Q2 2018 Edition
© 2018 TRANSWESTERN transwestern.com
A Message from
Larry P. Heard
The Great Recession of 2008-2009 was a grueling economic test for most industries across the globe. By contrast, if the current economic expansion lasts until next summer (2019), which I fully anticipate, it will be the longest expansion in U.S. history. Even today, after nine years of recovery, companies and individuals still exercise business judgments with lessons learned from that period of dislocation.
In 2018, business activity across our nation is fueling healthy property fundamentals that continue to strengthen. Institutional investors are allocating more to private debt funds than at any time in the past two decades. Developers and lenders have continued to deliver new product during this expansion, introducing new supply at a reasonably measured but accelerating pace calculated to meet emerging demand. We also see prudent decision making and space utilization among industries, as businesses focus on streamlined execution and earnings.
This edition of Insights considers commercial real estate adaptations to shifting demand and a more circumspect occupier base during this extended recovery. We examine how office and industrial landlords have learned to more carefully consider tenants’ operational requirements, answering the call for efficient spaces that promote not only collaboration and creativity, but also aid employers in recruiting and retaining talent. As we all know, the battle for human capital has never been more intense.
Insights delves into the growth of urban warehousing and fulfillment centers to identify potential cost savings and recruiting benefits, and explore how infill sites can provide a competitive edge for companies that want to capture critical last-mile deliveries. Finally, we shine a light on nonprofit organizations to reveal some of the unique advantages they enjoy in property markets.
We trust you find these viewpoints beneficial as you plan for the second half of 2018. Thank you for your support and confidence in Transwestern.
Despite growing consensus that the U.S. is experiencing a labor shortage, job growth accelerated into the opening months of 2018. Net additions surged to 326,000 in February—the highest monthly figure since July 2016—before cooling to 103,000 in March. Over the 12 months ending March 2018, the U.S. economy added 2.3 million new jobs.
Annualized wage growth finally strengthened during the first quarter to just shy of 3%, after holding between 2% and 3% for most of 2017. The climb in wages stoked investor fears that a more bullish Fed will respond with more frequent rate hikes. However, we believe that the Fed will follow through with its plan for just three increases this year.
New concerns have risen, however. The Trump administration has taken an increasingly hardline stance on trade, introducing new tariffs on several imported goods including steel and aluminum.
The new tariffs, particularly for steel, greatly elevate the risk of a trade war with other industrialized nations. The European Union and China have already threatened retaliatory tariffs of their own. Ultimately, a trade war could severely hamper net exports, while at the same time raising prices for consumer and capital goods.
Interest rates and inflation
In light of the strengthening economy, the Federal Open Market Committee plans two more increases to the federal funds benchmark rate in 2018, following the implemented March rate hike. The increases directly affect consumer borrowing costs, especially for short-term debt, which could slow down robust consumer spending growth. Long-term interest rates have also crept up recently amid concerns about the expanding federal budget deficit.
Consumer price inflation continued to creep upwards during the opening months of 2018, following some improvement in 2017. According to the CPI-U, average consumer prices in March 2018 were 2.4% higher than they were a year prior, and 0.2% higher than in February 2018. Rebounding gasoline prices continue to fuel overall price inflation, increasing 11.1% over the 12 months ending March 2018. The considerable increase reflects OPEC production cutbacks, which have only been partially offset by an increase in U.S. production.
The sector-by-sector job growth narrative remains largely unchanged from the last couple of quarters, with net job additions almost across the board during the 12 months ending March 2018. The Professional/Business Services and Education/Health sectors again led job growth with approximately half a million net additions each during the period.
After a steady decline last year, the seasonally adjusted national unemployment rate leveled out over the past few months. As of March 2018, the jobless rate stood at 4.1%, unchanged from January and February but down from 4.5% in March 2017.
Gross domestic product
Real gross domestic product (GDP) growth rebounded in 2017, and that momentum is expected to carry over in 2018. During the final quarter of 2017, GDP increased at an annual rate of 2.9%. Consumer spending was again the primary driver of economic expansion during the fourth quarter, accounting for roughly 70% of all economic activity, but was bolstered by strong private-sector fixed investment and public-sector spending. A downturn in private inventory investment weighed down on GDP growth, and imports jumped 14.1%.
We continue to expect solid economic growth, but rising interest rates and wages may sap some momentum. While first-quarter GDP of 2.3% had slowed slightly from the previous quarter, it’s worth noting that first quarter results in recent years have been conspicuously weak in comparison to prior and subsequent quarters. This suggests a seasonality issue not captured by the annualization adjustments the BLS makes in reporting first-quarter figures.
Corporate profits totaled $2.21 trillion on an annualized and seasonally adjusted basis during the fourth quarter of 2017. This was unchanged from the prior quarter, but an increase of $57 million from the fourth quarter of 2016. Profits were expected to accelerate at a scorching 17% rate in the first quarter, thanks to a substantial boost from recently passed corporate tax cuts. Even as profits surge, there is some concern that upside is diminishing as rising interest rates and labor costs cut into margins.
According to the National Association of Realtors, the annualized pace of existing home sales was 5.54 million in February 2018, up from 5.48 million a year prior. The current sales pace is the fastest since before the national housing crash in 2007. The average sale price for an existing home was $281,200 in February 2018, up 4.3% from $269,600 in February 2017.
Our prediction last quarter that mortgage rates would rebound above 4% as the Fed winds down its expansionary policy proved true in the first quarter, with the average commitment rate for a 30-year, conventional, fixed-rate mortgage standing at 4.45% as of March 22.
Notwithstanding major shocks to the economy, a major recession within the next 12 months is unlikely.
Job growth remains solid, with February gains beating even the most optimistic of projections. In addition, wage growth is finally picking up thanks to a tightening job market. Another two federal funds rate increases are almost certain in 2018, as the Fed becomes more confident in the strength of the economic recovery. Despite fears early in the year, we don’t anticipate steep inflation in the near term. Nevertheless, we expect markets to be increasingly volatile as they react to rising labor costs, interest rates, and inflation.
A nonprofit organization bears a responsibility to maximize the cash flow from donors to its mission. Yet many benevolent groups fail to capitalize on opportunities to minimize occupancy costs, missing out on tremendous savings uniquely available to tax-exempt groups.
Eliminate pass-through taxation
A typical market-rate commercial property uses a net-lease structure, in which the tenant pays a base rental rate plus maintenance, building insurance and all real estate taxes. Most building co-operatives use a similar structure to portion out taxes among occupants.
Did you catch that last part? In a conventional lease or co-op structure, the real estate tax burden passes through to the tenant or occupant. Even if the entity using the space has tax-exempt status, in most cases each user pays a portion of the building’s property tax burden based on their share of the overall square footage.
In Austin, Texas, for example, property taxes account for as much as half of building operating expenses, or about 19 percent of gross rent. And in New York City, taxes constitute as much as 25 percent of a typical lease rate.
With a better real estate strategy, nonprofit entities can exercise their tax-exempt status to eliminate that portion of overall occupancy costs for a substantial savings.
How? One option is to eliminate the tax-paying middleman by rejecting leasing to instead acquire and own the organization’s real estate. Tax rules vary by state and municipality, but it is generally consistent that a nonprofit’s owner-occupied real estate is free from real estate taxation.
Consider, too, that property tax factors into an investor’s real estate acquisitions. In competitive bidding, a nonprofit can afford to bid higher for a desired property than an equally resourced investor, because the profit-oriented investor must reserve a portion of its capital and future cash flow to pay taxes.
Ownership isn’t the only way to access money-saving benefits. A nonprofit landlord can extend its tax-exempt benefit to qualifying nonprofit tenants, for example. Conversely, a nonprofit may choose to lease out excess space in an acquired asset to help offset mortgage payments or to generate revenue for its own programming.
If the nonprofit’s leadership is determined to lease a conventional commercial space, and if local laws allow, it may still achieve the benefits of its tax exemption through a leasehold condominium structure. In New York, the leasehold agreement must be binding for 30 years or more.
In California, a nonprofit can achieve exemption from property tax on real estate that it occupies entirely, either through ownership or a lease. California also allows a multitenant property to qualify for the exemption, provided that all tenants are qualifying nonprofit organizations. Scenarios will vary by state and by local tax practices.
Additional savings may be available: The nonprofit may be able to issue tax-exempt bonds to finance its acquisition, for example. Scrutinize acquisition closing costs for state or local taxes associated with property transfers for possible exemption.
Developers may offer attractive deals to nonprofits that fulfill mandates to include social services or other benevolent components in projects on public land, or in public-private partnerships.
Weigh any incentives carefully: In scouring the market for programs that might reduce occupancy costs, nonprofits shouldn’t be distracted by some employment-based incentives that many governments offer to encourage economic development. Because nonprofits don’t pay income tax on employees, they don’t receive additional benefit from many of those programs.
Once the organization commits to a new owned or leased space, work with the contractor building out the space to route any purchases of construction materials, fixtures and furnishings through the nonprofit, rather than incur sales tax by having the contractor purchase those items directly.
Advisors familiar with the local market, tax law and benefits available to nonprofits can be invaluable in designing and executing a real estate strategy.
A nonprofit and its advisory team need a thorough understanding of the organization and its mission before launching a search for new space.
Many tax-exempt groups require conventional offices for administrative and back-office functions, but need a different type of space to carry out programming, such as dormitories, commercial kitchens and dining areas, an auditorium or hall for large meetings, truck docks and floor space to process and store donated goods, a retail showroom or other usage-specific real estate.
Affordability is always a consideration, but there may be other imperatives related to services offered. Even if the actual cost is reasonable, offices that appear ostentatious may detract from a service organization’s desired image.
Consider security and access. A facility sheltering survivors of domestic abuse, for example, may need to preserve the anonymity of the people it serves by offering a separate, secure entryway away from the main entrance used by employees, volunteers and administrators.
With a complete picture of the ideal space, the search team can narrow its search to appropriate properties and occupancy scenarios. Many commercial landlords prefer leasing to nonprofits, which are often high-credit tenants with long histories and multiple funding sources.
Some communities even offer zoning geared to nonprofits. New York, for example, offers Community Facility Restricted Space and Zoning, in which rents are based on what a nonprofit is willing to pay.
Many consumers and businesses are aware that companies prefer to locate fulfillment and distribution centers close to their end users. This time-proven concept recently entered mainstream consciousness through news coverage of national site searches by major online retailers as firms seek to reduce the time and cost of last-mile deliveries within major population centers.
Because urban real estate typically costs more than similarly sized sites on a community’s perimeter, companies should expect to pay more rent for infill distribution space. What they stand to accomplish, however, is more than simply shortening last-mile deliveries. Benefits can include more efficient and faster delivery to urban addresses, improved access to labor, fewer hours spent in freeway traffic, and often, good positioning for deliveries to the suburbs and rural areas.
Distribution’s No. 1 cost
For decades, retailers have relied on trucks to deliver furniture and large appliances to customers from stores and warehouses. The array of goods whisked through city streets each day has expanded to include packages from e-commerce sellers, as well as a growing volume of meals and groceries being delivered to homes, businesses, restaurants and hotels. In fact, research by Foremost Quality Logistics and the Council of Supply Chain Management Professionals (CSCMP) found that transportation accounted for more than 67 percent of overall costs in a typical supply chain, dwarfing the next greatest expense – inventory carrying cost – which averages 14 percent.
That makes transportation the main target of cost-control efforts in a logistics operation. Practices that trim miles from delivery routes or eliminate time lost to traffic congestion increase overall profitability, particularly if those improvements affect the last mile, which is usually the least-efficient leg of a product’s journey to the end user.
The cost to move a full rail car or semitrailer of goods to a warehouse is relatively small on a per-unit basis, because the cost is spread over hundreds or even thousands of items. Delivering those same products in smaller batches or individually from a warehouse to consumers increases the per-unit cost, because efficiency declines as the expense of a delivery truck and driver is spread over fewer and fewer items.
Suburbs benefit, too
Relocating a remote warehouse operation to an urban infill site reduces delivery costs by shortening the distance travelled to reach end users within that population center. This is the logic behind shortening last-mile deliveries.
But the urban core is not the sole destination; what about customers in the suburbs or outside the major metros? Doesn’t relocating a distribution center into a city increase the cost of deliveries from that point to rural addresses proportionally to the way that it lowers the expense of delivering inside the city?
In a word, no. The differentiating factor is time saved by avoiding traffic that congests the freeways in most major U.S. cities.
A delivery vehicle that begins its day’s deliveries from a warehouse inside a major metropolitan area to reach customers within the same market will avoid much of the traffic associated with highway commuters making their way into the city. A truck leaving at the same time and from the same distribution point, but loaded with packages headed to suburban or rural customers, is essentially reverse commuting on the highways. Both trucks avoid idling in dense highway traffic, saving both time and fuel.
The tightening labor supply and an ongoing driver shortage have made access to a skilled workforce a primary concern for many industrial firms. Labor represents approximately 10 percent of supply chain costs, considerably more than logistics firms spend on rent, which averages less than 6 percent of total cost, according to Foremost Quality Logistics and CSCMP.
Fierce competition for qualified workers explains why some companies in the Sun Belt are adding air conditioning throughout their distribution centers. These investments in a more comfortable working environment help to compete for warehouse workers with major e-retailers. Likewise, some industrial companies are borrowing a page from the office sector playbook by adding recreational rooms that appeal to a young work force.
Remember, too, that a top factor in worker satisfaction is the commute. Delivery drivers may expect to spend much of their day on the road regardless of a warehouse’s location, but the workforce that operates the distribution center – from managers to those who process incoming goods, assemble orders or load and unload trucks – deal with a daily drive to and from their workplace. While the suburbs offer many good workers, neighborhoods closer to the downtown core offer a larger, high-quality talent pool that will benefit from the shorter commute.
While urban distribution centers may come with a higher rental rate than a suburban industrial property, the benefits often outweigh that additional expense for companies that gain the opportunity to offer faster deliveries, rein-in transportation costs and enhance their ability to attract and retain qualified workers.
More than a decade has elapsed since December 2007, when the Great Recession touched off a two-year decline in U.S. office occupancy and a rent correction that extended into 2010.
The economic expansion that began in June 2009 – one of the longest on record – has fueled rent gains and welcome value appreciation in commercial properties: The average investment price per square foot of office space is now up 63 percent from its point at the recovery’s outset in June 2009. And the 7 percent total return that U.S. commercial real estate generated in the 12 months ending first quarter of 2018 marks a stark contrast to the 18 percent loss of the year through first quarter 2009.
Since the downturn, and largely in reaction to those difficult years, companies have expanded their views on what constitutes a workplace, have grown accustomed to alternative strategies, and have raised expectations for the experiences an office building can provide. More than a shift in aesthetics, this evolution reflects a pervasive drive for efficiency and a renewed awareness of real estate’s role in supporting the bottom line.
Doing more with less
Perhaps the greatest changes in office usage this cycle reflect a rethinking of space requirements, including what was previously a typical space allocation of approximately 250 square feet per office worker. That worked well for mixed private offices and dedicated workstations, but today’s preferences for open offices and shared workstations have reduced that number by 20 percent or more.
Technological advances, including the migration to cloud-based data storage, continue to enable reductions in space requirements. With today’s enhanced worker mobility, many companies incorporate telework programs that further slash requirements for office space, because some percentage of the team will nearly always be off-site. The cumulative effect of these changes allows a company with approximately 160 employees, which would have filled 40,000 square feet in the previous cycle, to accommodate the same workforce in perhaps 32,000 square feet or less.
A new generation of office workers has joined the workforce since 2008, and after nine years of steady job creation at the national level, employers must now compete for labor based largely on how well they meet the workplace expectations of potential hires.
Individuals who never worked in an office building before the Great Recession are more likely to have formed ideas about the ideal work setting on college campuses and in coworking spaces, and will gravitate to jobs offering a similar array of flexibility and amenities. In turn, many employers now seek out real estate with open floor plans, shared gathering spaces for work and socializing, on-site food and beverage options and an assortment of dining and entertainment within walking distance.
Developers have heeded the call by delivering new construction in amenity-rich locations, both in urban centers and in suburban settings. Suburban properties that are near walkable dining options, or provide those options within their own mixed-use developments, can gain a competitive edge in leasing. The proliferation of rental housing in urban and suburban submarkets throughout this cycle has added to the potential customer base for retailers in and near office properties, introducing amenities that have aided the marketing of nearby office buildings.
Open floor plans are highly marketable, but are often limited by a building’s structural elements. Newly constructed offices tend to minimize internal columns and walls that hamper open layouts.
Some landlords have renovated their existing office buildings to be more competitive, relocating interior support columns and elevator banks to the building perimeter. While new buildings tend to minimize lobbies and instead provide common gathering spaces and amenities, office renovations can achieve a similar effect by converting large lobbies to lounges, cafés or recreational space.
Renovations can enable a landlord to attract tenants and collect premium rent, helping to offset construction costs. For example, analysis of 45 office renovations in the District of Columbia found that adding above-average design and amenities to second-generation Class A buildings enabled landlords to raise rents by 7 percent. In most cases this was offset by construction costs that averaged $120 per square foot. Yet within 1.5 years, most of those owners had leased around 50 percent of the space that was vacant before renovation. Similar but non-renovated buildings took three to four years to lease up after a large tenant vacated.
Because tenants are more likely to interact with each other in today’s common areas, bringing together firms in complementary industries creates ecosystems that can foster creativity and collaboration. A successful combination of companies will keep common areas buzzing with activity, enhancing the property’s allure to new tenants.
Growing back-office trend
Experience has shown that many companies will pay premium rent for space that helps to attract and retain talent, particularly since companies require less space per employee than in years past. Wage growth and the need to pay competitive salaries demands that firms control occupancy costs, however.
In an accelerating trend, some companies in high-end urban districts are lowering overall costs by relocating back-office functions to more affordable, suburban space. This allows a company to keep client-facing team members such as a salesforce and executives in Class A space that conveys the firm’s desired image, with a smaller footprint. Those who don’t require direct contact with clients can occupy the lower-rent space, which can be a win-win if it shortens the employees’ commute.