The Real Economy This Episode: Investing in Real Estate David Snow, Privcap: Today, we're joined by Joe Brusuelas, Chief Economist at McGladrey, and Jim Clayton, Head of Investment Strategy and Analysis at Cornerstone Real Estate Advisers. Gentlemen, welcome to Privcap and welcome to the Real Economy. Unison: Thank you, David. We're talking about a very important sector in the U.S. economy: the real estate sector. Obviously, real estate has gotten a lot of attention, especially since the beginning of the great recession. So I'm very interested to hear what signals both of you are following within real estate to have a sense of how that might impact the economy and, also, what the investment opportunities might be within real estate. Starting with a question for Joe: what are you watching most closely as you observe developments in real estate? Joe Brusuelas, McGladrey: In residential real investment, I'm looking at housing starts and building permits foremost. I'm looking at purchase of light vehicles and at different forms of unemployment. I'm looking at different metrics that tell me how tight the labor market is getting. Specifically what I'm looking at is the employment- to- population ratio that's 25 to 34, which is one of the better forward- looking metrics we have. That allows us to predict where housing starts are moving. Housing starts are sitting currently at roughly 1.1 million on an annualized pace. My sense is that the employment conditions for that particular cohort have improved so much that, by the middle of next year, we should be well above 1.2 million at an annualized pace. And while that's not yet fully utilizing the capacity to produce total housing stock, it means we're well on the way to that recovery we want. What I'm looking at most closely is the composition of construction. That is the ratio of single- family residences built compared to multi- family dwellings. What we're seeing here in this cycle is [that] multi- family dwellings are really leading the way. And that has to do with at least a temporary shift in
preferences among that 25 to 34- year- old cohort for renting rather than owning. Now, the key thing here is if that were to persist, we've got a different housing market than we had before the crash. My sense is that a lot of lifecycle decisions have been put off because we've had such a difficult recovery. Once those lifecycle events occur, then I think we'll see much more [of a] return to what we would call normalcy. And those preferences will shift from renting to buying homes, moving out of core urban areas to suburbs. Then, that's when we likely see a much more pronounced recovery in the housing market. I don't think that's in the cards in this cycle. That will likely be the next business cycle. Jim, you're watching the real estate sector for slightly different reasons. You're trying to figure out where to put your dollars or your clients' dollars. What signals are you watching and what are they telling you? Jim Clayton, Cornerstone Real Estate Advisers: We're more focused on the commercial and multi- family, if we put those together. But, of course, the residential single- family side is incredibly important for us as a gauge for the overall economy, the health of the economy and the health of consumers. Also, it has a very important dynamic this time around with the multi- family sector, as Joe said. It is a different animal this time in terms of the housing starts the much larger proportion of those are multi- family. And the strength of that market is actually somewhat surprising to some over the past year. We thought we were going to have almost too much supply in some areas, but vacancy rates have continued to decline in a large majority. A couple things that Joe touched on, in terms of what we're looking at I love the employment- to- population ratio Joe mentioned. That's one metric that I think the Fed is really relying on in terms of its labor- market slack. And that age cohort is crucial. They're delaying a lot of things, as Joe pointed out, in terms of renting. In terms of other parts, the labor market is key and there is some really encouraging news coming out, despite the rough start we had with the economy in the first quarter and some people getting very pessimistic on short- term, month- to- month fluctuations in employment, which it's a survey. It's noisy. It's interesting that if you look at where we were just a year ago, job openings are up 44%. Hires are up 5%, which...is above the actual hiring rate we see in the BLS survey. That's why a lot of the policy makers and lead economists look at the JOLT survey job openings, layoffs and turnovers rather than the monthly BLS,
which you cited. Even if you look at quits now, this is what's important it's up 11% on a year- ago basis. That means a full 11% of the workforce has decided to leave their job for a better job, better pay or better career advancement. Indeed, we're already seeing wage pressure build wages and salaries are up 2.8%. And, in our proprietary middle- market survey at McGladrey, three- quarters of our respondents have told us that they're having problems finding qualified workers. If 2014 was the year commercial real estate recovered from the recovery, I think 2015 is the year we saw healthy expansion. I expect to see really solid expansion again next year in 2016, simply because the economy is going to continue to grow between 2.5% and 3%, which unfortunately is well above our long- term trend, because our trend rate is 2%. What's the right way to read the real estate economy, given the fact that some areas like New York are showing a marked increase, whereas others appear to be languishing? I think you have a number of different dynamics going on, but you certainly see that in the bigger, what we tend to call gateway cities New York, San Francisco, Boston, etc. You've got a very different world today in terms of the types of jobs that are taking place. More STEM [science, technology, engineering and math] or tech- oriented; TAMI is the big word everybody uses in New York for technology, advertising, media and information. That has really reinvented and seen some transition in the way the center of gravity of the office sectors behave. But [there are] very deep, diversified labor pools in the right areas. Coupled with that, plus your high- growth areas, your lower- cost areas, like Texas, parts of Florida are really starting and Denver [there s] a big article about Heinz putting up an office building in the Wall Street Journal today. So, you've got a package of things. Some of the bigger cities that historically have been dominant are reinventing themselves. Then, you've got some of these newer, higher- growth cities with amenities where the younger people want to be and some shifting going on between those. I think it's the breadth and depth of the labor market recovery, and he pointed to it. If you take a look at a place like San Diego, for 25 years we've heard about nanotechnology and biotechnology. Well, it's happening now. Jobs around San Diego and Boston, two high- education clusters, have serious concentrations of employment in life sciences where the starting pay is often well above $100,000. You've got your highly- educated, mobile population moving to
areas like Denver. Then, of course, in Northern California San Francisco and San Jose you've got an epicenter of tech. Of course, down in Florida, you've got the jump- off point to South America, while it won't be quite as vibrant as it has been for the past couple years because of the slowdown in emerging markets, you're still likely to see a flow of capital into the area. And that is smart money moving into the U.S. ahead of rate normalization. Now, on a global basis, the tectonic plates are shifting. Global central bank policy is diverging. That'll attract as a magnet for capital into the U.S. And, because we're in a period of low rate and low inflation where there is substantial interest- rate risk on holding, fixed- income individuals bringing money into the country are going to be looking at alternative investments. And housing is definitely one of them. If we go back to the employment recovery in what cities are doing well and what aren't, there are cities that are losing, definitely. There are certain parts of the country that are not recovering and, because they cannot maintain, they cannot keep that younger demographic. They don't have that deep breadth of labor pool that I was talking about. So they have to reinvent themselves and some of them are older areas with high tax and high cost bases. But you can see that in the real estate price data. The rest of the country still has not quite fully recovered to where we were in 2007, with the exception of some of the metros we've mentioned that I would put in the major bucket. But you can really see the divergence and, going back to your point with capital flows and interest rates, we're the exact same view. Despite the uptick that you've seen to 2.4 in the 10- year Treasury, that's still an incredibly low number. People are very scared even the German bond yield doubled, that's the headline. Those forces are still going to be there with the ECB and that foreign capital coming in that's what they're looking at. And they're going to go to the big metros that they're familiar with and continue to create opportunities. Does the inflow of foreign capital from places like China distort the way you're able to look at the fundamentals of investing? I think you are seeing some of that with select assets, but it's a very narrow segment in terms of the trophy, although they are moving into other parts of the real estate and other businesses. But that capital it's hard to say it distorts. Some of that has a very long- term view and they have a global view. So, you're going to have a difference in somebody who's looking at the world and thinking about a required return that they need to satisfy their
goals versus somebody who's local and wants a slightly different discount rate and doesn t have that diversification or that global view. You re going to have the natural segmentation, I think. What [that] means is it creates opportunities for...local people who actually understand the market, right? That to do different things and figure out where is growth going to occur next? Think Brooklyn 10 years ago, all right, think maybe downtown now. Think over at Chelsea and Midtown South a few years ago. It creates opportunities to really figure what's the next thing in that area if it continues? I wouldn't say that it necessarily distorts. But it's a reality you have to deal with. And it could change things if that capital moves elsewhere. I tend to think of it this way: it means they have confidence in our economy, in our institutions, our legal systems and our currency unit of account and store of value. They're not coming in to distort the market. They're coming in to take advantage of it and protect the capital. But to come back to...are we worried? The one area where it could happen is, right now, people are really focused on the assets. If the pricing of those assets starts impacting the financing, if people start increasing LTVs, if we start getting more complicated, if we start doing things of that sort, if it brings in more debt, then we could be a bit more nervous in that part. Let's talk about a big topic the inevitable increase in interest rates. What is that going to do to pricing, especially in the biggest cities? A big concern for real estate investors is what's going to happen to property values if interest rates start to increase? They have...been artificially low. We think that interest rates going up is a sign that the economy is doing well. The real estate space markets are really getting to the point where vacancy rates across the board are at or below natural vacancy rates, which is setting the stage for sustained rent growth and, therefore, NOI on property. We're at a stage of the economic cycle where it's relatively slow growth, but it should be a protracted recovery. So we've got the NOI going up at the same time as the interest rate it's a race between those two things. And [that] means...we cannot just expect property values to be going up simply because rates are going down, which happened off and on for the past three decades, if you look at the long- term trend. If you're going to make money in real estate and increase your property value, you have to be a
real estate person. You have to create income; more of your return is going to come from income at this stage of the recovery. I agree with most of what he said and I do expect capital flows into the economy, suppressed rates the longer the curve. Even as the Fed has stopped purchasing assets in 2014, the fact that they're reinvesting the maturing proceeds of the $4 ½ trillion they have on their asset, balance sheet that tends to suppress rates at the long end of the curve, too. But we're in an interesting situation where we've had so much new technology arrive on the scene that it's not good enough just to become a LEED- certified building. I think one way to lift your NOI is to integrate the advanced environmental management demand technology into your buildings. In a lot of these older buildings that are going need to be retrofitted to meet the new demand for work, for space and for just the use of technology and data in these operations, this is one way to really generate excess returns even from mid- size, mid- career to older buildings. And I'm very optimistic going forward that's going to be one of the ways commercial real estate will enter a renaissance, even in the cities that aren't leading the tip of the spear in terms of where we're going with the economy. That's a very interesting perspective. You could say my answer was sort of somebody that has a diversified portfolio of properties around the country, not building specific. But then you brought into the actual portfolio, and asset management, you have to be prepared for that. And you actually have to work your portfolio, work your assets, and you're going to have winners and losers. And you obviously want to be holding on to the winners, but that's a terrific way of thinking about how you actually optimize the NOI at the property level and therefore negate some of the impact.