Commercial Real Estate Chartbook: Quarter 4

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1 Economics Group Special Commentary Uncertainty Continues to Hang Over and Shape the Recovery Economic activity appeared to turn up a notch toward the end of 211, and data for the early part of 212 suggest that the new year has gotten off to a solid start. The apparent pickup in economic activity has done relatively little to boost the commercial real estate sector, however. Activity cooled off appreciably following last summer s debt ceiling debacle and S&P s credit rating downgrade, which were, in turn, followed by the intensification of the sovereign debt crisis in Europe. The dust up in the credit markets has whipped up a cloud of uncertainty that held back leasing activity and inhibited deal flow and new construction during the latter part of 211. While glimmers of stronger economic growth are sporadically breaking through the clouds, the fog is still fairly thick, particularly when it comes to the risks associated with weakening economies in Europe, government spending cuts in the United States and a still-fragile financial system adjusting to colossal changes on the regulatory front. Heightened uncertainty tends to increase the value of liquidity. Class A apartments are benefitting the most from this trend. Leasing has surged while younger workers shun homeownership, and a larger proportion of workers in general are willing to pay higher rents in order to preserve their mobility. Demand for apartments remains remarkably strong given the still-relatively modest employment gains posted over the past two years, particularly in the South, where the population tends to be younger and where labor markets have generally lagged behind the nation as a whole. Sales of apartment communities remain brisk, and prices are up in a number of markets. Investors are also paying up for liquidity, driving cap rates lower for prime, well-located properties in large global gateway markets. Prices have also been driven higher in markets with outsized exposure to the energy boom, most notably Houston and Denver, as well as in areas benefitting from the growth in new mobile Internet technologies, such as San Jose and San Francisco and, to a slightly lesser extent, Los Angeles, Austin and the Research Triangle region. Figure Bars = CAGR Real GDP Line = Yr/Yr Percent Change GDP - CAGR: 2. GDP - Yr/Yr Percent Change: Figure Commercial Real Estate Vacancy Rates Percent Office Vacancy Rate: 17.3% Industrial Vacancy Rate: 9. Retail Vacancy Rate: 11. Apartment Vacancy Rate: 5. Mark Vitner, Senior Economist mark.vitner@wellsfargo.com (74) Anika Khan, Economist anika.khan@wellsfargo.com (74) Joe Seydl, Economic Analyst joseph.seydl@wellsfargo.com (74) Commercial Real Estate Chartbook: Quarter While glimmers of stronger economic growth are sporadically breaking through the clouds, the fog is still fairly thick. 4. Forecast Source: U.S. Department of Commerce, PPR, Reis, Inc. and Wells Fargo Securities, LLC This report is available on wellsfargo.com/economics and on Bloomberg WFEC

2 Operating fundamentals continue to improve across most property types. Improvement in the office market has been less dramatic. Still Moving in the Right Direction Operating fundamentals continue to improve across most property types. Apartment vacancy rates fell 1.4 percentage points in 211, as strong demand easily outpaced a modest rebound in new construction. Effective rents rose 2.3 percent and were up much more than that in red hot markets, such as San Jose, San Francisco, Austin, greater New York and Dallas. With the exception of a few extremely tight markets, most of the improvement continues to be confined to Class A developments. Leasing for B and C communities has been hindered by weak job growth and poor credit quality. Investors have also been more cautious, as many B and C properties face more competition from foreclosures and expected large-scale asset sales by the GSEs and banks. The dramatic improvement in operating fundamentals for Class A properties has led to a spike in development that may head off some of the run-up in rents. Many projects have faced difficulty arranging financing, however, and only a small number of units are currently being built. Demand for industrial space also remains relatively strong throughout much of the country, reflecting the recovery in the nation s factory sector as well as strong gains in international trade. Gains are evident across most major markets, with some of the largest absorption gains taking place in big inland markets, such as Atlanta, Phoenix and Chicago. International trade remains a key driver, lifting demand in Houston, southern California and northern New Jersey. Vacancy rates for industrial space fell.8 percentage points over the past year, with the largest drop, a whopping 1.3 percentage points, occurring in Savannah, which is home to the nation s fourthlargest and fastest-growing container port. Despite the improvement, rent increases remain modest, a reflection of the overbuilding that occurred in many markets during the 2s. As a result, new development remains sparse, with most new construction limited to build-to-suits. Improvement in the office market has been less dramatic, but absorption has remained in positive territory for the past five quarters, and, with new construction limited to just a handful of projects, vacancy rates have fallen slightly. Demand remains strongest in areas benefitting from growth in the technology and energy sectors, but is cooling off considerably in most major financial centers. Businesses tied to software development and entertainment programming for the mobile Internet have emerged as a key growth driver for the office market, fueling gains in the San Francisco Bay area and other tech centers, such as Seattle and Raleigh-Durham. New York City has also benefitted from this trend, with a number of prominent large leases during the second half of 211 helping to offset the drag from the slowing financial sector. Energy was the other big growth engine, helping to lease large blocks of space in Houston, Dallas and Denver. Demand for retail space picked up modestly during the second half of last year, but the outlook for the sector remains exceptionally guarded. A number of chains announced store closings after the holiday season, and consumer spending will likely remain constrained by sluggish income growth and higher food and energy prices. Figure 3 Figure 4 1 Regional Apartment Sector Cap Rates Percent Atlanta: 7.9% Dallas: 7.9% Phoenix: 7. Washington, D.C.: 6. New York: 6. San Francisco: 5.7% Real Nonresidential Construction Bars = CAGR Line = Yr/Yr Percent Change Forecast Nonres Construction - CAGR: -7. Nonres Construction - Yr/Yr Percent Change: 2.7% Source: U.S. Department of Commerce, PPR and Wells Fargo Securities, LLC 2

3 Nonresidential Construction Spending 6 Priv. Commercial and Lodging Cons. Spending Both Series are 3-Month Moving Averages 6 4 Private nonresidential construction spending continued to show improvement in the fourth quarter with manufacturing, power, transportation and education leading the way. Power outlays, which include power plants, gas and oil as well as wind and solar, are up 18 percent over the past year. Based on BEA s assumptions for the fourth quarter, structures outlays may lead to a slight upward revision to real GDP growth. The value of construction put in place, however, does not account for oil or gas drilling, which according to the American Petroleum Institute, fell in the fourth quarter. Nonresidential architectural billings remained in expansionary territory and generally paint a mixed picture, with commercial billings rising slightly and institutional projects slowing. Private Nonresidential Construction Spending Both Series are 3-Month Moving Averages Month Annual Rate: -13.9% Year-over-Year Percent Change: PPI: Materials & Components for Construction Quarter-over-Quarter Percent Change Month Annual Rate: 1.9% Year-over-Year Percent Change: 8.3% Private Transportation Construction Spending Both Series are 3-Month Moving Averages Materials & Components for Construction: -.1% Institutional and C&I Architecture Billings Seasonally Adjusted Month Annual Rate: 11.1% -6 Year-over-Year Percent Change: Institutional Billings: 51.3 Comm. and Industrial Billings: Source: American Institute of Architects, U.S. Dept. of Commerce, U.S. Dept. of Labor and Wells Fargo Securities, LLC

4 Commercial Mortgages Outstanding The total amount of outstanding commercial loans continues to contract, but the pace is moderating. The latest Senior Loan Officer Survey included a special question about recent CRE lending policies. The question s results indicate that U.S. banks continue to report a moderate easing in loan terms as well as a modest pickup in the demand for new CRE loans. At the same time, however, a small net fraction of foreign lenders reported having tightened standards for new CRE loans, most likely a result of ongoing financial strains in Europe. The amount of commercial mortgages held at private finance companies continues to contract, down nearly 14 percent over the past year. Of all the loan-holder categories, finance companies have shed the most CRE loans over the past year. Commercial Mortgages Outstanding Life Insurance Companies Other 1 Q Commercial & Multifamily Mortgages Outstanding Year-over-Year Percent Change Commercial & Multifamily Mortgages: -3.3% Commercial Real Estate Loans at Banks Commercial Real Estate Loans as a Percent of Bank Loans Commercial Banking Securitized 23% Savings Institutions Commercial Mortgages Outstanding Q Small Commercial Banks: 37.7% Large Commercial Banks: Net Percentage of Banks Tightening Standards Commercial & Industrial Loans Other 3 Commercial Banking 37% Life Insurance Companies Securitized 21% Savings Institutions -4 C&I Loans to Small Firms: -6.3% C&I Loans to Large & Medium Firms: -5.9% Source: Federal Reserve Board and Wells Fargo Securities, LLC

5 CRE Property Fundamentals 1 Operating fundamentals for all property types continued to improve with vacancy rates declining or remaining unchanged in the fourth quarter. The pace, however, has moderated along with belowtrend economic growth. Cap rates continue to pull off of their third-quarter 29 peak and have remained relatively stable over the past year. According to RCA, investors continuing to seek yield are moving beyond Class A apartments and central business district office. Cap rates have also declined for leased suburban office and grocery-anchored shopping centers. CMBS lending will likely slow in the coming year. Our Structured Products Research Group expects origination to reach only $25 billion in 212, a 17 percent decline from 211. Commercial Real Estate Percent, Dollars per Square Foot $18 1 CRE Cap Rates vs. 1-Year Treasury Yields Percent, Yield Industrial: 7. Retail: 7. Office: 7.3% Apartment: 6. 1-Year Yield: Net Percent of Banks Tightening Standards Commercial Real Estate Loans Commercial Real Estate Loans: $ $ Price: $ per SF (Right Axis) Vacancy Rate: 1.9% (Left Axis) Cap Rate: 7. (Left Axis) 3 Moody's/REAL Commercial Property Price Index Year-over-Year Percent Change $6 $ $45 $4 $35 U.S. CMBS Issuance Billions of Dollars CMBS Issuance: $. Billion $45 $4 $35 $3 $3 1 1 $25 $25 $2 $15 $2 $ $1 $1 $5 $ $ $ Year-over-Year Percent Change: 1.3% Source: Federal Reserve Board, PPR, RCA, Reis, Inc., Moody s, U.S. Department of Labor and Wells Fargo Securities, LLC 5

6 Apartment $12 The apartment market s impressive growth continued in the fourth quarter. Vacancy rates fell.4 percentage points to 5.2 percent, the lowest level since Q4 21. Rents continued to rise, and net absorption during the quarter totaled more than 5, units. The NMHC Quarterly Apartment Survey showed that the apartment market s strength has continued into the new year, with the survey s Tightness Index picking up to 6 in the first quarter. This index has been above its demarcation line of 5 for the past eight quarters. The GSE REO-to-rental conversion program the Obama administration is considering may slow rent growth by bringing more supply to the market. The impact should be greatest with B and C properties. Apartment Price vs. Vacancy Rate Dollars per Square Foot, Percent Apartment Effective Rent Growth Quarter-over-Quarter Percent Change Apartment Effective Rent Growth: -1. 9% Apartment Supply & Demand Percent, Thousands of Units % 5 $1 25 $8 $6-25 $4 Apartment Price: $9.82 per SF (Left Axis) Apartment Vacancy Rate: 5. (Right Axis) $2 3% 1 Apartment Net Completions: 8,865 Units (Right Axis) Apartment Net Absorption: 5,565 Units (Right Axis) Apartment Vacancy Rate: 5. (Left Axis) NMHC Apartment Tightness Index National Multi Housing Council, Diffusion Index Apartment Cap Rate vs. 1-Year Treasury Yield Percent, Yield Apartment: 6. 1-Year Yield: NMHC Market Tightness Index: Source: Federal Reserve Board, NMHC, Real Capital Analytics, Reis, Inc. and Wells Fargo Securities, LLC 2 6

7 Office $35 Office fundamentals continued to improve in the fourth quarter, but the recovery continues to progress at a moderate pace. Office vacancy rates have fallen little over the past year and remain elevated at 17.3 percent in the fourth quarter. New construction in the office sector will likely remain constrained due to high vacancies and the sluggish recovery in financial and professional services. With limited office supply and only slight pickup in office-using employment, net absorption will be slow to improve. Despite a pickup in overall hiring, job openings in professional and business services have cooled a bit in recent months. Office effective rent growth increased for the fifth consecutive quarter, reflecting increased leasing activity from tenants upgrading to newer space. Office Price vs. Vacancy Rate Dollars per Square Foot, Percent Office Effective Rent Growth Quarter-over-Quarter Percent Change Office Effective Rent Growth: % 1 Office Supply & Demand Percent, Millions of Square Feet $ $25 1 $2 9% -1 $ $1 $5 Office Price: $211.7 per SF (Left Axis) Office Vacancy Rate: 17.3% (Right Axis) $ 3% Office Net Completions: 2.4M SF (Right Axis) Office Net Absorption: 5.3M SF (Right Axis) Office Vacancy Rate: 17.3% (Left Axis) 6. Job Openings Rate - Professional Services Job Openings as Percent of Total Employment Plus Job Openings, SA Office Cap Rate vs. 1-Year Treasury Yield Percent, Yield Office: 7.3% 1-Year Yield: Job Openings Rate: 3. 3-Month Moving Average: Source: Federal Reserve Board, Real Capital Analytics, Reis, Inc, U.S. Department of Labor and Wells Fargo Securities, LLC 7

8 Retail $28 The retail sector, while still weak, is finally showing some signs of life. Rent growth picked up in the fourth quarter for the first time since Q1 28, and net absorption came in strong, with the occupied stock rising by 3.18 million units. Vacancy rates, however, remained unchanged at 11 percent. We will likely need to see several more quarters of growth in the retail sector before new construction increases in a meaningful way. The Q4 turnaround may simply be a result of seasonal variations. The winter months are typically the strongest for the retail sector. Reis vacancy and rent data are seasonally adjusted, while the completions and absorption data are not. We expect slower consumer spending in the first half of this year to slow retail expansions. Retail Price vs. Vacancy Rate Dollars per Square Foot, Percent Retail Effective Rent Growth Quarter-over-Quarter Percent Change Retail Effective Rent Growth: Retail Supply & Demand Percent, Millions of Square Feet Retail Net Completions: 1.9M SF (Right Axis) Retail Net Absorption: 3.2M SF (Right Axis) Retail Vacancy Rate: 11. (Left Axis) $24 11% $2 9% 4 $16 $12 7% -4 $8 Retail Price: $ per SF (Left Axis) Retail Vacancy Rate: 11. (Right Axis) $4 8. Real Personal Consumption Expenditures Bars = CAGR Line = Yr/Yr Percent Change Retail Cap Rate vs. 1-Year Treasury Yield Percent, Yield Forecast Retail: 7. 1-Year Yield: PCE - CAGR: 2. PCE - Yr/Yr Percent Change: Source: Federal Reserve Board, Real Capital Analytics, Reis, Inc, U.S. Department of Commerce and Wells Fargo Securities, LLC 8

9 Industrial $9 Operating fundamentals for industrial properties continued to improve in the fourth quarter, driven by growth in manufacturing, retail and international trade. Demand far outpaced supply, with only 5.7 million square feet of space delivered. As a result, the vacancy rate dropped.2 percentage points to 9.2 percent in the fourth quarter. According to PPR, leasing activity generated by retailers and third-party logistics firms, favoring large, modern product, remains strong, but space take-up by manufacturers is seeing the sharpest increase. The growth in industrial and warehouse space is also being fueled by changing retail strategies that place more of the operation in the warehouse and less on the sales floor. The growth in online sales is also driving demand. Industrial Price vs. Vacancy Rate Dollars per Square Foot, Percent Industrial Asking Rent Growth Quarter-over-Quarter Percent Change Industrial Asking Rent Growth: Industrial Supply & Demand Percent, Millions of Square Feet $8 13% 1 2 $7 11% 1-2 $6 9% -4 $5 $4 Industrial Price: $61.65 per SF (Left Axis) Industrial Vacancy Rate: 9. (Right Axis) $3 7% Industrial Net Completions: 5.7M SF (Right Axis) Industrial Net Absorption: 32.6M SF (Right Axis) Industrial Vacancy Rate: 9. (Left Axis) 8. Wholesale Trade Employment Growth Year-over-Year Percent Change Industrial Cap Rate vs. 1-Year Treasury Yield Percent, Yield Industrial: 7. 1-Year Yield: Wholesale Trade Employment Growth: Source: Federal Reserve Board, PPR, RCA, U.S. Department of Labor and Wells Fargo Securities, LLC 9

10 Regional Apartment Market Overview 11% 1 9% The strength of the U.S. apartment market has been a reoccurring theme in recent quarters. That strength, however, is very much a regional story. The most impressive growth in the apartment sector has occurred in many Southern and Sunbelt markets, with vacancy rates falling significantly in Greensboro, Charleston, Phoenix and Houston over the past year. Vacancy rates are the lowest in many West Coast markets, such as Portland, San Jose, San Diego and San Francisco. Absorption has picked up the most over the past year in Columbus, Chattanooga, Memphis and Raleigh. In general, apartment markets have tended to be strongest in areas that have seen large inflows of young workers, especially recent college graduates. Columbus, OH Apartment Supply & Demand Percent, Thousands of Units Apartment Completions: 26 Units (Right Axis) Apartment Net Absorption: 1,115 Units (Right Axis) Apartment Vacancy Rate: 7. (Left Axis) Greensboro Charleston Phoenix Houston Charlotte Fort Worth Providence Austin Atlanta Tulsa Tucson Indianapolis Dallas Orlando Little Rock Kansas City Jacksonville Columbus Las Vegas Denver US Minneapolis San Jose Westchester San Diego Central NJ Syracuse Rochester San Francisco Long Island Pittsburgh Suburban Va. Providence Milwaukee Los Angeles Albuquerque -2.7% -2.7% Apartment Vacancy Rate Change by Metro Percentage Point Change, From Q4 21 to Q % % -2.1% % -1.9% -1.9% -1.9% -1.9% Portland Hartford Buffalo Oakland Ventura Apartment Vacancy Rate by Metro Percent % 2.9% As of Q % 3.1% % 3.3% % 3.9% 3.9% 3.9% 7% Portland Apartment Supply & Demand Percent, Thousands of Units Apartment Completions: Units (Right Axis) Apartment Net Absorption: 59 Units (Right Axis) Apartment Vacancy Rate: 2.7% (Left Axis) US Columbus Chattanooga Memphis Raleigh-Durham San Jose San Diego Providence Columbia Las Vegas Little Rock Indianapolis Houston Greenville Cincinnati Ventura County New Haven US Miami Tulsa Apartment Absorption Rate Change by Metro Percentage Point Change, From Q4 21 to Q %.9%.9%..7%...3%.3%.3%.3%.. * Change in. Absorption/Occupied Stock....1%.1% -.3%..3%..9% 1. Source: Reis, Inc. and Wells Fargo Securities, LLC 1

11 Wells Fargo Securities, LLC Economics Group Diane Schumaker-Krieg Global Head of Research & Economics (74) (212) John E. Silvia, Ph.D. Chief Economist (74) Mark Vitner Senior Economist (74) Jay Bryson, Ph.D. Global Economist (74) Scott Anderson, Ph.D. Senior Economist (612) Eugenio Aleman, Ph.D. Senior Economist (74) Sam Bullard Senior Economist (74) Anika Khan Economist (74) Azhar Iqbal Econometrician (74) Ed Kashmarek Economist (612) Tim Quinlan Economist (74) Michael A. Brown Economist (74) Joe Seydl Economic Analyst (74) Sarah Watt Economic Analyst (74) Kaylyn Swankoski Economic Analyst (74) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 212 Wells Fargo Securities, LLC. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE