Businomics Blog

The Coming Mini-Boom in Commercial Real Estate

We are currently under-building commercial real estate, which will lead to a mini-boom. The pipeline of new buildings is thin, so as the economy improves, there will be very little additional space coming to market. Occupancy rates and rents will rise. The resulting increases in operating earnings will cause the mini-boom. However, a true boom requires easy money, which is not part of our future, at least over the course of the upcoming cycle.

As a good rule of thumb, we spend about one-and-a-quarter percent of gross domestic product on commercial and health care buildings. That figure was steady through most of the 1960s and ‘70s, until the Savings and Loan industry diversified into financing commercial real estate. At the peak in 1985, two percent of GDP was devoted to commercial construction. That overbuilding as well as the tighter lending rule associated with the FIRREA legislation led to below-normal construction in the early 1990s. The 2001 recession cut development levels again.

The recent economic boom and housing boom was not a commercial construction boom. The best years of the last decade were below the long-run average. In other words, the American economy entered the recession without an excess supply of commercial structures.

The recession certainly clobbered commercial real estate, pushing occupancy rates down, which triggered rent cuts. The long lead times of many projects kept pushing more floor space onto the market even as the recession was reducing demand. Commercial real estate is not healthy at this time, but there’s a vital distinction between commercial and residential real estate. We overbuilt residential, and then the recession lowered demand. In the commercial sector, we had not overbuilt—and then the recession lowered demand.

Last year commercial construction amounted to just 0.6 percent of GDP, less than half its long-run average. One might argue about whether the long run average is drifting up or down over time. However, there’s absolutely no way that the current construction pace constitutes the new normal.

I scanned a few market reports from around the country and found the pattern remarkably similar. Washington DC is one of the strongest economies in the country. Office vacancy rate dropped a little in the fourth quarter of 2010, but at 14.9 percent it’s still too high. Grubb & Ellis reports that last year net absorption was 4.5 million square feet, but there was only 0.7 million square feet of space under construction. That pace of new building activity is appropriate for an overbuilt market, but it won’t be appropriate forever.

Phoenix has a middling unemployment rate—9.3 percent, which is about average—and its industrial market is very soft, with a high vacancy rate that is gradually dropping. CBRE reports that net absorption last year was over six times greater than space under construction.

One of the worst economies of the large metropolitan areas is Tampa, where the unemployment rate is 12.4 percent. The retail sector has a fairly high vacancy rate, but in the fourth quarter net absorption was 323,000 square feet, according to Cushman and Wakefield. Completed retail space: a mere 18,500.

The economy is gradually expanding. The pace of growth is disappointing, but it’s definitely positive, triggering increased occupancy of all types of properties, in almost all parts of the country. Net operating income will improve, initially because of rising occupancy, and eventually from rising rents.

Improvement in the economy does not always trigger improvement in net operating income, because developers often anticipate the economic growth and build new space in anticipation of greater demand. That increase in floor space can sink rents even in a growing economy.

Today, however, there is hardly any speculative new construction. Banks and other lenders have tightened credit standards. They are skeptical of new projects given today’s high vacancy, and they are demanding very high equity positions before lending to developers. The lower loan-to-value ratios make it harder for a developer to earn the return that covers the risk. In addition, some developers who are convinced that their ideas are worthy projects even at a low loan-to-value simply do not have access to the equity capital needed to satisfy banks. The result: no one is building today in anticipation of tomorrow’s demand.

This improvement in commercial real estate will not become a full-blown boom, however. A real boom requires easy money, and plenty of it. Credit standards will remain high throughout the next cycle, and long-term interest rates will gradually rise as the global economic expansion fuels demand for credit.  Call it a mini-boom, but it’s still a great deal better than what we’re experiencing now.

What does this coming mini-boom mean for people in the commercial real estate business? Developers will need to start planning their new projects, which may involve more development of equity sources than development of dirt. Timing is crucial and will vary from market to market. Too early and developers will have a few bad years as they put property into still-weak markets. The greater risk, however, is too late, in which case others have already filled the need.

Tenants should consider extending their leases now, while the market is still soft. In a couple of years most markets will have shifted to favor landlords.

Landlords should be cautious about lease extensions. Those who need the cash flow may sign new leases at current rates, but those who can wait a couple of years will be well rewarded for their patience.

When the real estate market turns, we’ll all look back and say, “We should have seen it coming.” You can see it coming right now, even though the turn is a few years away.

Japan's Earthquake and American Manufacturing Businesses: Economic Impacts

Japan's terrible earthquake has economic implications for American manufacturers, in addition to the terrible human consequences. Japan's economy is large and diverse, with strong business ties to the United States. The key point to ponder is that Japan's businesses play three roles with respect to American manufacturers: customers, suppliers, and competitors.

Japanese Businesses Are Customers of American Businesses

Japan runs a trade surplus with the U.S., but that does not mean we don't export to her. Last year we sold a total of $60 billion worth of stuff to Japan, about three-fourths of which was manufactured goods. Our best-selling products in this trade are chemicals, computers and other electronic devices, and transportation equipment, mostly airplanes. Although these categories lead the list, every other category shows significant American exports to Japan.

In all cases, Japan's earthquake will slow American exports in the short-term. The damaged infrastructure, including transportation systems and the electric grid, will cause Japanese buyers to tell us to slow down our shipments. Over the longer-term, when rebuilding is critical, American manufacturers will enjoy increased sales in some niches, especially wood products and some machinery that will help repair or replace damaged infrastructure, homes and factories.

The Japan of the future may not look like the Japan of the recent past. Some businesses over there will never recover. Imagine a company that was operating at a very low profit margin, battling for global market share with China or other Asian countries. If the factory is seriously damaged, it may not be worth rebuilding. Or imagine another company which was not damaged, but whose supply chain was interrupted for several months. When it's ready to go back to production, it may learn that its customers have found other sources that they are now happy with. The impacts will vary from company to company, but the total impact will be slightly negative for Japan as a customer of American manufacturers.

Japanese Businesses Are Suppliers to American Businesses

Japan is not only a customer, but also a supplier to businesses in the United States. Among the industrial goods that we buy from companies in Japan, the largest elements are computers and electronics, machinery, and chemicals. It's interesting that chemicals are both a major export and a major import. The detailed sub-categories show some things we import a lot of, such as printing inks,
and other products we are large net exporters, including basic inorganics. Many American companies will find their supplies interrupted and will have to scramble to find alternative vendors.  Japan invented just-in-time manufacturing. Although its production costs are not the lowest, it has earned a reputation for reliability. American companies, which already to reporting slower delivery times from their vendors, are now faced with an additional supply chain challenge. In the near-term, this will certainly cause bottlenecks in some factories here in the states. Over the longer term, American businesses will find that many of the alternative vendors they turned to are quite satisfactory. Some of our purchases from Japan will resume quickly, but other purchases will be lost forever.

The imperative action step for American manufacturers today is to review their vendors for Japanese businesses that may be impacted. One does not want to blacklist Japanese companies, of course, but to make inquiries. It's a large country, and many of its factories are totally untouched, with logistics systems that are still functioning smoothly. However, it's imperative for a company to know the status of its vendors. Checking for Japanese suppliers is not enough. Purchasing managers need to check with all vendors to see if their ability to deliver will be impacted by the earthquake. A modern supply chain may have many links. If any one of those links goes back to Japan, then reliability needs to be evaluated, pronto.

Another supply chain problem will impact some American companies: their customers will have to cut back operations due to Japanese suppliers not able to deliver. Boeing sources some 35 percent of its 787 Dreamliner components from Japan. A disruption of their supply chain could trigger a production cutback that would impact many domestic suppliers to Boeing. (Boeing is currently assessing its suppliers, and no announcement of a production cutback has been made as of this time.)

Japanese Businesses Are Competitors to American Businesses

Finally, Japan is not only a customer and supplier but also a competitor. The largest trade imbalance between our two countries is transportation equipment, mostly cars. Despite the many U.S. factories owned by foreign car companies, we still imported $47 billion worth of cars and trucks last year--and that was a lousy year for car sales. Look for many American companies, not just in automobiles, to gain global market share at Japan's expense. Businesses that have faced stiff Japanese competition may be able to make inroads in many areas. It may seem heartless to some that American businesses would profit from Japan's misery, but it would be even more heartless to fail to provide goods to the people who want them. There's no use spreading the misfortune any wider than it needs to be spread.

However, there is a danger to American companies that expand to fill the void created by Japan: these gains may be temporary. As Japan gets its plants and transportation system going again, it may well win back sales lost during the turmoil. American companies that gain sales in the near term should be cautious about assuming the sales will last. The worst strategy would be to commit to large expenses, betting on the new sales continuing even as Japan recovers, only to lose to the old Japanese companies that have rebounded solidly.

Japan's earthquake throws a giant monkey wrench into the global economy. American manufacturers have to think carefully to gain from the opportunnities and avoid the risks that come from chaos.

Economic and Financial Impact of Tokyo Earthquake and Stock Market Sell-off

I rarely invite guest authors in, but the following piece is worth an exception. The author is Phil Diamond, CFA, Chief Investment Officer of Focus Point Solutions:

Before you all get the idea to ask the question, we thought we’d go ahead and answer it. What does this mean for our portfolios? The short answer is probably very little. Obviously, the outlook in Japan has changed in the last week. Much of Japan’s focus is going to shift from economic recovery and growth to helping their fellow Japanese ease their crisis.

The world’s reaction to this series of disasters has been overblown. Japan will have a time when they won’t be able to produce as much as they had produced. Part of this will be due to direct damage to facilities in the north where the earthquake and tsunami were focused. Part of this will be due to power shortages as most of Japan’s 55 nuclear power generators were taken off-line to check for damage. This second issue should right itself in days, the first may take months. But, Japan did not stop just because of the earthquake and tsunami. Most Japanese were not directly impacted by this disaster and will largely go about their business, perhaps even work a little harder if that can ease the suffering of their countrymen in the north.

Getting food, shelter and medical supplies to the stricken area is the first priority, but soon thoughts will turn to repairing and rebuilding this shattered area. That will create jobs and growth for the affected area.

Japan will need steel, cement, machinery and other materials to rebuild. These will largely be produced in Japan. There may be a slowing of exports as supply chains get interrupted, but that will get fixed and Japan will come back.

The gross overreaction of world markets and Japan’s market for that matter will soon be seen as just that, an overreaction. We did not value Japan’s stock market based on the assumption that there would be no earthquake and no tsunami. The idea is that looking forward, Japan’s stocks are worth their discounted future cash flows. Those cash flows have not been reduced by 20% in the last several days as Japan’s market has been. The market was probably a little pessimistic about Japan even before the disaster. Now, we are just too low in valuing many of Japan’s stocks.

The reaction of other world markets to Japan’s financial panic is just silly. What has made French consumer goods companies and English manufacturers worth less? Nothing. This is a reaction to perceived higher risk premiums by investors worldwide. We’ve been buffeted by the shock that disasters of this magnitude can happen in civilized places like Japan. If it can happen to them, it can happen to us. Well duh! Nothing is guaranteed, but the probability is that nothing like this will happen again for many, many years. This was a once in a century occurrence. We can’t live our lives and plan our futures and invest our money based on once in a century events.

The closest parallel to our mind was the reaction of the markets to the 9/11 attacks. The loss of life, the property damage, the impact on the broad economy were all far smaller from that event than from Japan’s current disaster. But, people reacted the same way. They panicked. What good did it do them? None. Within a couple of months the market had recovered all its losses from immediately after 9/11. Then we went on and completed our bear market, but the ultimate lows of the bear weren’t all that far below the lows hit the week after 9/11. If people stick with their plans and look at these types of events as opportunities rather than crises, they are better prepared to react correctly.

 As we have said before and will likely say again, “no one brags about selling on Black Monday.” But that is exactly what nearly everybody did. No one will be proud of selling Japan today. Few will look back at this moment and say they did the right thing.

Businomics Interview: Business Cycles and Management

Here's a video of me discussing the best book on economics and management.

 

Strategic Planning and the Economy

I heard a corporate CEO say something that is very, very rare. We were chatting about the economy and he rattled off the key economic assumptions of his company’s strategic plan. He cited the sector of the economy he sold to, the dollar, and energy costs as the three big assumptions.

CEOs almost always have opinions about the economy, but rarely do I hear them articulate the three or four key economic drivers of their company’s plans. This is vital not because CEOs are great forecasters of economic trends, but because successful business planning requires an understanding of what really matters to your company.

Begin the planning process by identifying the economic issues that really concern your business.  It’s easy for an economics discussion to get caught up in the budget deficit and American’s low savings rate. For most businesses, however, those are not the key determinants of their future. To discover the key drivers, think of a simple process: a firm buys inputs, processes them, and sells outputs.

 

How much can you sell? That will be a key driver for almost any business. The economic driver behind sales, though, depends on what part of the economy you are selling to. Starbucks sales are driven by discretionary consumer spending.  A door manufacturer’s sales are driven primarily by housing starts. The finicky guy in the company will note that some sales are for remodeling, and other sales are for non-residential construction. Tell the finicky guy to shut up until the one or two big drivers of company success have been identified.

The factors at work may include enablers of customer spending, such as credit availability. Also consider major alternatives that consumers might enjoy. It never hurts to put a laundry list of ideas on a whiteboard, but one or two (three at the max) entries should stand out as the dominant sales drivers.

Now think about those inputs. For most companies, they are far more diverse than the product sold. Some companies will begin with raw steel, but pretty much everyone should include human talent, energy and financing on the long list of items they purchase. Sorting out the big drivers is a bit more complicated here than it was for sales. Some inputs are very important to the company, cost a lot, but are fairly stable. If their prices and availability are steady, don’t bother worrying about them. When considering big drivers related to the inputs, don’t neglect issues of availability. When the economy improves, vendor performance falls. For many inputs, availability is far more important than price.

The inputs are not only the raw materials that go into the finished process, but the purchased goods and services that enable production.  Think about labor, energy and capital. Again, the key drivers will vary from company to company. The business with a conservative balance sheet probably won’t worry about credit too much, but the firm that is highly leveraged will need watch both interest expense and credit availability.

Identifying the key economic drivers is just one first step. Next, sketch out some scenarios. Don’t try for a perfect forecast, but try to construct some logically-consistent stories.  Here are a few examples.

• The economy continues to strengthen at home and globally. Sales grow, but energy costs rise faster. Vendor performance suffers. Interest rates rise, but financial institutions make credit more available. Labor markets tighten, with less-skilled workers readily available but skilled job applicants hard to find.

• Middle East political disruption pushes oil prices up. European economies stumble. The rising energy costs combine with weak sales to clobber profit margins. Bankers tighten credit standards as they fear another recession.

There are other stories to consider, but you get the idea.

Now combine these economic scenarios with key non-economic issues, such as the competitive environment and technological change. You may want to consider a couple of different scenarios regarding the non-economic issues, just as you did for the economics.

Now develop strategy for each possible scenario. It may be a bit cumbersome, with two or three economic scenarios combining with three or four non-economic scenarios, resulting in nine to 12 combined scenarios. This may look like a daunting task, but you only need to sketch out the major elements for each scenario.

After developing the appropriate strategies, compare them all. You may find that certain strategic actions are robust. You reach the same conclusion regardless of the scenario under consideration. For example, “using information technology to pass information from sales representatives to top management faster” may be an appropriate action step whether the scenario is fairly optimistic or fairly pessimistic. Other ideas may turn out to be unwarranted in any scenario.

The difficult part, of course, is choosing among strategic actions that make sense in one scenario but not another. This is where the senior management team will earn its bonuses. Picking actions to actually implement may depend on management’s judgment about the likelihood of the various strategies. However, great teams will also consider ways to add flexibility into their strategy. An simple action step might say, “Expand into the southeast region.”  An alternative would be “We will begin planning for a new expansion into the southeast market, but not start hiring or signing leases unless data through the second quarter reaches specified targets.”

Good planning is not easy. Some people want to get a decision made, whether it’s right or wrong, and implement immediately. Those are great people for getting things done, but they can work against good strategy. Calm them down and keep them participating. Ask them questions such as, “What problems will we run into trying to implement this stragegy.”

Other members of a management team will be more inclined to think and discuss and analyze and deliberate. These are valuable steps in the planning process, but it’s easy to get bogged down. When the leader (or perhaps facilitator) feels that the paralysis of analysis is setting in, it’s time to unleash the doers. Reach a consensus a move forward.

Planning is much more than economics, but the economic environment is still an crucial part of the planning process. It drives much of the variation in sales and costs—it has to be important. Though it’s often handled poorly, you can do well enough by focusing on the big economic drivers specific to your company.

Call me if you’d like some help with your business planning process.

The Future Is . . . Glass

Just when I was thinking that there has been nothing new under the sun since the invention of downloadable ringtones, I learn that our future will be dominated by glass. (Hat tip: Mark Perry, Carpe Diem).