DANIELLE DiMartino Booth, Commercial Real Estate, Federal Reserve, Restaurants

Congestion Indigestion – The Future of the Restaurant Industry in America

Oh how Mrs. Howe’s heart burned. Literally.

And so, her dutiful hubby descended to his basement where he concocted a remedy of calcium carbonate and sugar for his bride, much to her relief. And much to Jim Howe’s financial delight, his made-at-home remedy caught on like wildfire, extinguishing heartburn, neutralizing acidity and digesting indigestion far and wide. Could it be that the excesses of the Gilded Era were just what the pharmacist ordered in 1928? Or perhaps it was the hangover that set in the following year?

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Sasquatch Syndrome

Commercial Real Estate: Sasquatch Syndrome

Things were tough for Moscovians back in the Ice Age day.

The Trans-Siberian Railroad was still about 20,000 years from construction completion. And dinner in the form of wooly mammoths had this nasty habit of migrating east, as in so far east, it landed in what would one day be the United States’ Pacific Northwest. Passage was arguably simplified via the Bering Land Bridge, which hypothetically connected the two continents.

Folklore has it that the mammoths were not alone, but were accompanied by the Gigantopithecus. In that Gigantopithecus fossils have yet to be found outside Asia, stalwart believers maintain that a small population managed to flourish in their new home.

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Commercial Real Estate: From Towers of Gold to Pillars of Salt

Danielle DiMartino Booth, Money Strong LLC, Commercial Real Estate: from towers of gold to pillars of saltMix together mortar and lime with pressed hay and you too can construct a Tower of Gold, or at least the illusion of one.

If you have any doubts, pop on over to Seville, yes, the one in Spain, and have a look at the original Torre de Oro. Particularly entrancing is the vision of this 13th century dodecagonal watchtower at night. The gilded color reflected on the waters of the Guadalquivir River is as rich as you’ll ever be fortunate enough to behold.

The Spanish tower was originally one of two anchor points for a massive chain that blocked the river forming a defense against the Castilian fleet under Ramon de Bonifaz in the 1248 Reconquista. Unfortunately for the city’s residents, the chain did not hold and the besieged Muslim mecca eventually succumbed to the Christian forces. Despite its having been repeatedly under assault down through the ages, the Torre has withstood a series of attacks of the sort Mother Nature and revolutionary looters have thrown at it. So adored was the golden edifice, its destruction was never allowed. The Sevillians have demanded it be restored and re-restored over and over again. The time value of the building has clearly held strong to our aesthetic and architectural benefit.

As for the current generation of erected structures, today’s investors in commercial real estate (CRE) can be forgiven if they’ve got the urge of late to go soft on the sector. Fine, so the current CRE cycle is long in the tooth. The same could be said for the length of the rally in just about every other asset class and for that matter the current economic expansion.

What differentiates CRE from other asset classes is that it’s been hyper-driven by monetary policy gone wild. Flows into both U.S. commercial and high end residential real estate reflect the currency tug of war that started over three years ago. You remember that hissy fit the bond market threw at the mere mention the Fed might throttle back on its quantitative easing (QE) machine. Would inflation waltz hand in hand back onto stage? If so, might an inflation hedge into a hard asset naturally, dare say, logically follow? Well, then – let’s all join hands and pile hand over fist into real estate! For safety (never works out that way in numbers) that is.

In what can only be described as a full 360-degree turn from the initial days that followed the summer of 2013’s ‘taper tantrum,’ the Wall Street Journal recently ran an article titled, “Chinese Rethink U.S. Plans.” To say those trolling the Twittersphere took umbrage is an understatement. Vitriolic accusations of pots calling kettles black and casting stones in (overpriced) glass houses flew for days (good thing Tweets are capped at 140 characters as less is blessedly less when tempers flare).

Though few real estate consultancies are foolish enough to bite the hand that feeds them, there is a nascent acknowledgement that supply is becoming conspicuous in its abundance. “Supply rising but generally not over supply,” and “Real estate is late cycle,” are but two tentative subtitles to one to remain unnamed firm’s 2017 outlook. The real kicker, though, was, “Foreign buyers – from tailwind to headwind.” That gem speaks to the nitty gritty in the WSJ article, namely that foreign buyers, for all of their enthusiasm to jettison their capital, have hit their valuation threshold.

The specific deal punctuating the article draws the reader to a Street in Brooklyn, or more precisely, “a 22-acre, 15-building mixed use project in various stages of construction (that) is facing stiff headwinds.” As a nominal nod to said headwinds, the U.S.-based partner of the Chinese investor has taken a $307.6 million impairment charge and declared it will, “delay future vertical development.” The Chinese unequivocally deny any construction interruptions, insisting that they are, “meeting the goals and targets that were established when we invested in 2014.” Hmmm. Raise your hands if you want to read between those lines, in Mandarin, no less.

Rather than be plagued by such deep thoughts, perhaps at this point it would be best to step back and examine some basic metrics gauging the health of the commercial real estate market. If we start in the most amply supplied sectors and move our way down the spectrum, you may note that a pattern begins to emerge.

Let’s start with home away from home, as in hotels. To say we’ve built a few more lodging units in recent years than justified by the fundamentals insults veteran developers. In polite parlance, hotel room supply will outstrip corporate demand in 2017. In less genteel jargon, the main metric measuring the health of hotel profitability, as in RevPar, the product of a hotel’s daily room and occupancy rates, has tanked. The latest month’s read has RevPar nationwide growing at 1.6 percent over last year. In the event you like to keep score, that’s half the 3.2-percent rate thus far this year, and half the rate again of the 6.3-percent pace clocked in 2015. So yes, there’s a light on at the inn.

As for that stopover station in life, otherwise known as your apartment years, it’s a good thing cultural norms have shifted. It’s now cool to rent well into your prime earning years. Coming soon: it will also be economical as record supply finally chokes off rent growth. Over the past 12 months, 190,000 units were delivered across the 54 largest U.S. metros, a tad bit more than the 140,000 15-year average. But wait, there’s more! Another 244,000 units are slated for delivery in 2017, taking the bull run that started in 2013 in multifamily construction to a neat million unit. In the supply crosshairs, and in order of expected deliveries, are Houston, Dallas, New York, Washington D.C. and Austin. The deluge has finally cooled nationwide rental growth to 2.99 percent from a five percent pace a year ago.

It will come as no surprise that rents are outright falling in Houston (what’s the opposite term for ‘liftoff’?). But sliding rents are also a reality in New York. Would you believe Kings County, aka Brooklyn, is largely to blame? Just two years ago, as the Chinese were breaking ground on that mixed-use monster, 18 percent of the Big Apple’s supply entering the market was in Brooklyn; as of the third quarter that share had doubled.

It’s easy enough to attribute emerging stresses in CRE loans to oil patch woes. Take a drive through anywhere in suburbia and you’ll conclude quickly enough that retail is the next major source of loans behaving badly. Retail is a subject in and of itself. Rather than take a deep dive, take it on faith that there’s no way all of the excess supply can be absorbed and repurposed. E-commerce momentum cannot be contained and will push more household names into the netherworld. The true visionaries among real estate developers have long since slipped away from brick and mortar’s never ending funeral. They’ve got their sights set squarely on the lucrative potential for the fire sales of the land sitting under all those shuttered stores.

Less visible to the naked eye is the trouble brewing in office space.  Be that as it may, the numbers don’t lie. Commercial mortgage-backed securities (CMBS) comprise a mere tenth of CRE debt. Still, they provide an ideal prism into the health of the overall market given they are publicly traded; performance metrics are readily available. With that said, the most recent batch of data reveal that office delinquencies have been ticking up since midyear. Moreover, at $5.1 billion, the balance of delinquent office CMBS is second in size only to retail, which is saddled with a $5.9 billion pool of debt gone bad.

Did a lightbulb just gone off over your head as you pondered the preponderance of pressured properties peppered across this great nation? Is it time to head for the hills? Even short real estate, which we already know to be underperforming the broad market? The short answer to your urge to swiftly short the sector is, “It depends.”

It’s no secret that rising interest rates are an enemy of real estate in all its forms. Tack on the slow grind of the current economic recovery and you quickly conclude that the insufficient income thrown off by plenty of properties will easily be engulfed by higher financing costs. It’s critical to note that this dynamic was rendered moot in a zero interest rate environment. Refinancing you name it – from junk bonds to malls in the morgue – wasn’t near the challenge it would have been otherwise.

The reality of, “It’s the level of interest rates, stupid!” has Morgan Stanley’s CRE team a bit worried headed into the new year. First, a term of endearment, for developers, that is. ‘Net operating income’ (NOI) is the revenue a property generates after deducting the expenses required to operate the property. Word is, the higher the better. Enter Richard Hill & Jerry Chen at Morgan Stanley and the aforementioned rising interest rates. To keep things simple in formulating their forecast, they assumed a one percentage point increase in rates, which happens to be one in the same with the rise in the yield of the benchmark U.S. Treasury, give or take a basis point.

“We estimate that NOI growth would need to average nearly five percent over 10 years to produce the same levered return as today,” Hill and Chen wrote. “If NOI growth remained stable at three percent, near the historical average, then property prices would fall over eight percent to produce the same levered return as today.”

At the risk of mixing apples and oranges, the flashy new Standard & Poor’s real estate sector in the S&P 500 is off by precisely that much since it premiered September 19th.

As for what’s to come…did someone mention an election upset in the United States?

Animal spirits are the one thing that can rescue CRE in the year to come as a magnificent wall of maturing debt comes due. Some $120 billion in CMBS is up for refinancing in 2017. Tack on all other forms of CRE debt and the figure rises to $400 billion. A special feature of this debt vintage is that only 40 percent produces sufficient income to ensure refinancing is a sure thing (For any CRE types out there reading this, pardon the paraphrasing of industry terminology. This ain’t easy stuff to communicate to us laypeople.)

Add up all the factors and throw in tightening lending conditions for good measure. Hill and Chen estimate that 60 percent of the debt maturing in 2017 will be successfully refinanced while 20 percent is modified and 20 percent liquidated. Call that the base case scenario.

How to improve upon that projection? In two words, premature allocation on the part of investors either hungry for management fees or starved for yield.

Private equity is sitting on a $230 billion mountain of dry powder, as in funds earmarked to buy up real estate. That’s up from $210 billion at the end of 2015 and a mere $156 billion four years ago due in large part to pensions chasing returns. Meanwhile, it looks like CMBS issuance will rise to $65 billion next year pushing up the sector’s market share to 15 percent. And don’t count out insurance companies. Some analysts predict their market share could double or more from 2016’s 13-percent base, a prediction that’s been validated by insurers’ rising share of lending volumes in recent months. No doubt some of these insurers are international, which is understandable given negative, albeit rising, yields in so many countries. For identical reasons, many other types of foreign investors, especially of the sovereign wealth fund ilk, continue to flood the U.S. market with funds.

Global property investment will easily top $1.5 trillion this year. And New York will be crowned as the top-ranked target city, unseating London. The US will also boast the largest share of growth, with 15 of the top 25 cities on the top-ranked investment list.

If I’ve just talked you back into your own personal real estate investments, you may want to beg to differ…with yourself. Recall that the outlook remains iffy at best. At this late stage in the cycle, it can be prudent to be early and live to be liquid another day.

Not every tower, you see, maintains its golden allure forever. Real estate developers are the first to say they must be optimists to succeed in their chosen line of work. That said, many developers have gone down in flames, denying that the party has ended. Like Lot’s wife, they refuse to relinquish the past. They too look back, destroying what riches they had built, turning them into pillars of salt.

Commercial Real Estate Checks into the Heartbreak Hotel

Commercial Real Estate Checks into the Heartbreak Hotel

“I walk a lonely street.” Written in 1955, those five haunting words were all one man left of himself before leaping to his death from his hotel room window. According to a story that ran all those years ago in the Miami Herald, it would seem that he had heartbreakingly embraced the loneliness of being unknown and unmourned. What compulsion had driven him to destroy all identity leaving no trace of who he had ever been?

From that lonely man’s pain came a classic. “Everybody in the world has someone who cares,” wrote Florida school teacher and songwriter Mae Boren Axton. “Let’s put a Heartbreak Hotel at the end of this lonely street.” Though accounts vary, Axton and fellow songwriter Tommy Durden are credited with collaborating to write the song that would launch the career of a legend, one Elvis Aaron Presley.

For a different but more notorious legend, its last lonely and likely unmourned symbol has finally been laid to rest with the sale of New York’s Nylo Hotel. Marking nearly eight years since Lehman’s bankruptcy, the sale of one of the last properties in the storied investment bank’s exhausted portfolio thus closes the wound on the $691 billion bankruptcy, the biggest in U.S. history.

If eight years rings a bell for you, that’s because historically it’s just shy of how long economic cycles usually last. Commercial real estate (CRE) cycles tend to persist for a bit longer, about 10 years according to work by Christopher Lee of CEL & Associates, a real estate consultancy. Lee breaks typical cycles into four periods – Growth, Plateau, Crisis and Transition. Good entry points tend to present themselves in the Transition Period while good exit opportunities arise six months before or after the peak of the Plateau Period. That seems intuitive enough. Get in close to the ground floor of a cycle. Get out before the crisis hits.

Given that the current cycle is well past Transition and Growth, let’s focus on where we are in the Plateau Period. Lee’s qualifier list is as follows: Overly optimistic underwriting standards, an increase in capital raising, aggressive competition for talent, blind entrepreneurism, low cap rates, supply and demand out of balance, protracted closing period, increases in ‘guarantees,’ high investment sales activity and generous lease terms.

From discussions I’ve had of late with real estate folks on the ground, just about all of those factors can be checked in the affirmative. In fact, lending standards have been tightening for the better part of a year, a sign in and of itself of what’s to come.

As for cap rates, the rate of return on a given property based on the income it’s expected to generate, they’ve leveled off since the start of the year with a few notable exceptions. Cap rates are to real estate as price-to-earnings ratios are to stocks, a valuation metric, except for the fact that the lower cap rates are, the pricier the property in question.

As to those exceptional sectors, industrial space remains hot, hot, hot – and why wouldn’t it be as Amazon continues to take over the world? Self-storage is also a sector that continues to increase in value, which stands to reason as Boomers start to downsize but don’t have it in them to purge a lifetime of belongings that just won’t fit into their newer, more compact living spaces. And then there’s Canada, the great alternative to the north (and due west) in the event election results don’t come in quite as the pundits expect.

It stands to reason that when cap rates level off, prices follow. Indeed, according to the widely followed Green Street Commercial Property Price Index (CPPI), national prices rose by a mere one percent in June, a marked decline from the past three months’ three-percent increase and the seven-percent rise seen over the last 12 months.

Delve into individual sectors and you really start of get a sense of how the tide has turned. Consider the darlings of the current CRE cycle – apartments and hotels.

While the multifamily sector is still up nine percent over the past year, its price performance has literally hit a wall, as in up one percent over the last three months and flat as a pancake over the past month. Recall that an imbalance between supply and demand can be problematic during the Plateau Period. A recent Wall Street Journal story noted that in 25 of the largest U.S. cities, multifamily permits had risen by 39 percent in 2015.

In all, some 395,000 apartments were started last year nationwide. That classifies 2015 as ‘abnormal,’ according to the National Association of Home Builders which considers a normal year to entail the construction of 331,000 units. This year promises another aberration with 379,000 planned starts, a figure expected to be one-upped by 2017’s pipeline of 402,000. Move over George Jefferson – we’re all gonna be movin on up. Or will we?

Yes, some 1.4 million renters were added to the pool of leasees last year, capping off the addition of nine million new renters over the past decade as homeownership crashed to the lowest levels in modern history. Millions of millennials aside, could the market nevertheless be reaching a saturation point?

No doubt, June’s payroll gains were sufficient to reach for the smelling salts. Still, job openings are at a five-month low. And payroll gains averaging 147,000 over the past three months compared to last year’s 229,000 monthly average just doesn’t jive with record levels of apartment construction.

Exacerbating the dynamic is that most units built in the current recovery have been at the high end of the spectrum. It kind of helps that leaning luxuriously helps hit rate of return bogeys when interest rates are nailed to the zero bound. In any event, high-end rent growth peaked at eight percent five years ago and has since slowed to three percent.

Speaking of the high life, hotel construction has also been one of the current CRE cycle’s ‘It girls.’ Over 100,000 hotel rooms are under construction in the country today. Over half a million are in the pipeline. Leading the charge are the mover-and-shaker digs. Add up upper-midscale, upscale, upper upscale and luxury rooms and you find these categories comprise 82 percent of what’s being built today. Ah, the suite life.

It stands to reason that geography is playing its own hand in driving the deluxe trend. National room supply accelerated from 0.9 percent in 2014 and 1.1 percent in 2015 to 1.6 percent in this year’s first quarter. But in Miami, supply is growing gangbusters, up by 3.5 percent. Due north, the Big Apple is on fire, with supply up a blistering five percent from a year ago.

When it comes to hotels, the proper profit parlance to employ is the term ‘RevPAR,’ or revenue per available room. To arrive at this performance metric, you divide a property’s total revenue by the number of rooms and the number of days being measured or multiply a hotel’s occupancy rate by its average daily room rate – one of those six-pack, half dozen affairs.

Here’s an example, care of Investopedia: A hot boutique property has 100 rooms that boasts an average occupancy rate of 90 percent. If the average room rate is $100 per night, its RevPAR works out to $90. Easy, breezy.

First, occupancy. PricewaterhouseCoopers predicts that occupancy will flat-line this year at 65.5 percent and fall in 2017 to 65.0 percent. That’s saying something considering occupancy has been on the rise since 2010. Corroborating this are data from Smith Travel that reveal occupancy has deteriorated for four of the past five months, the worst run since the tail end of the recession in 2009.

A separate report by CBRE Hotels concurs that for the current cycle, demand growth peaked in the third quarter of 2015. This would certainly help explain RevPAR growth slowing to 2.7 percent in the first quarter from last year’s 6.3-percent pace.

Costs have also been climbing in the sector, which is certain to make management nervous as RevPAR growth continues to slow. Total expenses rose by 4.6 percent last year, the fastest pace in 20 years. As if on cue, the number of aggregate hours worked by accommodation employees peaked in January. When it comes to rising costs in the face of top line pressure, something always gives.

Add in the monster supply coming on line and in the works and you begin to understand why lodging is the weakest sector in the CRE space, with prices down 12 percent over the last year. (Maybe the Chinese purchase of the Waldorf did mark a turning point after all.)

Of course, a peak does not necessarily translate into a slump for the overall industry. For a protracted decline to emerge, tourism would have to take multiple hits, business spending on travel and expense would have to be curtailed and U.S. consumption would have to falter.

On those counts, the strong dollar and the Brexit will certainly not be additive. But optimism still rules the day. A fresh report out of the Global Business Travel Association projects business travel to grow by 5.8 percent per year through 2020, an acceleration from last year’s five-percent rate. In all, $1.2 trillion was spent on travel in 2015. The forecast calls for that figure to rise to $1.3 trillion this year led by a continued acceleration in China. At $291 billion, China surpassed the United States last year for the first time, clocking annual growth of 11.4 percent compared to 2.2 percent growth in the U.S.

As for consumption, it’s worth noting that income expectations remain below their March 2015 peak even as credit card usage continues to rise over last year – a classic sign of household budgetary distress. The relatively rapid increase in savings vs. consumption also suggests caution ahead.

At the risk of contradicting everything that’s been written thus far, and care of New Albion Partners Brian Reynolds:

  • The Pennsylvania Public School pension allocated $100 million into a real estate fund, $75 million into a real estate debt fund, and $75 million into a commercial real estate fund
  • The Michigan state pension is sending $310 into real estate funds
  • The Texas Municipal pension is investing $100 million in a real estate debt fund
  • The Houston Firefighters’ pension is giving $25 million to a real estate fund
  • The Missouri Local Government is allocating $65 million to an opportunistic real estate fund
  • The Fresno pension has sent $30 million to opportunistic real estate, and
  • The New Mexico state pension placed $75 million in a real estate fund


Reynolds figures that this late-stage money blindly chasing returns will give the real estate cycle legs, which would push the cycle to that 10-year mark if nothing else. “The duration and intensity of this credit boom will likely lead to a commercial real estate bubble,” Reynolds warns. “We seem to be on our way to that.”

Of course, this will end in heartbreaking tears. Of course the Federal Reserve will be to blame. Of course those most harmed will be the most vulnerable when the rent finally comes due. And of course, there will plenty of profits safely tucked away well before losses are incurred. As for the future guests at the Heartbreak Hotel. They won’t see what’s hit them until it’s much too late.