to be very uneven. Except for apartments, there will be limited new construction over the next 12-18 months. Credit markets have recovered and capital availability has become more plentiful again.
Economic Base Analysis
1-Mar-12 2
Economic Base Analysis Two types of employment Basic jobs - export goods and/or services and import dollars ( export sector ) Non-basic jobs - services only the local economy (internal consumption) - support sector 1-Mar-12 3
Economic Base Analysis Objectives Identify basic employers and/or Industries Forecast change in the basic employment Forecast change in the total employment & income Forecast change in the population GROWTH! 1-Mar-12 4
Economic Base Analysis Total Population Total Employment Basic Employment Changing basic employment FORCES changes in total employment and total population. 1-Mar-12 5
Economic Base Analysis Process A. Current Economic Base 1. Identify the economic base categories 2. Estimate basic employment 3. Determine total employment and calculate the EBM 4. Determine total population and calculate the PER 1-Mar-12 6
Economic Base Analysis Process B. Future Economic Base 1. Estimate the future basic employment 2. Multiply future basic employment by the EBM to estimate future total employment 3. Multiply future total employment by the PER to estimate future total population Total Employment Basic Employment = EBM Total Population Total Employment = PER 1-Mar-12 7
Calculating The LQ LQ is a statistical index method of comparing the local economy to the national economy e = LOCAL employment in industry X as a proportion of TOTAL LOCAL employment. E = NATIONAL employment in industry X as a proportion of TOTAL NATIONAL employment. 1-Mar-12 LQ = e / E 8
Interpreting The LQ LQ > 1 - Industry is part of community s economic base LQ = 1 - Industry is not part of the community s economic base LQ < 1 - Industry is not part of the community s economic base 1-Mar-12 9
Calculating Basic Employees LQ - 1 LQ = percentage of employees in category that are basic Total employees in category x percentage of employees that are basic Basic employees in category 1-Mar-12 10
Population Employment Ratio Formula Total population Total Employment = Population Employment Ratio (PER) 1-Mar-12 11
Future Economic Base 1. Estimate future basic employment 2. Multiply future basic employment by the EBM to forecast future total employment 3. Multiply total employment by PER to forecast total population 1-Mar-12 12
Additional Considerations EBA forecasts future conditions for industry categories starting from a snapshot But, also would like to know Current strength of the economy Recent trends of those strengths How competitive specific industries are relative to their counterparts in other regions Any fundamental weaknesses in the economic base industries This brings us to 1-Mar-12 13
Shift-share Analysis Examines relative market strengths Identifies successful vs. weak businesses Measures how well a business category has performed relative to national businesses Gives institutional investors the ability to choose markets in which to invest Explains why local growth might vary from the national average. 3 1-Mar-12 14
Shift-share Analysis Theory: A community s actual employment growth (AG) over time is explained by National growth trends (NG) in general The community s industry mix share effect (IM) The community s regional employment shifts (RS) Formula: AG = NG + IM + RS Assumption: National Growth (NG) is the base line starting point Questions to ask If AG is > or < NG Is the community s industry mix (IM) more, or less, concentrated in fast growing companies? Is there a reg l shift (RS) to or from the community? 1-Mar-12 15
Determining Stabilized Vacancy Rate - Forecasting Vacancy Rates - Calculating Absorption
Market Equilibrium Market equilibrium is a point in time during a market cycle in which rents neither rise or fall. The vacancy rate at that point of supply & demand balance is the stabilized vacancy rate.
Stabilized Vacancy Rate What is the typical range of stabilized vacancy rates? It varies substantially by market and by property type. Multifamily Residential 3% to 7% Retail 6% to 10% Industrial 6% to 10% Office 8% to 12% Hotel 30% to 35% We can determine a range of stabilized vacancy rates by examining changes in market rents and occupancies over time.
Determining Stabilized Vacancy Rate Example #1 The stabilized vacancy rate for this market ranges from 3.0% to 5.1%
Forecasting Vacancy Rates Steps: 1. Using Economic Base Analysis, forecast changes for employment, population, household formations, and retail sales. 2. Estimate future demand for households (Units), retail space (GLA), office space (RSF) or industrial space (SF). 3. Estimate future supply for the appropriate property type based upon new construction (pipeline) and demolitions (drain) during the forecast period. 4. Calculate the forecasted vacancy rate.
Forecasting Vacancy Rates Example # 2 Given: 35,228 current total employment in the workforce 16,775 basic jobs currently in the workforce 275 new basic jobs added to the market 22% of workforce are office using employees occupying 1,743,750 RSF of office space Calculate: EBM = 35,228/16,775 = 2.10 16,775 + 275 additional basic jobs = 17,050 future basic jobs Future basic jobs 17,050 x 2.10 EBM = 35,805 future total employment 35,805 future total employment x 22% office using jobs = 7,877 future office employees
Vacancy Rate Example # 2 Continued 1,743,750 current occupied office RSF / 7,750 current office jobs = 225 RSF per office employee [ Ratio] 7,877 future office employment x 225 RSF per employee = 1,772,325 RSF future office occupancy [Future ] Given: 1,937,500 RSF is current office inventory with an additional 100,000 RSF in the pipeline to be delivered during forecast period 1,937,500 current RSF + 100,000 new RSF = 2,037,500 RSF [Future Supply] (Future Supply Future ) / Future Supply = Forecasted Vacancy Rate (2,037,500 1,772,325) / 2,037,500 = 265,175 / 2,037,500 = 13.0%
Forecasting Vacancy Rates Example # 3 Given: 35,228 current total employment and 35,805 future total employment in the workforce (from example #2) 92,843 current total population living in the market area 1,250 non-household persons currently in the market area 2.85 persons per household on average in the market area 30% of all households occupy rental apartments [Tenure] Calculate: Current population non-household population = 92,843 1,250 = 91,593 current household population Current population-to-employment ratio [PER] = 91,593 / 35,228 = 2.60
Vacancy Rate Example # 3 Continued 35,805 future employees x 2.60 PER = 93,093 future household population 93,093 future HH population / 2.85 persons per HH = 32,664 future households 32,664 future households x 30% tenure = 9,799 future apartment households [Future ] 10,100 units is current apartment inventory with an additional 250 units in the pipeline to be delivered during forecast period 10,100 current units + 250 new units = 10,350 units [Future Supply] (Future Supply Future ) / Future Supply = Forecasted Vacancy Rate (10,350 9,799) / 10,350 = 551 / 10,350 = 5.3%
Absorption Absorption is the amount of inventory (units or square feet) within a market area that become occupied during a specific time period. It is usually measured over a period of 1 year but can also measured on a monthly or quarterly basis. It is typically expressed as a total number of units or SF but can also be expressed as a rate based upon total inventory.
Absorption Formula The formula used to calculate absorption is: EOY occupied units - BOY occupied units Absorption units The same formula is used for both market and specific building calculations.
Calculating Absorption Example # 4 Building Name Rent able Area Available Space Ashland Park 8,990 2,000 Batesburg Office Complex 7,665 1,000 Bonham Center 6,000 0 Boyd Building 75,000 75,000 Carlisle Offices 8,500 1,980 Dutch Center 93,566 9,238 Executive One Center 20,000 1,000 Hampton Street 13,000 1,000 Sylvan Building 15,000 2,100 Windsor Commercial Park 26,960 1,100 Answer: 215,360 EOY occupied -180,263 BOY occupied 35,097 Absorption 274,681 94,418 = 180,263 Assume that the above data is for BOY. If at EOY, the occupied space has increased to 215,360 SF what is the absorption?