The New Normal in Real Estate

The July jobs report released by the Bureau of Labor Statistics on Friday was disappointing. Private employers added a meager 71,000 net new jobs to their payrolls, but these were more than offset by the loss of 202,000 government jobs, resulting in a net loss of 131,000. Of the government layoffs, 143,000 were associated with the winding down of the 2010 Census, which was expected, and 48,000 were eliminated from state and local agencies, which are seeing tax collections plunge. Unlike the federal government, most state and local jurisdictions cannot borrow and so must balance their budgets every year or make up the difference from their rainy day funds. Year-to-date, monthly job gains have averaged a paltry 93,000, less than half the number required to put the economic recovery on firm footing. Many economists are reducing their growth forecasts for the remainder of this year and into 2011. Goldman Sachs, which correctly predicted the recent slowdown, has reduced its GDP forecast for next year to 1.9 percent, down from 2.5 percent. A double-dip recession remains unlikely, but the odds have risen recently. The recovery doesn’t feel like one.

The “new normal” is a term being used to describe this uncomfortable scenario, characterized by very slow growth, persistently high unemployment, the threat of deflation, and lingering caution on the part of consumers, businesses and investors. Some analysts say this could last three to five years or even longer as households continue to deleverage and governments become unwilling or unable to provide further stimulus. What would the new normal look like for commercial real estate?

Sluggish hiring means the leasing market recovery could be abnormally slow for the office market, which depends on job growth, and also the retail market, which depends to a large extent on whether consumers feel secure in their jobs. The industrial and apartment markets have already turned the corner. Rebounding exports and inventory restocking have supported demand for industrial space, while apartments are benefitting from low construction and pent-up demand. But the inventory restocking cycle is winding down, and apartments need stronger job growth to sustain their nascent turnaround. None of the four major property types are out of the woods yet, and in a new normal economy, they may be slow to emerge.

On the investment side, the flight to quality, i.e. U.S. government Treasury securities, is keeping returns on fixed income investments extremely low. The income returns provided by high quality, well leased commercial real estate look good in comparison, particularly since price declines for top-tier properties appear to have run their course. A continuation of the new normal means that investor demand will remain focused on this narrow slice of properties, and the expansion of demand to include a broader set of properties across the quality spectrum will unfold slowly. Conversely, a brisk leasing market recovery would likely broaden investor demand more quickly.

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