Tuesday, January 26, 2016

Recovery and Transition

The economy is not only going through (or suffering through? – it seems like it sometimes) a recovery after a rather rough recession/depression/panic, it is also going through a transition that started with the invention of the World Wide Web, or really, with the invention of the computer itself. In truth, economies are almost always going through some sort of transition – innovations do not stop or start, but always seem to be trickling in. Computers and the internet, though, just like steam before them, are putting the global economy through a much larger transition than we might be used to. The effects are happening slowly; it takes time to find the next market efficiency, and most new market efficiencies are resisted by the existing major players and the congressmen they employ. But happening they are, and happen they will and your best bet is to get on board sooner rather than later.

Efficiency really is the name of the game. It is the reason capitalism, with its focus on competition, beats mercantilism (i.e. crony capitalism) and socialism. Efficiency in this regard means cutting costs – getting the most for the least – and commercial real estate is a great place to make those cuts. For one thing, values were forced to reset after the Great Recession. But more importantly, computers and the internet continue to change the way people work. Office tenants have been trending towards less office space per worker. Computers are only getting smaller, and smart phones and broadband allow more workers to be productive away from the office. So even when office firms are hiring and signing leases, it’s likely that they’ll be taking smaller spaces, relatively, than they did in the past, and this extends the time it will take for the office market to fully recover.

Medical office has been going through a similar transition. The day of the artisan doctor – one man in one office with his own receptionist and assistants – is over, and the new era of medical groups has arrived. Doctors become salaried employees who are not on call 24 hours a day, 7 days a week, several doctors share a receptionist and office staff, and ultimately take less medical office space per employee than they would have in the past. The reason for this transition is the screwed up world of health insurance and government regulations, of course, not technology, but it’s a transition just the same, and one that brokers should pay attention to. Moreover, healthcare providers are moving into retail centers to get closer to customers and, more importantly, to probably pay less for rent.

Retail has other problems though, in the form of online retail. Shopping online doesn’t cost more, and it’s often more convenient (two generations of rampant narcissism has done nothing to make the shopping experience more pleasant), so it’s on the rise. More online sales means less demand for physical retail real estate – witness mass closures of Staples and Radio Shack, and shrinking retail concepts from grocery to electronics.

The big winner in all this might be industrial space. If the trend is towards spending less on commercial real estate, industrial product, which tends to be less expensive than either retail or office space, becomes an option. This is particularly true when it comes to online retailers. While they do not need physical retail space, they do need physical warehouse space, and giants like Amazon appear to be aiming to have warehouse space in every major and minor city in the country to allow them to ship to their customers, and accept returns from their customers, as quickly as possible.

The slow post-Great Recession recovery is not just slow because it’s slow, it’s slow because businesses are forging a brand new identity and are finding brand new ways to do business. Commercial real estate will adapt to this transition, but only if real estate professionals recognize it. Those who do will likely reap the reward of being ahead of the competition.

Tuesday, January 19, 2016

Not Obsolete - Demand Challenged

A few weeks ago, I began an investigation into obsolescence of buildings in the office market here in Southern Nevada. The question has been floating around for several years now: Is obsolete space artificially increasing Southern Nevada’s office vacancy. This is an interesting question, and not an easy question to answer.

The first challenge is in identifying what makes a property obsolete. The factors might be structural (i.e. how the property is designed) or geographic (i.e. where the property is located). The character of the ownership of a property might make it obsolete as well. All of these are important factors, but they not necessarily easy to quantify – at least not when you have a few hundred properties to work with.

The term obsolete is itself a problem, as needs change over time, a formerly “obsolete” property can become viable once again. Witness the brief moment before the Great Recession when vacant retail big boxes suddenly became attractive to call centers (before they moved to India and then moved back to the United States ...).

For my part, I decided to ditch the term obsolete, and use the term “less desirable”. To decide whether a property was less desirable, I first examined the lease comps we have collected over the past three years to determine the average time on market for each class of office.

On average, Class A availabilities remained on the market for 2.7 years before they were leased. Class B availabilities remained on the market for 2 years. Class C availabilities for 1.6 years. I then assumed that an availability that was on the market for twice as long as this average period of time was “less desirable” for one reason or another.

Using this assumption, I got the following stats:

Class A: 25% of available space is less desirable
Class B: 25% of available space is less desirable
Class C: 34% of available space is less desirable

If you removed this less desirable space from the market (without removing the “less desirable” buildings this space is in from total inventory), you would bring office vacancy down to around 13 percent. This appears to make the case that the office market, though not as healthy as it was before either the Great Recession or the Boom, is not as unhealthy as it seems.

I wasn’t done, though. I decided next to look the situation on a building by building basis, using the office market as my test case. It is possible to have a less desirable available unit in an otherwise desirable property, so simply looking at less desirable availabilities can skew our results. I wanted to figure out which properties in Southern Nevada were generally less desirable.

To figure out which buildings would make the list, I tallied the “less desirable” space in each building. If that space represented 50% or more of that building’s total size, I deemed the building “less desirable”.

What did I learn from this experiment?

1. There is a great deal of old space available in the office market. Medical office space is worse off than professional office space, and office space is worse off than industrial and retail space.

2. Medical Class B and Industrial Flex space stay fresher longer; the average Class B Medical unit was on the market for 1030 days before it leased, and for Flex 1380 days, indicating that tenants in these product types don’t care much if a space has been vacant for an extended period. Quickest turnover is in Incubator, Medical Class A and C and in Strip Centers.

3. Less desirable buildings are not the same thing as old buildings. The average age of less desirable buildings is 16 years, but the buildings themselves range in age from 5 to 37 years old.

4. Old parts of town do not dominate in the less desirable category. Properties built in the waning days of the Boom have struggled to absorb space. If any submarkets dominate, it is the Southwest along the Beltway, the Airport submarket and West Central. East Las Vegas, Henderson, Northwest, Downtown and the small North Las Vegas submarkets actually come off pretty well.

5. The Beltway is not a bust, but it does not seem to automatically increase the desirability of office space. Many of Southern Nevada’s less desirable properties are located near the 215. As alluded to above, the old center of the Valley – what we would characterize as Downtown, East Las Vegas and West Central – have the fewest “less desirable” buildings.

Tuesday, January 12, 2016

Into the Weeds with Employment

For several centuries now (or maybe it just feels like centuries), I have tracked Southern Nevada employment and used it as an aid in determining future performance of the industrial, office and retail markets. The concept was simple. Tie the different sectors of employment to the product types, look at the employment trend, and extrapolate commercial real estate performance. More jobs usually means more occupied square feet.

This was fine as a thumbnail sketch, but there were weaknesses in this concept. The employment sectors used by the State of Nevada for a given business do not always relate to what that business is using its occupied space for. A manufacturing company, for example, might take industrial space in which to actually manufacture things, but it might also take office space for its executives and accountants and such. Whether the company is in industrial or office space, it is still a manufacturing company, and its employees might – might! – be included in the manufacturing category, whether they are in industrial or office space.

I decided a few months ago to try to figure out, as nearly as possible, what percentage of jobs in these different employment sectors were tied to the different types (and subtypes) of commercial real estate. To do this, I downloaded random groups of companies from Sales Genie. This data included the SIC code for the company in question, its address and the number of employees at that location. I then cross-referenced the addresses to the properties in our own database, and thus determined the product subtype occupied by each business. It was then easy to discover how many employees from each SIC code were stationed in each subtype (and class, in the case of office properties). Granted, time restraints forced me to rely on random samplings of businesses, but I plan to revisit this process each year to further refine my data.

For an example, let’s look at industrial space. In the past, “industrial employment” was a sum of the following employment sectors: Construction, Manufacturing, Transportation & Warehousing and Wholesale. Now, I know that industrial properties take in a share of virtually all sectors of employment. Because of this, I know that industrial employment is actually larger than previously thought, and the drop in employment between 2010 and 2011 less severe.

The above table shows the change in estimated industrial employment between the old method of calculation versus the new method of calculation.

As a result, I think I have a much better idea now of how changes of employment impact the different property types, and therefore have an improved aid in predicting future demand.

Tuesday, January 5, 2016

Moving Targets

Think of the economy as a river. A river is water that is moving from a higher elevation to a lower elevation. If anything gets in its way, the water moves around it or, eventually, through it. There’s no thought process involved, or the act of a higher power. Water is driven by gravity to find the lowest ground it can.

Economies are likewise driven to be efficient. Producing the largest quantity at the lowest price. Why? Because human beings demand it. There is almost no end to what human beings want, and therefore producers want to produce as much of something as they can, and consumers, who have so many desires, want to pay as little as possible. Ultimately, the marketplace is where consumers and producers meet in the middle.

Hoover Dam, photo by Ansel Adams
Human beings can erect dams to manipulate the flow of water. Note that I said manipulate, not stop. The water cannot be stopped. Hoover Dam forces water through channels to spin dynamos, but it doesn’t stop the water from flowing. Other dams force the water into fields to irrigate crops, but they do not stop the water.

Likewise, human governments can erect regulations, taxes and other such things to manipulate an economy. They can make something artificially cheap or expensive, but eventually the market will work around those artifices to put that product at the “natural” market price.

I’ve recently read an article about innovations in healthcare. The supply of healthcare is, like a river, finding a way around artificial impediments. Because the old way of delivering healthcare, via individual doctors and surgeons, has been made artificially expensive with cost-sharing “health insurance” and government mandates, producers and consumers are finding a way to “meet in the middle” with medical groups, do-it-yourself treatment aided by handheld computers (let’s stop calling them cell phones – they’re really so much more), health clinics, etc. At the moment, the victim of this market-driven innovation is medical office space. Medical office space was designed to serve the old market of doctors and patients. At the moment, it is being negatively impacted by the change in healthcare delivery – a change initiated not by the free market, but by large public and private institutions.

Will we, at some point, return to a more traditional model? Perhaps. As healthcare delivery moves away from the very institutions that sought to dominate it, they will have to adapt or die. In the meantime, the medical office will have to adapt to the new way of doing things. It may do this by clever redesigns to serve medical groups and health clinics, or by re-purposing itself to other uses.

Thus the ebb and flow of commerce continues. Keep this in mind when dealing with developers and building owners. The consumer (in this case the potential tenant or buyer) is always a moving target, and forces much larger than they are in the driver's seat. Spend some time understanding the macro-economy to better understand the micro-economies you deal with when you represent a landlord or tenant.
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