Momentum 2014 Commercial Real Estate Outlook A CohnReznick LLP Report FEBRUARY 2014
mo • men • tum noun: impetus and driving force gained by the development of a process or course of events
Table of Contents
Today’s Commercial Real Estate Business Environment.............................................................1 Critical Issues Facing Commercial Real Estate in 2014.................................................................2 The Road Ahead: Economic Outlook for 2014―From a Walk to a Trot.........................................9
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Preface The difficulties associated with the global financial crisis may be well in the past, but the lesson indelibly learned is to never let optimism—no matter how well founded—get in the way of thoughtful analysis. This is particularly useful advice now, when the commercial real estate industry is undergoing significant change due to a number of large-scale forces that are combining in powerful, global ways. Commercial real estate has always been a core area of focus at CohnReznick. In Momentum 2014: Commercial Real Estate Outlook, the members of CohnReznick’s Commercial Real Estate Practice share their views on key activities that shape this vital industry: capitalization trends, regulatory changes, construction and property dynamics, demographic shifts, and economic factors. We then provide our assessment of how these activities are affecting investors, developers, owners, operators, and lenders. We conclude with a list of specific issues and economic developments that industry participants should carefully examine this year. It is our view that, beneath the current optimism and opportunity, the commercial real estate industry is now in a period of great flux that will set the tone well into the next decade. Those who take the time to understand the bigger picture—and who then act with speed and confidence—will be at a significant competitive advantage. We hope you find Momentum 2014: Commercial Real Estate Outlook to be a thought-provoking commentary on the state of the industry.
David Kessler, CPA Partner, Commercial Real Estate Industry National Director
Today’s Commercial Real Estate Business Environment
Having endured the abrupt and unprecedented economic downturn that began in 2008, the commercial real estate industry has had to adjust to a similarly unique “recovery.” Fundamentals are strong and the earlier gloom and doom has given way to a more balanced and rational exuberance than that of a decade ago. At the same time, the broader economic recovery has not ignited the robust, widespread “boom” of earlier rebounds. The primary reason for this is that the near-collapse and slow repair of the global financial system has not taken place in a vacuum but alongside other equally significant events. The Millennial Generation—typically identified as people born in the early 1980s to 2000s— constitutes a growing economic force with priorities and needs very different than those of their Boomer parents. The rebirth of urban centers is offering economic vitality and quality of life, while the maturation of digital industries has transformed the way we live, shop, and work. The cautious optimism of the commercial real estate industry is fueled by these dynamic social and market forces. But each of these epic developments is actually a complex combination of growth and decay. Many cities have begun to thrive again while scores of suburbs struggle. Some industries and business models lag behind the relentless migration toward the digital future. The recovery is uneven not because it is weak, but because it has had to absorb these seismic shifts along the way. The story of today’s commercial real estate industry is the story of identifying and embracing the possibilities while maintaining the flexibility of managing the strategic and operational challenges these changes bring.
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Critical Issues Facing Commercial Real Estate in 2014
Capitalization Capital flow is the axis around which commercial real estate revolves. The following examines the current capital environment from the perspective of investors, real estate funds, and lenders. Investors After several years of skepticism, U.S. commercial real estate is once again a highly desired asset class for both domestic and foreign investors. Despite the occasional musing that higher returns might be available in other countries, investors favor the United States for its long-term economic prospects and its political stability. This faith has continued to hold through government shutdowns, legislative gridlock, and an avalanche of new regulations. While investors may have shed their earlier squeamishness about real estate, they have not abandoned the skeptical “show me” attitude adopted during the downturn. Fund managers are no longer evaluated by gut feel but by past performance and computer algorithms. In today’s environment, even a good track record is not enough. Investors are looking for a sense that the track record “matches the manager” rather than being the result of an extended lucky streak that is awaiting a return to the norm. Investors are also placing a higher premium on diversification—there are too many macro-level forces at work to risk following a single strategy.
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Momentum 2014: Commercial Real Estate Outlook
Real Estate Funds The race to build property portfolios that will benefit from the new economy has separated real estate funds into two distinct camps. The largest funds, armed with war chests accumulated through their broad, long-term investor base, have been competing against each other for trophy properties in primary markets. Their investors are happy to accept the returns of 6% to 8% that these properties generate in exchange for a relatively low level of risk. Smaller and mid-sized funds, which generally lack the table stakes necessary to play in the primary markets—and needing to differentiate themselves from their larger rivals—have looked for higher return opportunities elsewhere. Instead of a trophy tower in Chicago’s Loop, for example, they may be looking at an industrial to office/mixed use conversion in the brickyard. Or, primary markets might be bypassed altogether for secondary and tertiary markets that have been historically off the radar of the largest funds. What the smaller funds lack in capital they hope to make up for in agility and vision. In the last couple of years, funds have tended to self-segregate along these size and investment strategy lines, competing primarily against others within their own class. Going forward, these boundaries may be blurred as the larger funds seek to expand their portfolios outside of core properties and primary markets. The heightened competition for non-core, alternative assets will be a test of skill and fortitude. The largest funds with their greater resources will go up against smaller funds with closer market knowledge, greater investing flexibility, and faster decision making.
While investors may have shed their earlier squeamishness about real estate, they have not abandoned the skeptical “show me” attitude adopted during the downturn. Image TBD
Funds of all sizes will be affected by the many regulatory initiatives that are being exercised in 2014 (see Legislation section). These requirements, however, will pose a greater burden on smaller funds that, in general, lack the back-office infrastructure that this heightened level of compliance demands. To the extent that regulations are intended to reinforce transparency and hinder overzealous lending practices, they help provide a framework for funds to meet the demand from investors for information. But at what cost to a fund’s operations? Fund managers are finding themselves spending more time, energy, and resources on investor communications. But trust is a two-way street. Once a manager has earned it, he or she will expect to operate without having to explain every move to second-guessers. Lenders Investor enthusiasm for commercial real estate would have little impact without a surge in available debt financing. But while the availability of debt may have returned to pre-recession levels, the sourcing for that debt is starting to shift. Banks―which are constrained by regulations limiting involvement with alternative assets, and by credit committees that have institutionalized the lessons of the recent past―are gradually taking a more limited role. Instead, private equity debt funds are lending to non-core projects. Low-risk trophy properties are being backed by cash-rich life insurance companies that, like private equity funds, operate in a more flexible regulatory environment than banks.
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Critical Issues Facing Commercial Real Estate in 2014 In addition, conduit lenders continue to provide a larger share of capital, primed by the appetite of bond investors for alternatives to Treasury paper and an evaporation of earlier credit-quality concerns. As a result, Commercial Mortgage-Backed Securities (CMBS) issuance has climbed back to $80 billion in 2013 from a recession-low of $3 billion in 2009. It could well reach $140 billion this year—consistent with the healthy but not frenzied levels before the run-up to the crash (see figure below). U.S. PE Company Inventory
U.S. CMBS Issuance by Year 250
230 203
200
Billions USD
168 150
94
100 66 50
48
80
78 54 30 12
0
3
44
11
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Commercial Real Estate Finance Council
While this sourcing mix is working well for now, it raises questions worth considering for the future. If banks wait for more sustained economic growth before jumping back into the market, will they find themselves boxed out by other lending sources? How much turbulence will private equity debt funds tolerate before turning the spigot off? Will the implementation of Dodd-Frank and the Volker Rule dampen CMBS issuances? How effectively these questions are addressed will help determine the robustness of the commercial real estate recovery.
What does CohnReznick think? The continued rebound in commercial real estate is being fueled by large-scale changes in both the economy and society at large. At the same time, the capitalization rules of the real estate industry are also being rewritten as funds further segment themselves and adopt new strategies, lenders shift roles, and investors narrow their selection criteria and carry new expectations. We believe these developments represent more than the usual jostling of players, but rather signal a significant realignment in the market that will define the current cycle. Real estate decision makers need to seize the position they wish to occupy before the window of opportunity closes.
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Momentum 2014: Commercial Real Estate Outlook
As discussed in the introduction, the world of commercial real estate does not operate in a vacuum. Factors like interest rates, legislation, demographics, and sociological trends greatly determine both opportunity and risk.
Interest Rates While no one can predict the path that interest rates will follow, the Federal Reserve has signaled that the gradual rise that began in the second quarter of 2013 will likely continue in a deliberate manner. This transparency has removed a key uncertainty as the market has already factored in such a rise in its investment strategies. As Janet Yellen takes the reins, and the official unemployment rate continues to fall, the general expectation is that any rise in rates will be proportional to economic growth. Therefore, what is taken away by financials will be replaced by stronger underlying fundamentals.
Cap Rates With cap rates at near historic lows in several property sectors and numerous key markets, signals are mixed as to the direction they will take this year. Simply looking at the available data suggests they can’t fall much lower. However, with interest rates trending slightly higher and real estate expected to receive greater competition from the bond market for investor dollars, cap rates should ultimately rise in 2014. This trend will be supported by an upward creep in rent rates as the economy continues to improve.
Strong M&A activity in 2013, especially during the third and fourth quarters, is on track to continue into this year and possibly beyond.
Mergers and Acquisitions Strong M&A activity in 2013, especially during the third and fourth quarters, is on track to continue into this year and possibly beyond. Real estate companies as well as private equity firms are now finding attractive alternatives to traditional banking resources for refinancing existing property assets, while simultaneously exploring potentially lucrative M&A opportunities. The gradually improving economy, continued low interest rate environment, and stability of property fundamentals have all contributed to the increased level of business confidence in the market that is currently fueling the heightened activity.
Legislation Basel III and Dodd-Frank Years after their passage, and after extended commentary and debate, 2014 will finally see the implementation of key elements of both Basel III and Dodd-Frank. These regulatory initiatives will have significant impact on the ability of banks and funds to invest in or loan to real estate projects. While there are a number of ways to look at the changes, it may be best to consider how Basel III and Dodd-Frank together will affect equity holders on the one hand vs. debt holders on the other.
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Critical Issues Facing Commercial Real Estate in 2014
We expect compliance requirements to continue to drive consolidation among funds.
On the equity side, last year Dodd-Frank removed the exemption many hedge funds, private equity funds, and asset managers relied upon to avoid registering with the Securities and Exchange Commission (SEC) as Registered Investment Advisers. Registering placed them under a new set of regulations overseen by the SEC’s Division of Investment Management. Starting last year, they must undergo SEC examination to test for compliance. Funds holding real estate assets should expect to attract additional scrutiny given the new regulations and their illiquid investments. While the largest funds have had the resources to prepare for these changes since they were first announced, small- and mid-sized funds will find the increased regulatory requirements a burden. This is particularly so given that compliance requires continued attention to ongoing SEC guidance and the evolving nature of the fund’s portfolio. We expect compliance requirements to continue to drive consolidation among funds. On the debt side, the Volker Rule limits bank investment in alternative asset classes to no more than 3% of total assets. It also increases the capital reserve ratio for Tier 1 assets from 4% to 6% and requires acquisition, construction and development (ADC) loans to be backed by a capital reserve of 150%. Banks will respond to this new environment based on their size. Large banks will retain good loans, but divest themselves of their riskier real estate loans/portfolios to comply with Basel III thresholds (although they have seven years to do so). They will become more selective when deciding which projects they lend to. Community banks, however, may find themselves dissuaded from the commercial real estate market altogether— which would dry up a key source of construction funding.
Community banks are also concerned about a provision in the Volker Rule that will require them to divest themselves of most types of trust-preferred collateralized debt obligations (CDOs). A January 2014 interim ruling allows them to retain interest in certain CDOs, primarily those backed by trust preferred securities (TruPS CDOs). With community banks holding $600 million in CDOs, the subsequent write-downs could negatively impact Basel III leverage ratios, further distancing them from the real estate market. FIRPTA The Foreign Investment in Real Property Tax Act (FIRPTA), enacted in 1980, requires foreign buyers of U.S. real estate to pay a 10% tax on their investment at the time of purchase. This regulation, which is intended to subject foreign investors to a tax similar to the one that domestic investors pay at the time of sale, has been chronically difficult for the IRS to enforce. To address this, new regulations require the U.S. seller to withhold the tax. On paper, effectively raising U.S. real estate prices by 10% for foreign investors should dampen foreign interest. But it is our view that foreign investors continue to see the U.S. market as somewhat depressed. This, combined with a relatively weak dollar, suggests that foreign investors will not be deterred by the 10% penalty and will continue to be attracted to the U.S market.
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Momentum 2014: Commercial Real Estate Outlook
Construction and Property Dynamics Given several consecutive years of little construction in most sectors, new construction should continue to accelerate throughout 2014 and beyond. The big question will be multifamily— the one sector to enjoy steady growth during the downturn. Will interest rates at historically low levels, combined with a slowly improving economy, nudge renters to home ownership and slow down multifamily? Or will the Millennial generation—naturally skeptical of long-term commitment—along with their downsizing Boomer parents, continue to boost the rental market and extend multifamily’s run as the asset class of choice? Regardless of how these questions unfold, property conversions will continue to play a critical role in real estate’s rebound. But here, too, the laws of supply and demand will hold fast. There is only so much industrial/warehouse property or underused office space available that is also located in resurgent urban neighborhoods. These properties are already attracting larger, deeper-pocketed investors. So, while investment should continue in current hot areas, there will also be further growth in less-developed areas linked by transit to urban hubs. This “transitoriented development” will be different than the post-war suburban sprawl. Rather than acres of tract homes, these new projects will be self-contained communities designed around a more fluid sense of mobility (walking, car sharing, biking) rather than car ownership. Skyrocketing construction costs pose a potential speed bump to this onslaught of activity. It will also be some time before the semi-skilled workers who form the backbone of the construction industry—and who left in droves during the downturn—can be replaced.
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Critical Issues Facing Commercial Real Estate in 2014 Demographics Much of the enthusiasm within the commercial real estate industry is driven by massive demographic shifts. As the Millennial generation continues to move into adulthood and take their first jobs and apartments, they are placing a premium on flexibility and simplicity. Having seen their parents struggle with mortgage and car payments during turbulent economic times, they do not see home ownership as the defining life passage that past generations did. Having lived their lives “always on, always connected,” they view work/life boundaries as largely artificial. They also have a sophisticated approach to sustainability and a “greener” living environment. At the same time, their parents are downsizing and looking to retire to the same vibrant urban areas that are attracting their children. So the continued attraction of conversions is not just another example of real estate’s pursuit of highest and best use. Repurposing industrial properties as loft-like work spaces, office towers as condominiums, and vacant department stores as data centers reflects a larger societal shift in how we are forming communities and creating the infrastructure needed to support them. This is all good for those investing and developing in attractive markets. Conversely, it poses an intractable challenge for the suburbs that are not connected by rail to desirable hubs and for those urban areas where renewal has not taken place. Here, there remain few viable options outside of good property management and cost control. The next generation of investors and developers As the commercial real estate industry responds to the needs and priorities of the Millennial generation, it is worth noting that the Millennials themselves are stepping up to form the next generation of investors and developers. Naturally entrepreneurial, they are setting off to pursue their own projects after several years of working for an established fund or developer. Given their disregard for boundaries and compartmentalized thinking, it is not surprising to see them approach the industry with a fresh perspective.
What does CohnReznick think? Demographics and opportunities for construction and development may drive much of the optimism in commercial real estate, but legislation and interest rates determine how long that optimism lasts and how it is translated into action. Investors who have not already taken advantage of current and near-term lower rates should do so immediately. It also pays to remember that prepayment penalties are tax deductible in the year in which they are incurred. Despite the great deal of legislative activity, most of it affects those who can invest in real estate, but not the real estate market itself. Capital appears to be plentiful—what banks do not provide, others will. Similarly, the priority of the Federal Reserve under its new board chair will be to continue a policy of “no sudden movements” in continuing to match monetary policy to continued economic improvement. The road ahead is clear.
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The Road Ahead: Economic Outlook for 2014
“ From a Walk to a Trot, by Patrick J. O’Keefe, CohnReznick Director of Economic Research The pace of the U.S. economic expansion should accelerate in 2014. While those gains will be solid and self-sustaining, reduced monetary stimulus and rising regulatory restrictions on the financial sector will constrain the degree of escalation. Real gross domestic product (GDP)―that is, the total output of goods and services adjusted for inflation―is already at its highest level in history. Over the course of 2014, the rate of growth should approach that of 2010, the best year since the recession ended, when real GDP rose 2.8% on a fourth-quarter-over-fourth-quarter basis. Total employment should exceed its pre-recession peak by mid-year as jobs gains average more than 220,000 per month in the year’s first half and then accelerate through the end of the year. Household incomes―key, since consumers account for more than two-thirds of all spending―will grow moderately this year. Purchasing power will rise faster, however, as gains in after-tax income outstrip still-subdued inflation. Consumers’ disbursable incomes will be augmented by further reductions in their financial obligations (viz., interest payments on mortgages and consumer credit). Households’ annualized mortgage interest payments alone are down by more than one-third (about $210 billion) from 2007. Coincidentally, a revitalized housing sector and rising real estate values―together with buoyant equity markets―have increased net worth to a record $77 trillion and, thereby, bolstered consumer confidence. Private investment should also provide impetus during 2014. Despite increases in 12 of the past 16 quarters, inflation-adjusted private investment is five% below its 2006 peak. The ullage is attributable to spending on structures (primarily residential). After languishing for much of the recovery, spending on structures―both residential and nonresidential―is gaining traction. But their contribution to total output is still one-fourth less than the average during the 25 years prior to the downturn. A revitalized housing sector and continued jobs growth (i.e., increased demand for nonresidential space) will narrow that gap in the coming year. And as construction spending accelerates so will jobs growth. At the end of 2013, construction provided 1.6 million fewer jobs than pre-recession; lost construction jobs alone more than fully account for the nation’s total employment shortfall. America’s industrial sector (manufacturers, utilities, and mines) entered 2014 on a sound footing, with fourth-quarter output recording its largest increase since mid-2010. While manufacturers’ orders were wobbly as 2013 ended, shipments were up and inventories well behaved. Manufacturing demand appears solid due to two factors.
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The Road Ahead: Economic Outlook for 2014
Only about one-half of Dodd-Frank’s rules have been finalized and full implementation isn’t expected until the end of this decade.
The first reflects increased demand for passenger vehicles in the aftermath of the recession-elongated replacement cycle. Auto assemblies in 2013 (10.8 million vehicles) were the highest since 2005 and almost double 2009’s output. The second source of manufacturing strength is exports, which account for about one-quarter of total shipments. Although conditions globally are mixed, growth among the advanced economies should bolster demand for American goods. Manufacturing jobs languished during the recovery. At 2013’s end, manufacturers employed 1.7 million fewer workers than pre-recession. As with construction, manufacturing alone more than accounts for the national jobs deficit. Coincidentally, private service employment is 2.6 million higher than pre-recession. Inflation-adjusted spending on services by all sectors is at an all time high, almost 5% greater than before the recession began. Real services spending declined in one quarter during the downturn, twice afterwards. The declines were nugatory. Services spending and employment are expected to accelerate steadily during 2014. Fiscal policy, particularly Federal spending, has exerted drag on the economy for the past couple of years. In fiscal year 2013, the Federal deficit fell by more than one-third and it is still shrinking. But even the reduced deficit is unsustainable. Despite narrowing its deficit, the Federal government is still borrowing one of every five dollars that it spends. Consequently, its debt burden grows and, eventually, debt service will impinge on other priorities. Realigning the national budget should not be disruptive in 2014. Instead, on current policy, it should be marginally stimulative. Since the start of the financial crisis in September 2008, the Federal Reserve has injected some $3.1 trillion into the economy by using newly created money to purchase U.S. Treasury instruments and federally-guaranteed mortgagebacked securities. Its intervention, commonly known as “quantitative easing” (QE), averted an implosion of the global financial system.
Since late 2010, QE has been used to stimulate job growth. But most of QE’s $3 trillion remains in the banking system (i.e., has not found its way into the general economy). The Fed has now begun reducing (presumably to zero) its QE purchases. QE “tapering” is a wild card for 2014’s economic outlook. In large part because QE of this magnitude is without precedent. It is probable that financial markets will be more volatile as tapering proceeds, but its impacts on the general economy will depend on the degree to which interest rates move upward. A second wild card for 2014, one that directly affects the financial sector but has implications for the general economy, is the implementation of “Dodd-Frank” legislation that fundamentally restructures the nation’s entire financial apparatus. Dodd-Frank’s goal is to prevent future financial catastrophes. But its inevitable consequence is that fewer prospective borrowers (businesses and households) will qualify for a reduced pool of credit, with terms that are more restrictive and costs (interest and fees) that are higher. Only about one-half of Dodd-Frank’s rules have been finalized and full implementation isn’t expected until the end of this decade. Nonetheless, it is already altering the financial landscape in unanticipated ways and, therefore, looms as a 2014 wild card.
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About CohnReznick’s Commercial Real Estate Practice About CohnReznick With origins dating back to 1919, CohnReznick LLP is the 11th largest accounting, tax, and advisory firm in the United States, combining the resources and technical expertise of a national firm with the hands-on, entrepreneurial approach that today’s dynamic business environment demands. CohnReznick serves a large number of diverse industries and offers specialized services for Fortune 1000 companies, ownermanaged firms, international enterprises, government agencies, not-for-profit organizations, and other key market sectors. Headquartered in New York, NY, CohnReznick serves its clients with more than 280 partners, 2,200 employees, and 26 offices. The Firm is a member of Nexia International, a global network of independent accountancy, tax, and business advisors. For more information, visit www.cohnreznick.com.
The CohnReznick Advantage for Commercial Real Estate CohnReznick’s Commercial Real Estate Practice provides a broad array of accounting, audit, tax consulting, tax compliance, and business advisory services across all sectors, operating platforms, and geographic regions. Our pledge to provide commercial real estate clients with senior-level engagement teams and forward thinking, success-oriented strategies is what we call The CohnReznick Advantage. The Cohnreznick Advantage is based on delivering the following benefits to our clients: • Industry Insights, Optimized Solutions – We proactively advise investors and owners on the current market by anticipating challenges and developing strategies based on a client’s portfolio, investment objectives, and risk profile. • Transformative Advice – We provide commentary on a broad array of international, federal, state, and local tax issues to help clients navigate complex tax laws and capitalize on relevant tax benefits. • Responsive Culture – Our streamlined organizational structure enables key engagement team members to provide faster, smarter, more efficient services by empowering them to make decisions and provide hands-on advice. • Capital Markets Dexterity – Working with Reznick Capital Markets Securities, we help our developer clients forge strategic alliances with critical capital sources. • Proactive, Resourceful Service – We consult regularly with client management to develop effective resolutions to critical issues and ensure expectations are met and documented. • National with Global Reach – Having worked with commercial real estate clients in all 50 states and internationally, we understand the regulatory requirements and other issues pertinent to specific geographic areas and countries.
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