Trend Czar

Dead

"If you're in (commercial) real estate you are either depressed or have nothing to do."

"Every level of activity has stopped--debt is worth more than equity, there is no financing available, nobody is doing deals."

"It's dead."

"I've never seen anything like it."

Groups have been forming for months--many months--to do workouts and specialized asset management assignments--conservatively there's at least $100 billion in troubled real estate investments out there needing attention.

But despite all the TARP, stress tests, and Fed infusions banks and other institutions haven't been forced to write off and liquidate bad assets--everybody is still afraid to recognize market values because it might be just too much of a shock to the system... So we are in this period of languid calm where nothing can get done.

At least, transactions seem to be slowly picking up in the housing markets because banks are finally selling foreclosed properties. That's at least a sign of what's to come in the commercial world, but we're probably months away--at least through the summer and maybe not until next year.

It's frustrating, stultifying, dispiriting. Well, dead probably sums it up best.

Looking for signs

I want to see the green shoots, some hopeful signs that the economy is getting better. At this point the stock market is no better than a casino--nobody invests for the long-term anymore. It's all betting short-term. Recent run-ups don't express any enduring confidence, and the gains over the past few months seem more along the lines of profiting off overly beat up sectors like the forlorn financials.

The Main Street vibe isn't particularly good. In Las Vegas last week, the cab drivers said business isn't getting any better. Indeed, the casino action was inappropriately sedate. Plenty of people ambled along the strip but many were sight seeing not going to shows, playing the tables, or shopping. The free stuff like the Treasure Island pirate show and the Bellagio fountain music drew big crowds. At the Bellagio, room rates dropped under 200 bucks a night for a non-high roller with a little negotiation.

I got a call last week from somebody else losing a job at an architecture firm... And there was the story about someone embarrassed over having their credit cards refused in front of their daughter.
Gasoline prices are headed up again and we haven't hit the prime summer driving season just yet. For people out of work or trying to makes ends meet with less, higher driving costs make life that much tougher.

In Manhattan, the for rent signs in empty storefronts have proliferated since the beginning of spring. Another dress shop went belly-up around the corner last week.

The landscape design guy says he is surprisingly busy--people figure they won't be cashing out of their homes real soon so they might as well make the yards look better.

At least at the Mom and Pop IGA in the beach community, the shelves are getting stocked again after a spare winter when the line of credit was reduced. The next three months until Labor Day mean everything...

And while the economy hasn't emerged from its winter, summer has arrived, and there's nothing wrong with that.         

Viva Las Vegas and ICSC

Attendance was down at ICSC—“back to normal” before the transaction mania of the last few years, according to one convention veteran. But Mike Kercheval, ICSC president and CEO, pointed out that the Monday lunch set a record—“maybe that’s because it’s free,” he told the 3,000 plus in the Hilton ballroom. They probably wanted to hear Sam Zell who had a good story about how a monkey drove a bus over a cliff, while everybody else was partying (drinking, smoking dope, and lewd behavior) in the back—his apt parody of the market collapse.  He wondered why everyone was so surprised at what happened and blamed bad psychology for making things worse, in particular bemoaning sharp declines in REIT prices. He didn’t mention how he sold Equity Office just before the monkey headed off the cliff or his misplay buying into the newspaper industry (Tribune Company) with some of those profits.

In the end ICSC is mostly about transactions—buying, selling, and leasing, and attendees have been struggling mightily to do any deal making. It was a feast and now it’s a famine thanks to the credit market gridlock. People mostly wanted to know when the recession would end—Zell predicted housing markets would bottom in the summer as normal population growth pushes demand and eats into homebuilder inventories. And Mark Zandi, the Moody’s economist, pegged October for the economic bottom.

In my session on “New Realities = New Trends”, I talked about the ten trends that point to more restrained living standards over the next generation—between now and 2040. It was a sobering talk about how deleveraging from high debt, an aging population, rising taxes, and global competition would combine for more restrained lifestyles and less consumption in the future. It wasn’t the type of message people wanted to hear at shopping center industry convention. One guy apparently left saying “Now I can slit my wrists.”

Although I had a full house at the presentation, my room was a fraction of the size of a concurrent panel headlined by my old Equitable Real Estate colleagues Kieran Quinn and Mike McNamara. Their session was titled “Finding Money in the Capital Market Chaos.”

At ICSC, everyone was trying to figure out how to find the next bus.

PS: Many thanks to architect Ron Altoon, shopping center strategist Jeff Green, Midway Companies CEO Brad Freels, and Retail Property Solutions principal Beverly Ricks for participating in my session.             

See you in Las Vegas

If you're heading out to Las Vegas for the annual ICSC RECON meeting, I'll be speaking on Monday afternoon 2:30-4 pm, headlining the session New Realities=New Trends. I plan to highlight the ten trends I think will change how we live, work and shop in America over the next generation. In addition, Jeff Green, Ron Altoon, Beverly Ricks and Brad Freels will be on my panel engaging in what I think will be an illuminating discussion. So please join us at the Las Vegas Convention Center.
 
The last time I was out to Sin City was more than 18 months ago when the markets were just starting to turn. I was presenting Emerging Trends at the ULI Fall Meeting. The strip was still running and gunning, but I told the audience that all signs pointed to a major fall for this hot growth city. The construction mania was obviously out of hand. In fact, I amplified on that prediction shortly after in one of my first TrendCzar blogs back in November 2007.
 
This Monday's session will take a more long-term view. I think the country is in for dramatic change. We need to climb out of our significant debt hole--that won't be easy. We are aging rapidly and becoming ethnically more diverse. Our suburbs are urbanizing and we need to become more efficient in our lifestyles as energy prices escalate and congestion increases around our most important gateway cities. Convenience to work and shopping will take precedence over larger homes for many people. Technology will continue to slow growth in retail and office property sectors despite the fact we will be adding 100 million people between now and 2040. It all adds up to living less large, needing to save more, and probably shopping less.
 
Find out more. Hope to see you on Monday.

Aging more rapidly

We've been anticipating for the last decade or more how the United States population will be aging. I remember back in the mid 1990s when investment advisors were all getting on the bandwagon to develop or acquire senior residences and adult communities. There was a bit of a building binge and developers got way ahead of themselves. But the gray tide of baby boomers finally will start to gain momentum over the next decade.

According to census data, approximately 55 million Americans are aged 60 or over today. That's about 8 million more than in 2000. But by 2020, we'll have about 75 million in the 60 plus crowd and in 2030 that number will escalate to about 90 million. So in a little more than 20 years we will be adding 35 million seniors to our ranks.

Meanwhile, the number of young people--20 and under--won't be growing nearly as fast.  We've been in a bit of rut since 2000--the number of younger Americans stands at about 83 million, a few million more than at the beginning of the decade. That number should increase to 90 million by 2020 and 98 million by 2030.

So in the course of 25 years, we will have shifted from a country where there were nearly twice as many 20-and-youngers as 60-and-overs to a situation where there are almost has many seniors as youngers.

Don't scrap playgrounds and elementary schools. But it's almost time to start installing more ramps and rails.      

The real costs of T-I allowances

A sinking American office market raises questions about the impact and value of tenant improvement allowances to owners and investors. In a note to me, a veteran portfolio manager suggests shifting the T-I burden to tenants--the industry practice in most other world markets. He argues that would reduce future volatility and buffer U.S. office investors in the next cycle from the severity of losses they now face in today's tailspin. Leasing brokers probably will take issue since this shift would impact commission volumes and tenant moves, and my correspondent would prefer that I not use his name to maintain good relations with them. But his arguments are worth considering. Here is his analysis:       

Contrary to much of the rest of the world, U.S. office practice is landlords fund a substantial portion of tenant improvement costs.  The allowance is generally less for lease renewals than for new leases, and the allowance is greater for longer lease terms than for shorter ones, and more for strong credit tenants than weak ones.  It is not uncommon for landlords to amortize significant amounts of "above market" allowances as additional rent at an above market interest rate, say 8 or even 10%.  When cap rates are lower than the interest rate there is an arbitrage that puts money in the owner's pocket on valuation or sale.

Typically, the T-I allowance shrinks in tight markets and expands in soft markets. In really soft markets, allowances can approach "turn key" and in combination with other concessions such as free rent, moving allowances, lease pick-ups, and above-market broker commissions, it is not uncommon for the net present value of a lease to turn negative, sometimes by as much as several dollars per sq. ft. per annum.  Why would a landlord do this?  Well, fixed operating expenses can easily run from $8-20 per sf per annum, so even if the lease is a net loser, it at least diminishes the carrying cost of fixed expenses on vacant space.  Thus the sayings, "no honor in vacancy" and "just make the deal".

But landlord T-I allowances contribute to the extreme volatility of office sector returns and associated risks compared to other sectors--warehouses, apartments and retail which are much less capital intensive (in the retail sector, the tenant pays for most if not all of the fit-out).  In a down economy, not only do office rents and associated net operating income decline, but concessions and capital expenditures also increase, whipsawing cash flows.  One could argue that even the best quality, optimally located office building in a top tier U.S. city is not really a "core" investment due to the exaggerated effect that capital expenditures have on yields throughout the cycle.  Yet, people tend to think of Class A office assets in the top eight MSAs as the epitome of core investments.

Now, the current down market presents formidable hurdles to accepted practice regarding landlord T-I allowances.  Owners are hanging on for dear life having gone "long asset" and "short liabilities" for any properties acquired in the 2005-2007 timeframe.  Their ability to meet debt service obligations (even at current historically low floating rates) is in jeopardy as interest reserves crumble in the face of declining rents and increased T-I allowances and free rent concessions, not to mention the prospect of having to pay down debt at maturity.  In many cases, equity has been wiped out completely and they are just hoping and praying the world changes.  How then, can they possibly manage the increased T-I allowances expected by the market?

Maybe it is time for a broad-based campaign (admittedly in the face of market forces and accepted practice) to shift the T-I burden to tenants. That's how markets operate in most of the rest of the world. What would be the benefits?

• Volatility of financial performance (and associated risk/return characteristics) of the office sector would be drastically reduced.  Office properties could then exhibit truly core characteristics for top quality properties in the better markets. 
• The true cost of an office move would be better accounted for in the market.  It is likely that fewer tenants would be inclined to move if responsible for the full cost of fit-outs.  As a result, more tenants stay put, further dampening office sector volatility. 
• The office sector would be "greener".  While LEEDS Gold and Platinum interiors are laudable, there is nothing more sustainable than utilizing your in-place improvements for a longer period of time.

Who would be the possible losers?

• The construction/building materials industries would not like the drop-off in activity that might result from tenants moving around less frequently.
• Leasing brokers would be similarly affected with lower overall leasing activity.  Lease renewals typically pay lower commissions and tenants' brokers might lose influence in the market. 
• In some cases, leasing brokers get paid commissions based on "gross rents" that are exaggerated because they include an amortization of landlord tenant improvement costs.  These might be scaled back somewhat.

That might be a small price to pay for a less volatile and more sustainable future for the office sector.

Living standards ebb

Swine (sorry pork producers) flu may be abating at least for now, the stress tests don't break bankers into too much of a sweat, and the car companies will survive, if barely (did we have any doubts?). A few U.S. companies scramble to make solar panels but we ceded most of that product's manufacturing overseas in the 1990s. And the market here remains suspect. There are wind turbines, but the whole wind energy thing hasn't gotten off the ground yet. Some people (mostly in West Virginia ) pin their hopes for electricity production on the ludicrous proposition of "clean coal." The President talks about bringing back securitization with proper regulation (in the New York Times Magazine), but the new world order for the financial industry likely means restrictions which will reduce transaction volumes and the fees that go with them. Whether we get health care reform or not, doctors complain they can't make a living. The web is wiping out newspapers and magazines, while shrinking other media companies. And many of the other jobs in our country are brokers, accountants, lawyers and various intermediaries, which feed off of transactions and benefit from complicated tax codes which normal people can't understand and which actually create considerable inefficiencies.

Competing economies, meanwhile, can produce what we do for less (much less)--workers' compensation and benefits, space costs increase in places like China, Brazil and India, but are far below here in the U.S.

It's not a pretty picture especially when you consider that many people, companies, and of course our banks are up to their necks in credit problems.

The long-term trend lines suggest that the vaunted American standard of living is in for unavoidable decline unless we produce something that the rest of the world needs, wants, and can't produce itself. The car companies have been the leading edge of this unfortunate turn. We've had an advantage on the tech and bio tech fronts, but its eroding as many of our brightest went to Wall Street instead of into engineering and medical fields. And financial acumen of the sort that created our recent debacle won't be in great demand over the near term.

We'll start to see a long overdue shift in graduate degrees away from finance, business and law into science, tech and engineering. But will the rigor improve enough in our public school systems to feed demand for the high caliber demand required in science and tech fields? In the meantime, the jobs outlook appears less than robust unless you can latch onto some government contract work in defense or infrastructure. As a result, there won't be a big rush to fill empty office space or push up housing prices--once we reach a bottom.

But it could be worse--you could be in the travel agency business, specializing in vacation packages to Mexico.