Score: Industrial 5, Office 2

I’m struck by the discrepancy in the recent performance of the office and industrial markets. One would expect their recoveries to proceed at roughly the same pace, but the uneven nature of this economic recovery is having an uneven effect on the recovery rates of these two property types.

• The industrial vacancy rate peaked at 10.9 percent in the first quarter of 2010, so the market has been in recovery for four consecutive quarters with the vacancy rate declining by 80 basis points to 10.1 percent during this period.
• The office vacancy rate, by comparison, peaked at 17.9 percent in the first and second quarters of 2010 and has fallen just 20 basis points to 17.7 percent in the fourth quarter of 2010 and the first quarter of 2011. In other words, the office market recovery just about flatlined in the most recent quarter.

The industrial market got an early jump thanks to the inventory rebuilding cycle. Beginning in July 2009, manufacturers began to see their order books increase as companies, which allowed their inventories to dwindle during the recession, were forced to restock. Production and shipments picked up, and absorption of industrial space turned positive in the second quarter of 2010. Demand has remained solid thanks to strong exports, business capital spending and a cautious rebound in consumer spending. The industrial market does not get far out of balance due to the shorter construction timelines for an industrial building (six months +/-) relative to an office building (18 months or more), so the recovery, as measured from the peak vacancy rate to a balanced market, is probably in about the fourth or fifth inning of a nine-inning game.

The office market is heavily dependent on the labor market. Although job growth has picked up in recent months, the improvement has not shown up in absorption of office space, which has been about one-third the rate of a typical office market recovery. This could be due to the normal lag between employment growth and space absorption (rule of thumb is two quarters) and/or to the prodigious amount of shadow supply (empty space still under lease) that built up during the recession. With the economy slowing (first quarter GDP of just 1.8 percent), it will be interesting to see if the labor market has enough momentum to power through the soft patch and propel the office market – only in about the second inning of its recovery cycle – toward equilibrium. The Employment Situation report, to be released this Friday at 8:30 a.m. Eastern by the Bureau of Labor Statistics, will help answer that question.

Late in 2010, economists revised their growth forecasts upward as a result of the tax agreement reached by Congress in the lame-duck session at the end of 2010. This agreement included a two-year extension of the Bush-era tax cuts, a 13-month extension of federal jobless benefits, a temporary cut in the share of the Social Security payroll tax paid by employees and several other provisions. And, right on cue, growth GDP growth climbed to 3.1 percent in the fourth quarter, and other indicators began to point toward a stronger 2011.

However, some economists have been revising their growth forecasts downward in the past few weeks as a result of rising oil prices, global turmoil (eurozone, the Middle East and Japan), persistent weakness in the housing market, and layoffs in state and local governments. While highlighting the fact that no one has a crystal ball, these roller coaster forecasts suggest that the economy is not yet in calm waters, which could impact the pace of recovery for commercial real estate.

Q&A w/B-O-B

Last week I gave two presentations to individual investors, clients of a financial adviser that offers Grubb & Ellis’ healthcare REIT on its platform of investment alternatives. At the last minute, the adviser asked us to yank some slides specific to real estate and focus more broadly on the economy. That left plenty of time for Q&A, which often ends up being almost an afterthought at many presentations, but this time it was a central part of the event.

My colleague Chad Hunt, a wholesaler who represents Grubb in the Upper Midwest, took notes and had me write up my responses afterward. So here they are — my short answers, sometimes more like opinions, to a wide range of questions on the economy. Take what you like and leave the rest, and be sure to let me know if you disagree. Let’s get some discussion going.

Q: Distinction between public versus non-traded REITs

A: Long-term returns are solid for both types of investments with public REITs holding the edge recently, but that comes at a price of greater risk. Publicly traded REITs are volatile like stocks, which also means they are more liquid than non-traded REITs. Non-traded REITs pay a steady dividend in the range of 6-7% with the anticipation of some upside when the properties are sold.

Q. Easy fix for social security?

A. Solutions include: increasing the age for partial benefits from 62 to 63 and full benefits from 67 to 68 for people currently in their 20s or 30s, giving them plenty of lead time to plan; some form of means-testing, i.e. reducing benefits for wealthier recipients; and eliminating the income cap (currently $106,800) above which workers are not taxed for social security.

Q. What drives prices of gold, commodities & oil?

A. Gold prices are driven almost exclusively by speculation, usually related to fears of economic collapse and/or inflation. Short bursts of speculation play a supporting role in prices of energy and commodities, but underlying demand fundamentals related to economic growth play a bigger role over the longer term.

Q. Are municipal bonds in trouble? Meredith Whitney says there will be dozens of significant defaults in the next year or so, shaking investor confidence in muni bonds.

A. Most analysts think that is overdone. Revenues in many states have bottomed and are beginning to grow again, and the same dynamic is in place for municipalities. The exception will be for jurisdictions that have made unwise investments such as Harrisburg, PA (renovation of city’s trash incinerator) and Orange County, CA (dangerous bets on the direction of interest rates in 1994). That said, states and municipalities still must make tough spending cuts to balance their budgets, and some troubled states such as Illinois are having to pay high interest rates to sell their bonds.

Q. Stimulus package: Was it warranted?

A. Economists are split. Some say there is no such thing as a shovel-ready project, so those expenditures didn’t perform as advertised, while funds given to states and municipalities merely postponed the cuts that are being made now. Others, including me, think the program was worth the cost because it helped restore confidence in the global financial system.

Q. If government eliminates Fannie Mae and Freddie Mac, what effect will that have on the housing market?

A. Impacts will include greater use of variable rate mortgages and less reliance on 30-year loans (shifting interest rate risk to borrowers), fewer subprime loans, and less investment in housing overall, which would shift capital to more productive uses. This is probably warranted as government policies resulted in too much capital being allocated to housing, particularly in the last decade. Some analysts believe private issuers and investors will fill most of the gap left by Fannie and Freddie so that the impact on loan terms would be quite manageable for borrowers.

Q. Which types of REITs are strongest?

A. In terms of underlying market fundamentals, apartments and healthcare properties are strongest followed, in order, by industrial, retail and office. The falling homeownership rate and demographics (the boomers’ kids) are driving demand for apartments. Aging boomers and the steady increase in healthcare spending are driving demand for medical office and other healthcare properties. The strong manufacturing sector, weak dollar, exports, business capital spending and a slow but steady recovery in consumer spending are driving demand for industrial properties. Shopping centers are benefiting from the release of pent-up demand that developed during the recession and also continued weak pricing power by retailers. Office properties are expected to recover last because demand is dependent on job growth, which is lagging.

Q. When will businesses stop expecting the government to bail them out?

A. I would argue that they already are. Governments are broke and have no money for handouts.

Q. Will Republicans & Democrats come to an agreement to cut the budget deficit?

A. Yes! … I hope. When push comes to shove, the parties will compromise.

Q. Is there a point of no return as we increase the debt?

A. Probably, but no one knows for sure. We are in mostly uncharted waters with the exception of the debt spike during World War II. Publicly held debt is projected to increase from 59% of GDP in 2010 to 77% by 2020. There is not a specific threshold above which the debt ratio becomes a threat to the stability of the financial system and the economy, but economists generally seem to prefer ratios below 60% and are made nervous by ratios above 80%. Uncomfortably high levels of debt could undermine faith in the dollar, causing investors to shun U.S. Treasuries. This, in turn, could cause interest rates to spike as the Treasury would be forced to offer higher rates, perhaps uncomfortably high, to attract investors willing to finance its debt, which would hurt the economy. Debt levels rise during recessions as tax collections fall and support payments such as unemployment insurance increase – that is normal and desirable. But the long-term rise in the debt-to-GDP ratio even after the economy recovers could pose danger to the financial system and will likely require increased taxes, reduced entitlement spending or a combination of both to return the ratio to a lower, more sustainable level.

Q. Is the government trying to monetize the debt?

A. Not intentionally. The Federal Reserve is trying to “re-flate” the economy by maintaining rock-bottom short-term interest rates and buying hundreds of billions in Treasury debt and mortgage-backed securities to keep long-term rates low (called quantitative easing). Fed officials would like to see inflation return to the range of 1.5 to 2% but will begin raising interest rates if inflation appears to be gaining momentum.

Q. Is inflation measured the same today as it was several years ago?

A. No. In 1999, the Bureau of Labor Statistics adopted a new methodology estimated to reduce the CPI calculation by 0.2 percentage points per year. Click here to view the explanation from the BLS.

Q. Will Internet sales reduce demand for retail space over the long term?

A. It will cause only a modest reduction in the growth of demand for bricks-and-mortar shopping centers, which is fueled by population growth (see below) and the gradual increase in wages. It won’t actually result in a reduction of shopping center space.

Q. When will the housing market recover?

A. Sales will begin to pick up during the spring selling season of 2012. Prices will not recover to their pre-bubble peak for five years or more.

Q. Is the saving rate impacting retail sales?

A. The personal saving rate, which fell below 1% during the bubble years and shot above 8% during the recession, has leveled off in the range of 5-6% while retail sales have been growing lately at a solid year-over-year rate of 7-8%. Consumers have made a reasonable compromise between reducing debt and spending for necessities.

Q. Why are companies sitting on so much cash?

A. Cash and other liquid assets on the balance sheets of nonfinancial businesses totaled a record $1.93 trillion at the end of the third quarter. This equated to 7.4% of their total assets, the highest share since 1959. Companies are stockpiling cash as a buffer against a potential future disruption to the financial sector that might hinder their ability to borrow. A wait-and-see attitude regarding the strength of the economy also is playing a role. When businesses feel more confident in the stability of the financial system and the durability of the recovery, they will begin to expand their payrolls, but not before.

Q. When will banks start lending again?

A. Banks are actively looking for good credits, but they are being much more cautious (rightfully so) than during the bubble years.

Q. Will lack of population growth in the U.S. restrain economic growth?

A. The annual rate of population growth is expected to decline only gradually from .98% in 2010 to .79% in 2050. In absolute numbers, this equates to a gain of 3.021 million in 2010, rising to 3.450 million in 2050. Even as the percentage growth declines, the absolute growth increases because the base upon which the percentage growth is calculated increases every year. Hence, the country will continue to grow, adding to the labor force, generating demand for housing, etc.

Q. If the budget is slashed, will that hurt the economy?

A. Liberal economists answer an emphatic yes while conservative economists say reduced government spending will take the pressure off interest rates, opening the door for more borrowing, spending and investing by private sector companies. Economists call this “crowding out,” when government borrowing to fund the public debt begins to compete with the needs of private borrowers, driving up interest rates. When the economy was in free fall, increased spending via the stimulus, rising unemployment insurance payments, etc. helped stabilize the economy at a time when there was little or no demand from private borrowers (except those desperate to stave off disaster – not the best credits) and thus little or no crowding out. It could become more of a problem as the recovery accelerates. With the recession in the rear view mirror, government spending cuts are unlikely to derail the recovery and could minimize the crowding out effect.

Q. What happens if gas goes to $5 per gallon?

A. It will raise the potential for stagflation – slowing growth coupled with rising inflation – but only if the price stays high over a sustained period of time, say six months or more.

Q. What is the long-term impact of the government printing money?

A. Printing money is one way to describe the Fed’s purchase of hundreds of billions of dollars in government and mortgage-backed bonds, i.e. quantitative easing. I believe the first round had a stabilizing effect on the financial markets at a time when it was sorely needed – late 2008 and early 2009. The second round (QE2) coincided with an upward run in the stock market, which helped ignite stronger economic growth at the end of last year. Many economists are loathe to admit that the Fed’s actions did any good, but I think they helped. Do we need another round of quantitative easing – QE3? Probably not.

Vigilantes?

In Commercial Property Executive, I recently wrote about an intriguing idea put forth by Glen Esnard, the president of Grubb & Ellis’ capital markets practice, and I want to expand upon it here. Glen suggested the following: “From a longer term perspective, look for [commercial real estate] investment capital to flow to those states that optimize the blend of balanced budgets, low taxes… low regulation and business incentives. Businesses and people are more mobile than ever, and intelligent capital will go there first.”

It’s tempting to think that commercial real estate investors might hold the same sway over states and municipalities that bond market vigilantes have with countries, i.e. ready and willing to pull their investment capital from jurisdictions that overtax, overspend and over-regulate. Bond market vigilantes can refuse to buy the debt of certain countries – Greece, Ireland and Portugal come to mind – that don’t balance their budgets, forcing them to pay higher interest rates to borrow compared with better-managed countries such as Germany.

At first blush, this theory doesn’t fit commercial real estate; investors are putting their capital to work in exactly those states with reputations for heavily taxing and regulating their citizens, both residents and businesses. Last year, KBS Realty Advisors paid $651.5 million for the recently completed 300 N. LaSalle, a near-record for Chicago of $500 per square foot. This year, Illinois legislators boosted the corporate tax by 45 percent and the state income tax by 67 percent, prompting several governors to invite Illinois businesses to relocate to their states. Would KBS have reconsidered its purchase had it known what the state was about to do? Maybe, but I would guess not since investors are also bidding up property prices in California and New York, two other states with big deficits and heavy regulatory burdens. Nor are property investors beating a path to Indiana, North Dakota and Alaska, states whose public finances are in relatively good shape.

Yet I wonder if it’s a different story when you move beyond the high-profile core assets that have become magnets for REITs, pension funds and private capital. Consider the following proposition: States with well-managed finances are able to offer a better overall package of incentives – tax abatement, site location, workforce training – to relocating businesses, and nearby properties would see spillover demand including restaurants, apartments and space suitable for contractors. But is this the same as real estate investment capital (as opposed to non-real estate businesses) moving to these states? Not in a big way unless you get enough relocating businesses to form an industry cluster such as the automotive industry in the South or the biotech industry in San Diego and Boston. When that happens, you may see some outside capital targeting commercial real estate in these areas.

Overall, I give Glen’s theory a qualified “no.”  Sorry Glen, but keep those thought-provoking theories coming my way. I need more fodder for the blog.

 

Institutional Investors Speak

One thing I particularly enjoy about the dinner events that Grubb & Ellis hosts for its institutional investment clients (besides the tasty vittles) is the opportunity to query our guests on the issues relevant to commercial real estate. I get to do this because I moderate a short pre-dessert discussion during which I invite our clients to weigh in on the issues of the day, after which I provide the Cliff Notes version of my forecast for 2011. At our dinners last week in Boston and New York, here are three key points made by senior executives at major institutional investment companies:

• Interest rates will remain low, though not as low as they are now and not as low as many analysts expect. The yield on the 10-year Treasury, 2.80 percent on Monday, will rise to the range of 3 to 3.25 percent by mid-2011 versus a sub-3 forecast by Wells Fargo, PNC and Goldman Sachs among others.
• Asked whether the main driver of property prices next year will be improving market fundamentals (vacancies, absorption, rents) or continued cap rate compression, the majority of our guests said continued cap rate compression, suggesting little faith that a leasing market recovery is imminent. This would seem to suggest a disappointing year for opportunistic investors because it’s tough to reposition properties when tenant demand is weak and Class A landlords are draining tenants from properties that would quality as opportunistic, i.e. Class B.
• Will institutional investors broaden their targets next year beyond the core assets driving demand in 2010? Not if our guests are a representative sample, which I believe they are. Nearly all stated that they had no plans to move beyond their current targets.

Talking Points

Q3 Leasing Market

1. Absorption has turned positive for all major property types: apartments in 2010 Q1 (Reis), industrial and office in 2010 Q2 (G&E), retail in 2009 Q3 (CoStar). Apartment absorption has been brisk, but the recovery is going to be slow for the other three property types.
2. The construction pipeline is largely empty, and there are few new starts.
3. Vacancy has peaked for all property types and is coming down at a moderate-to-brisk pace for apartments, very slowly for industrial, office & retail. Quarter-end vacancies: Apartments @ 7.1%, a very sharp decline from 7.8% in Q2 signaling that the apartment recovery will be more robust than many thought during the depths of the Great Recession. Industrial @ 10.6%, down from 10.7% in Q2. After a surge of demand in Q2, the pace of recovery pulled back in Q3. Office @ 17.8%, down from 17.9% in Q2. Market has barely budged in past three quarters due to anemic pace of recovery in labor market. Retail @ 7.4%, down from 7.5% in Q2. This sector is recovering earlier than was expected 12 to 18 months ago. Unemployment is high (9.6% in Sept.), but 90% of labor force is still employed, and some pent-up demand is driving the market. Upper income households are spending again, too.
4. Asking rental rates have broadly stabilized, and some Class A properties in certain markets such as Manhattan and San Francisco have been reducing concessions packages.
5. The labor market has added 874,000 payroll jobs year-to-date through October and 1.1 million in the private sector. Credit is readily available through the capital markets for large companies, but small companies continue to have trouble accessing bank credit. Facility consolidations are still happening.
6. Biggest risk: The economy continues to struggle. A double-dip recession is unlikely, but the rate of growth is weak. The economy’s immune system is compromised, meaning that unforeseen events could reduce the already-low levels of confidence. There is not much energy in the leasing markets, and there could be stops and starts. For example, second quarter industrial absorption was strong, reflecting growth in manufacturing exports beginning in the second half of last year, but third quarter absorption was disappointing.

Q3 Investment Market

1. Sales transactions year-to-date through Q3 totaled $60.4 billion of apartment, industrial, office and retail properties valued at $5 million and up – 82% above the same period in 2009.
2. Transaction volume has picked up every quarter this year on a sequential and year-ago basis. Compared with a year ago, volume was up 49% in Q1, 85% in Q2 and 105% in Q3.
3. Transaction $ still low by historic standards with further increases expected.
4. Prices appear to have stabilized overall judging from Moody’s/REAL commercial property price index and the NCREIF database.
5. Investors are focused on the upper end of the quality spectrum – core properties in primary markets. This is evident in the average deal size of $21.3 million year-to-date versus $14.1 million during the same period in 2009. Although the dollar volume of transactions has risen by 82% this year, the number of transactions is up by just 20%.
6. Biggest risk: Unforeseen spike in interest rates or a double-dip recession.

 Forecast

1. Expect the leasing market recovery to be slow and uneven until the labor market picks up. Job growth could be disappointing in 2011, perhaps in the range of 1.5 to 2.0 million – which would leave a remaining deficit of around 6 million and a year-end unemployment rate of around 8-8.5%.
2. Expect the investment market to continue gaining momentum in 2011 unless interest rates rise unexpectedly. Federal Reserve officials and many economists think this is unlikely because there is so much slack in the labor market, real estate, factory utilization, etc. But there is a small chance – perhaps 10% — that investors could pull back from U.S. Treasuries due to their meager returns, weak dollar and huge increases in supply, which could cause a spike in inflation and interest rates.

Jammin’ at the ULI

I never fail to pick up some interesting market intelligence at the Urban Land Institute conferences, but at the fall meeting last week, the pickings were slim. It wasn’t because of the roster of seminars and speakers, which is always first-rate. I think it’s because the commercial real estate investment market hasn’t changed much in the last six months. There is still a flood of capital chasing a very narrow slice of the market – core properties in primary, supply-constrained markets. And the leasing market hasn’t budged much, either. All property types are positioned at or just past the bottom of the market and are recovering at a very sluggish pace, except for apartments (see below). Having said that, I picked up some anecdotes that are worth sharing:

• One of my colleagues who works in the research department of an institutional investor came into the conference worried that his company is overpaying for core properties. By the end of the session, he said he was more at ease. After all, it’s his job to worry about overpaying. Still, he didn’t sound all that convincing.
• In order to win the bidding contest, core property investors have to keep going-out cap rates very low, maybe 50 basis points above going-in cap rates or even flat. With the potential for higher inflation and interest rates in the future, this has some investors talking about increasing the holding periods, which is the norm in Europe for core property investors. The buy-and-flip strategy is risky if interest rates spike. Properties financed with long-term, assumable mortgages will benefit.
• As an aside, my colleague, Jeff Majewski, executive managing director of Grubb’s capital markets group, says that most commercial mortgages (agencies, life companies, etc.) are assumable subject to lender approval and a 1 percent assumption fee. If a borrower locks in a 10-year Freddie loan today at 4.5 percent with 80 percent leverage, it’s safe to assume that rates will be higher in two years. Thus, a below-market, assumable rate for the eight years remaining could add value to the property. The rub is that an 80 percent loan in 2010 may be 70 percent in 2012. The agencies and the life companies will top off the tank and provide second mortgages behind the first for qualified deals. That is not possible for CMBS-financed properties, however.
• In the closing general session, Donald Kohn, the recently retired former vice chairman of the Federal Reserve Board of Governors, said he doesn’t think inflation will be a problem in the foreseeable future because there is so much excess capacity in the economy (the labor market, residential and commercial real estate, factories, etc.), and the recovery is expected to be painfully slow with full employment – a jobless rate of 5 to 6 percent – several years away. However, he acknowledged a small chance for a blow-up if investors decide to stop buying U.S. Treasuries, which could cause a sudden spike in interest rates and change the strategy for investors on a dime.
• The best news I heard came from J. Allen Smith, CEO of Prudential Real Estate Investors, who said investors will tire of paying premiums for core properties and will gradually take on greater risk. He termed this “bidding fatigue” and thinks the transition to a greater appetite for risk will happen at an orderly pace. This suggests a measured return to normalcy in the commercial real estate investment market and, by extension, the broader financial markets.
• The apartment market is firming at a faster pace than most analysts thought possible 18 to 24 months ago despite the loss of 8.3 million payroll jobs peak-to-trough and the huge shadow supply of rental housing – unsold condos and foreclosed homes being offered for lease. This is due to a combination of factors: stricter standards to obtain a mortgage; uncertainty on the part of prospective buyers over whether home prices have bottomed and a more skeptical attitude toward the long-term benefits of homeownership; and a slowly recovering labor market with 863,000 private-sector jobs added so far this year.

Investor Zeitgeist

Grubb & Ellis recently conducted a survey of its commercial real estate investment clients to determine their views on the market.

• The economic mood turned darker over the past 11 months. In a similar survey conducted last November, 38 percent of respondents expected “job growth strong enough to reduce the unemployment rate” to return in 2011 – the most popular answer. In the survey just concluded, 43 percent said this will be delayed until 2012.
• We asked investors which type of “-flation” most concerned them. In the earlier survey, respondents were split evenly in their concern over inflation and deflation, each of which garnered 38 percent of the votes. In the recent survey, stagflation ran away with 53 percent of the responses followed by deflation with 30 percent and inflation a distant third with 17 percent. This reflects a fear that the U.S. could be slipping into a “lost decade,” the label applied to Japan’s economic malaise in the 1990s.
• Two other questions tapped the vein of economic angst among investors. From a list of eight potential drags on the investment market, just under half of the respondents viewed a stalling recovery as the biggest threat. Government actions and tax reform scored a distant second. In another question related to the economy, 48 percent of respondents do not anticipate a double-dip recession, but 41 percent said the Great Recession “never really ended.” Thus investors are skeptical of the recent declaration by the National Bureau of Economic Research that the Great Recession ended in June 2009.
• The interest rate outlook of the respondents is even more pessimistic than the forecasts from mainstream economists. Respondents say the yield on the 10-year Treasury will increase 50 basis points by the end of next year, which would put it around 3 percent – about 50 basis points below the outlook from economists. This is very low historically and emblematic of an agonizingly slow recovery.
• In terms of investment volume, respondents say that 2004 is the new normal. Properties valued at $223 billion traded hands that year according to Real Capital Analytics. By comparison, the peak of the market in 2007 brought transactions valued at $507 billion while a decade-low $54 billion traded last year. Through the first eight months of this year, just under $55 billion-worth of properties have traded. Although year-to-date investment volume is up substantially from the same period last year, it remains well short of the new normal, i.e. a level of equilibrium between buyers and sellers.
• The pessimistic tone of the economic responses coexists with signs of optimism for the investment market. Eighty-one percent of the respondents view themselves as net buyers in the next 12 months. While core properties attracted the most enthusiasm, value-add and opportunistic investment strategies were the second and third most popular responses, a clear sign that the intense competition for core assets is pushing investors to take more risk.
• Slightly more than half of the respondents said that apartments are their top choice for a “safe, secure investment” in core property. Industrial was a distant second.
• Who are the biggest competitors vying for properties? Respondents say that private equity and private and non-traded REITs have the cash and are driving the engine down the track.

A Few Thoughts on Local Area Employment

Outside of Washington, DC, the mid-section of the country from Texas and Oklahoma northward through the Dakotas has held up the best — think energy, agriculture, commodities, no housing bubble. New York and Boston are bouncing back pretty well. And Pittsburgh, of all places, is the poster child for the comeback economy. It now has an energy component with companies seeking to mine the nearby Marcellus Shale.

Looking at job growth data from the U.S. Bureau of Labor Statistics over the last 12 months (July ’09 to July ’10), some surprising metros are in the top 20:

• College towns: Missoula, MT (U. of Montana), Manhattan, KS (Kansas State), College Station-Bryan, TX (Texas A&M), Las Cruces, NM (New Mexico State), Austin, TX (U. of Texas) and Iowa City, IA (U. of Iowa) are all in the top 20. In a way this is surprising given budget cuts at many public universities, but note that most of these are in the Texas/Great Plains swath of states mentioned above. Enrollment is up at many colleges as students stay in school to wait out the job market.
• Small Midwestern metros where export-led manufacturing and/or the auto industry have bounced back. Sandusky, OH (+4.0%), Kokomo, IN (+3.4%), Mansfield, OH (+2.6%) and Muncie, IN (+2.4% — also home to Ball State University). Keep in mind these areas were very hard hit.
• In absolute year-over-year job gains, top five metros are Washington, DC (41,800), Dallas-Fort Worth (31,300), Boston (21,300), Austin, TX (18,600), and Oklahoma City (9,200).
• Bottom five metros are Chicago (-70,800), San Francisco-Oakland (-42,800), New York (-28,900 – although it has bounced back since late last year), Riverside-San Bernardino (-22,800) and Detroit (-19,400).

Coincidence or Leading Indicator?

My colleague Matt Wright, Grubb & Ellis’ client services manager in the Philadelphia region, notes that the spread between the U.S. CBD and suburban office vacancy rates tends to compress until late in expansion periods and widen during periods of contraction. This makes sense conceptually; it takes less time for developers to plan and deliver suburban projects, which are usually smaller and less complex than projects in the urban core. Thus, the earlier delivery cycle in the suburbs pushes vacancy higher after the initial pent-up demand has been met, while the later delivery of projects in central business districts keeps the lid on vacancies until late in the expansion cycle. The result: a widening CBD/suburban spread until late in the expansion cycle.

During both of the most recent downturns, the spread began to widen seven quarters prior to the sustained run-up in the overall vacancy rate. Not only was timing consistent, but the degree of relative change between the two variables was as well. When controlling for this seven-quarter lag, statistical analysis indicated a very high degree of correlation, with R values of .91 and .98 respectively.  A value of 1 would suggest that the two variables had a perfect linear relationship meaning they move in the same direction and at the same pace all the time. The take away is that once the spread began to increase, seven quarters later the overall vacancy rate did too and at a very similar pace.

Is there a reverse-correlation during recovery cycles? Four quarters before the most recent market turnaround in 2004, the spread began to compress. Guess what happened four quarters ago: the spread began to compress. If this correlation is to remain intact, it means that the third-quarter vacancy rate would need to decline. Could this happen? Absorption was low but positive in the second quarter, ending a string of eight consecutive quarters in the red. This suggests that overall vacancy could be at the peak and ready to reverse direction.

To summarize, the CBD/suburban spread began to widen during the last two expansion cycles seven quarters before the overall vacancy rate began to increase. And the spread began to narrow four quarters before the overall vacancy rate began to fall at the beginning of the last recovery cycle – and could be about to do so again. We will be watching carefully to see if the overall vacancy rate falls in the current quarter, which would keep this relationship intact.

U.S. Office Market Vacancy Rates