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Learning Center Experience
By Robert Shelton, Full-Time Faculty Published June 2014
Have you ever found yourself at a spectacular place with a breathtaking view and no binoculars? As you look around, you see a line of commercial telescopes, on stands, with a place to insert quarters. In the middle are two lenses for your eyes and between them a knob that says Turn to Clear Vision. Let's see if we can turn the knob just far enough to give a clearer picture of the outlook for commercial property through 2014.
The 2014 forecast for commercial property indicates modest but slower than normal growth. The National Association of Realtors (NAR) projected the 2014 economy to grow at an annual rate of approximately 2.5 percent. Economic uncertainty is likely to continue into 2014, as corporations wait to see how they will be impacted by the implementation of the Affordable Care Act, as well as the historically high long-term unemployment rate. Most economists agree that while the unemployment rate lowers slightly, it does not take into account the number of workers who have left the workforce. When looking at the details, most jobs indicating new employment are in the lower paying job categories or in part-time positions. Interest rates have begun to rise as the Federal Reserve hints that 2015 may bring higher rates. To further cloud the details, first quarter 2014 gross national product (GNP) came in at a very disappointing 0.1 percent increase. This will make it very difficult for the economy to expand enough to meet the NAR-projected 2.5 percent growth rate within the remaining three quarters. So, let's turn the knob a little further and see if we might clear the picture for 2014.
Residential real estate thrives with low unemployment rates, low interest rates, and plentiful sources of mortgage funding. Texas, parts of California, the nation's capital, and a few other states are the beneficiaries of these variables where certain types of homes are selling at above asking prices with competing offers that can be easily financed at historically low rates. When you see these variables, you will also see positive movement in local commercial real estate.
Commercial real estate needs a viable workforce, financing alternatives generally from large banks or specialized institutional lending sources, and dependable sources of capital to finance expansion. Corporations and businesses need reasonably priced properties, located close to their primary markets, perhaps capable of being expanded as dictated by the success of the business. Where employees once ran up and down aisles or riding fork lifts collecting parts or products for shipping, today conveyor belts run by sophisticated computers do the same thing, more quickly, more efficiently, and less costly.
Commercial real estate investors may come in different forms. An investor may be a general contractor or developer, accompanied by an insurance company as their financial partner who specializes in building warehouses. It might be build-to-suits where the contractor builds a building for a specific tenant's use, either to lease or purchase. Once occupied, the entity may elect to sell the property to an investor, a group of investors, or to a REIT who will put it into their portfolio of properties. While these investors look toward long-term appreciation, the property can be sold to various institutional entities within the term of the underlying lease. The key is the underlying strength of the tenant. If the product is in demand, the tenant is viable, and the property is financeable, then the risk/reward ratio is favorable. Naturally, if these factors are present, capital can be found in almost every market.
So, think of commercial real estate as being business related. Within this category are five major disciplines: office, industrial, retail, apartment, and hotel. Each discipline is affected by the availability of capital, the cost thereof (interest rates) and whether that market segment is being affected by high or low employment rates. Okay, let's turn the knob again for a closer look.
Office properties can be anything from single-story, free-standing, or condominium design to high-rise buildings with many floors of parking underground. Large institutional-grade properties are expected to bring in higher returns in prime markets, as companies fight to find profitability in this prolonged down market. What we know is that companies can downsize, remain neutral, or upsize their operation to suit the specific market conditions. This resilience could allow office property investors a better-than-average return, even in what appears to be a weak economy.
Conversely, industrial corporations have less resilience, as many industrial manufacturers are vulnerable to offshore competition and price undercutting. Investors may provide build-to-suits for cash-rich companies, but the risk is much greater when you only have one tenant, usually on a relatively short 3- or 5-year lease.
Retail success depends upon variables such as a stable workforce, a niche market, popular product line, competition, and profit margins in a very competitive environment. Higher unemployment generally results in the retailer carrying a higher inventory, with less turnover, and lower profits. As we begin to emerge ever so slowly from this stagnant economy, there are signs of a strengthening retail sector with new discount malls and major renovation to some existing malls. Some economists believe we can grow this sector by 5 percent for 2014, versus 4 percent in 2013.
Apartments do very well in times of higher unemployment as workers either move out of homes to reduce overhead, or look at apartments as temporary housing until the residential market stabilizes. Apartments represent attractive investments to individuals who have the funds and credit to procure one. However, they are management intensive, have high turnover rates, and can give thin margins when too many are built and the demand decreases. Apartments have done very well after the 2007 decline in residential home sales. Numerous condominium projects found it hard to sell their units after the downturn in residential sales, so they converted to leasing the units. This temporary measure assured them of income until the market for condominiums stabilizes, at which time they will resume selling units as the leases expire.
Hotels are another subcategory of commercial properties that are directly affected by current levels of employment. I stayed in a very clean national motel chain in Monterey, California about a mile from the convention center. For a 4-day weekend event, I was offered a single king at a preconvention package rate 75 percent less than the rate charged by the convention center hotel. As the economy slowly strengthens, I doubt I can count on that room rate for next year's convention.
You do not have to see vacancy numbers to understand the effects of prolonged low employment rates; corporate uncertainty regarding a major shift in health care costs; reluctance on the part of major developers and investors to begin commercial construction projects in areas with high vacancy rates; or the reluctance of retailers to expand when they are sitting with high inventories. Yet, American industries have been remarkably adaptable.
As of January 1, 2014, a research report, "Startup Business Failure Rate by Industry," from Entrepreneur Weekly, Small Business Development Center, Bradley University, University of Tennessee Research, stated 58 percent of insurance and real estate companies are still operating after 4 years. In addition, 49 percent of manufacturing companies and 47 percent of construction and retail industries are still operating after 4 years. On the surface one might conclude these are not very good numbers. On the other hand, given the condition of the economy, the high unemployment rate, and the uncertainty in so many critical areas, these results mirror the strength found in the stock markets over the past 5 years.
So, what can we expect for 2015? Let's go back to the telescope and turn the knob one more time. Oops, time just ran out! Stay tuned!
Robert Shelton is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.
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