What Exactly Do We Mean By Recovery?

Declaring that an economy has recovered, at least in the context of the latest recession (you might have read about it – it was in all the blogs), is a tricky undertaking. Are we counting “recovery” as a return to the economy at the peak of the bubble, at where it was before the bubble began, or at some guess at where it would have been without the bubble?

Aside from the timing, what are we waiting for to recover? If it was just a matter of visitor volume, Las Vegas finished its recovery last year. Since I'm a commercial real estate researcher working for a commercial real estate firm (Colliers International, to be precise), do I need commercial real estate to fully recover before I declare the local economy recovered?

For the purpose of this article, I offer two definitions of recovery. A recovery will:

• Bring the local economy back to a point before the beginning of the bubble (circa 2005)

• Use an index of the following measures of the local economy – New Home Sales, Commercial Occupancy, Gaming Revenue, Visitor Volume, New Residents, Employment, Taxable Sales, and Port Traffic in Los Angeles (this is the Recovery Index I have been using since 2009)

Using these definitions, Southern Nevada’s economy had an index value of 100 in January 2005. The index reached a peak of 109 in October 2006 and a trough of 83 in April 2010.

At this trough, Southern Nevada's economy reached an index value it hadn't seen since its last recession in 2001/2002 - essentially erasing 8 years of economic growth. It is entirely possible that the growth we might have seen during that period, had there been no economic surge, is gone forever. One could argue that, sans the surge, the economy would have an index value of 110 now, an index value we're about 5 years away from reaching at the current rate of growth, which isn't negligible.

If we look at index growth in 5 year periods, we see the following:

1996-2000 = 26.2% (5.2% average annual growth)
2001-2005 = 19.4% (3.9% average annual growth)
2006-2010 = -17.5% (-3.5% average annual growth)
2011-2013 = 9.4% (3.1% average annual growth)

Current index growth is about 80% of what it was in 2001-2005, and 60% of what it was in 1996-2000. Growth in the last three years is about at 90% of the negative growth experienced in the "plague years" of 2006-2010. If we wanted to erase the effects of the Great Recession, we would need to more than double current rates of growth, a situation unlikely without an explosion in construction activity in Southern Nevada.

Where is Southern Nevada today in terms of getting back to where it was in 2005, what one might call a "do-over recovery"?

In September 2013, Southern Nevada’s economy has an index value of 94, so not recovered yet, but not so far off. In 2012, the index value started at 89, increased to 93 by November 2012, and then it started to fall. From February 2013 to May 2013, the index value stuck at 91. Growth began in June and has continued since. If economic growth in the next few years matches the growth pattern of 2012/2013, Southern Nevada’ s economy should finish recovering by October of 2016!

Could the recovery move more quickly? Naturally. The economy was stronger in 2011 than it was in 2012 and has been in 2013, so it is certainly possible for the economy to recover at a faster pace. If we were to assume economic recovery on pace with 2011, Southern Nevada would have finished its recovery in July 2015 – better, but nothing to crow about.

Given the two possible rates of recovery described above, it seems reasonable to assume that Southern Nevada’s economy, and specifically its commercial real estate market, have at least two or three more years to go before they can be said to have recovered to a pre-recession level. Simply put, Southern Nevada is not currently making up the ground it lost during the Great Recession.

Happy Days Are Here Again ... I Hope

The human mind is a funny thing, not only because it apparently has the consistency of chilled pudding, but also because of the way it snaps between despair and ecstasy (though bear in mind that ecstasy is a strong term for what I’m about to discuss).

I was under the impression that net absorption was going to be lower in the third quarter than it turned out to be. It is good news that it wasn't, and though I’ve been a little leery about the industrial market due to weak job numbers and the large impact of build-to-suit projects on that net absorption, I’m almost ready to declare the industrial market completely healed, throw the confetti, toot the horn and start being an optimist.

When a person is expecting bad news, good news has a greater impact on their mood than it would have had had they been expecting good news. The reverse is true as well. It’s important for us to check our optimism and pessimism at the door when prognosticating, and instead look at the data and the trends it suggests, draw on our experience with past trends, and come to a reasonable conclusion.

A full year before the beginning of the Great Recession, I noticed that industrial vacancy rates were on the rise. Gross absorption was slipping a bit, but we were adding tons of new space that was not pre-leasing well. While the trends suggested to me that demand was flagging, the market had conditioned itself to expect strong demand, and proceeded on that assumption. Why let the facts get in the way of a good story, after all. That being said, I certainly did not expect demand to suddenly fall off a cliff at the end of 2007.

Now we’ve been engaged in the Great Recession for nearly six years. Gross absorption is healthy but not really on the increase, but net absorption is very strong, suggesting that existing tenants are no longer downsizing or closing their doors. The lack of new industrial jobs would tend to corroborate this impression on the market, as a lack of closures and downsizing does not necessarily translate into job growth. This is good news, and yet I’m having a hard time expecting it to continue.

So, what’s the story in Southern Nevada’s commercial real estate markets? As much as I fear admitting it, I think Southern Nevada has finally entered the recovery phase (I’m crossing my fingers right now hoping that the fourth quarter doesn’t make me look like an idiot). While job growth is not terribly strong (though this might have something to do with how the data is collected), most economic measures are leveling off or improving, and the real estate numbers have been pretty strong across the board.

The industrial market looks poised to absorb more space in 2013 than it absorbed through the entire Great Recession, and if net absorption remains somewhat constant, the industrial market will be ready for new speculative construction in about 12 months. Retail has been in positive net absorption territory for about two years, and though office is still seeing declining asking rents, its net absorption has been pretty strong for the past year-and-a-half. Office is not doing well in 2013, but that has something to do with continued weakness in the financial services sector (including real estate) and the health sector (health services companies tend to take space in professional office space more than medical office space these days, much to the regret of medical office landlords).

Office notwithstanding, the Great Recession appears to be over. Go ahead and throw some confetti - get it out of your system - and brace yourself for 2014.

Any Diversification Today?

In today’s post, I want to examine how the landscape of commercial real estate had changed over the past three years in terms of tenant industry (i.e. what line of business the tenants were in). This is new ground for me, so I decided to begin with the industrial market, examining what share of industrial lease and user sale activity different industries held.

If you think this graph did not help increase my understanding of the situation, you are correct. Different industries have, on a quarter by quarter basis, had their ups and downs, but the only industries to show a trend were manufacturing and construction, and those trends were pretty slight.

To get a better handle on the situation, and gain some context, I decided to abandon my relatively small sampling of lease and sales activity data for a much broader store of data – employment.

When we look at jobs in Southern Nevada, we see surprisingly little change over the past twenty years in the share of jobs between different sectors. The only significant changes have been in the construction sector and leisure and hospitality sector.

The construction sector held 9 percent of the region’s jobs in 1994, swelled to a colossal 12 percent in 2005/2006, and has now fallen to just 6 percent of the region’s jobs. While a farmer with nine cows and one pig could create the illusion of farmyard diversification by killing eight of his cows, he certainly would not be better off than when he started. Having 2,000 fewer construction jobs now than in 1994 has not improved economic diversification in Southern Nevada.

The leisure and hospitality sector, on the other hand, has added almost 107,000 jobs over the past 20 years, but has seen its share of the job market shrink from 35 percent to 32 percent. Perhaps this is not a massive drop, but one that is indicative of some diversification of employment. Over the same period, the share of employment in the professional and business services sector and the education and health sector have both increased by 3 percentage points. Again, this may largely be a matter of the draw-down in construction jobs, but both sectors have shown percentage growth in excess of 140 percent over the past twenty years, adding a combined total of 113,900 jobs. It seems likely that the leisure and hospitality sector has lost some of its employment share to these two service industries.

This may not be the diversification some folks want, but it’s the diversification we have for now.

Once Bitten, Twice Shy

After surviving an impressive housing bubble that burst just 5 years ago, many Las Vegans are eying the current housing recovery with a suspicion. The sales figures look good, but with prices increasing by 20% or more year-to-date, are we just entering a new housing bubble?

First, let’s examine the market of yesterday and the market of today. In the period 2005 to 2007, Las Vegas saw an average of 2,625 new homes sell per month, while the median price of a new home increased 5.8 percent over that period. In the past twelve months, new home sales have averaged 573 per month, and the median price of a new home as increased by 11.5 percent. So, obviously, even if a bubble is forming now, there is a magnitude of difference in scale between what was occurring then and what is occurring now.

The activity of investors is often pointed to as another similarity between then and now, but this is not quite so. The investors that caused heartache a few years ago were often over-leveraging themselves to buy homes that they thought they could re-sell at a tidy profit in just a few months. Unfortunately, they discovered that the amazing price increases they were seeing were all due to the activity of other investors, and even with very low interest rates and the willingness of traditional home buyers (or lack of knowledge) to borrow far more than they could afford, the investors priced the occupiers of homes out of the market, found they could not keep up their mortgage payments, and the market collapsed. Home builders, working feverishly to keep up with the perceived demand, built many more houses than were needed, and thus the housing crisis and the Great Recession.

How are things different today? The investors of today are not the investors of yesterday. Having spoken to people within the housing industry in Southern Nevada, I have found that the individual investors of today are coming in with plenty of cash and are not over-leveraging themselves to buy investment homes. Moreover, many of the investment sales we are seeing in Southern Nevada today are by institutional investors, buying hundreds of units, often directly from banks.

How are things the same? When housing sales are driven by investors, they leave a gap in the market. From the perspective of home builders, a house sold is a house that is off the market. In fact, though, an empty house is still effectively on the market. When tracking commercial real estate, vacancy is the thing that matters! An investment property must eventually pay for itself, either by means of rent paid by an occupant, or by the value of the property appreciating past the value of the loan taken out to buy the property in the first place. The last bubble was driven by such appreciation of value, not by renters occupying houses, but the appreciation could not keep pace with the prices being paid for houses.

More importantly, when home builders saw houses selling a few years back, they took it as a sign that more houses were needed. Home builders today are gearing up to begin building houses in earnest once again in 2014. The question is whether they are building for investors or for occupants? Unfortunately, the vacancy rate for single-family homes is notoriously hard to determine, with different groups (the U.S. Census Bureau being one) coming up with wildly different numbers. This is unfortunate, because it would fill a crucial gap in our knowledge of the home market.

One clue to whether Southern Nevada is once again getting ahead of itself might be found by comparing household growth in Clark County (based on information from the Clark County Demographer and Claritas) to new home sales (based on information from Dennis Smith’s Home Builders Research). Demographic data from Claritas states that 42.9 percent of households in Clark County rent homes or apartments rather than own single family homes or condos, so we’ll adjust the household growth figures by 43 percent to get a better idea of how many buyers were entering Clark County each year.

What does this graph tell us? First and foremost, in-migration into Southern Nevada dropped sharply in 2008, 2009 and 2011, but has generally been on the rebound in the past two years. Second, we see that new home sales decreased substantially in 2007, at the beginning of the housing crisis, and continued to plummet in 2008 and 2009; in 2012 they began a slow recovery.

In 2005 and 2006, Southern Nevada was selling approximately three times as many new homes as it was adding new households that were likely to own homes. This suggests that most of these new homes were purchased by investors rather than occupants. The percentage declined in 2007, reaching what would be the lowest percentage in the nine years covered by this chart. In 2008, the first full year of the Great Recession, almost five times as many new homes were sold as new households moved into Southern Nevada, despite a steep decrease in the number of new homes sold. Since 2009, Southern Nevada has gained an average of 1,300 households per year and sold an average of 5,400 new homes per year, again, more than 4 times as many new home sales as new households likely to own rather than rent entering the region.

In 2013, Clark County is projected to expand by 3,200 households and sales, if they remain steady, should reach 7,200 new homes, approximately a 2:1 ratio. While this is not as high a ratio of new home sales to new households as recorded in 2005, 2006 and 2008, it is higher than in 2007 (when the market began to cool), 2010 (when the federal government juiced the housing market) and 2012. This suggests that investors once again are beginning to dominate the housing market. Fortunately, they are buying new homes at lower prices (28 percent lower) than they were in 2005, but the median price of a new home has increased by 13 percent in the past five months. While this is good for house flippers (though we know how that story ends), it is bad for owner/users and problematic for landlords, as they must still compete with multi-family projects and cheaper, existing homes that are on the rental market.

If Southern Nevada’s population was expanding more rapidly, and if the median new home price was expanding much more slowly, I would feel more comfortable about the current expansion in new home sales. As it stands, home builders must be very careful about new home construction in 2014, as they might once again find themselves building more homes than they can sell if investors once again cool on Southern Nevada.

Vegas Enjoys the Spring Thaw

Waaaay back in November of 2012, the Las Vegas economy, which had been in growth mode for a good 10 months, decided to take time off for the holidays. What followed, in terms of the CRE Recovery Index I maintain, was a pretty rapid slide, from an index value of 91 (a value of 100 represents the economy as it was in January 2006 – i.e. the “good old days”) down to 86, roughly the value we had in December 2011 just before the 2012 growth spurt began.

In March, though, the index began to grow again, and in April 2013 it stands at an 89, not far from the 2012 high and well above the low of 80 recorded in March 2010 at the low-point of the recession.

On a year-over-year basis, the following components of the CRE Recovery Index have posted growth, going from the highest growth to the lowest: New Home Sales (76.6 percent growth), Clark County Taxable Sales (5 percent growth), Gaming Revenue (3.1 percent growth), Employment (2.2 percent growth) and Commercial Occupancy (1.8 percent growth). With the exception of new home sales, we’re looking at very moderate growth in the economy. Depending on who you speak to, new home sales are either going to maintain their dynamic growth, or they’re at the end of it, but for now they are definitely driving the CRE Recovery Index higher. If new home sales do slack off in the coming months, it is likely the index will either turn flat or begin to decline once again.

Components of the index that experienced negative growth over the past 12 months were New Residents (negative 12.6 percent growth), Container Traffic in Los Angeles (negative 7.1 percent growth) and Visitor Volume (negative 0.6 percent growth). While a small dip in visitor volume isn’t much to worry about, the much larger dip in residents moving to Clark County is, as a lack of new bodies could disrupt new home sales.

Get It Together, Vegas

Have you ever known somebody who just couldn’t get it together, at least not permanently? They would get their stuff together for a few months, and then slide right back into their old back habits. If you work in Las Vegas commercial real estate, the answer is yes, and the friend is the real estate market.

2012 was a pretty good year for our CRE Recovery Index. There were a couple small dips in the index, but overall, things were looking up. The market did pretty well, as the index is supposed to predict, with office and retail putting up good, though not great, numbers, and industrial lagging behind until the first quarter of 2013, when it showed some surprising life. 2011 was a year of peaks and troughs, with things better at the end than the beginning, but 2012 was a pretty smooth ride in the right direction. And then 2013 showed up.

Just as the market posted its first all-around positive quarter in 5 years, with the industrial, office and retail markets all showing positive net absorption, the index was heading down. December 2012 saw the index fall from 91 to 88, inspired by lower visitor volume and gaming revenue and a less traffic through the port of Los Angeles. This wasn’t too worrisome, though, since tourism numbers can fluctuate and port traffic is, at best, a minor piece of the puzzle for Southern Nevada. January remained at 88; port traffic dropped again, but so did the number of new residents moving into the Valley, new home sales and, once again, visitor volume. These were balanced, though, by higher gaming revenue and taxable sales. February saw another dip in the index, down to 86, where the index stood in January 2012. New home sales were down again, as was gaming revenue, visitor volume, new residents and taxable sales. Is it time to worry?

If the index is accurate, it predicts a slow second quarter for commercial real estate, and perhaps a slow third quarter as well. That doesn’t necessarily means negative net absorption, but just less positive net absorption than we would like. While the office market has had three quarters of positive net absorption, the numbers have been on the decline. Retail has also been positive but weak. Industrial has the benefit of strong build-to-suit activity now, and will probably do well through mid-year. But, in general, the way ahead for commercial real estate could be a little rocky for the next few months.

The Future of Vacancy in Las Vegas

Image by Lasvegaslover, from Wikipedia article

Imagine if you will a car accident on a busy street. The accident is a big one, and it is clear that the street will be blocked for some time. Naturally, drivers on their own would begin searching for alternate routes. Before too long, the side streets would be filled with cars avoiding the accident scene, and though things would be slowed down for a while, eventually they would be back up to speed (or close to it). In time, the accident would be cleared, and life would go on just as it had before.

Imagine, however, if the accident could never be cleared. Cars would simply take to those side streets as the “new normal” and the old street would fall into disuse. What I’m getting at here is the concept of being left behind.

Commercial real estate in Southern Nevada may be going through a similar situation. When the market was overbuilt in the mid-2000’s, vacancy rates skyrocketed. Now, having trudged through 5+ years of recession, the market appears to be returning to some level of normal demand for product. The assumption by some, of course, is that vacancy will now return to where it was before the recession – perhaps slowly, but inevitably.

The truth, however, is that it might not. Buildings that were completed during the boom may, in fact, never be filled with tenants. Location and designs are two reasons, of course, for why these buildings may remain unpopular with potential tenants, but age is now becoming a third. Some of these unlucky buildings are not 5 to 6 years old. Potential tenants of these buildings may begin opting for newer buildings – build-to-suits, of course, but also the new speculative product that is bound to be built over the next 5 years. What happens to these “lost buildings”?

On the one hand, they may find favor with tenants looking for second generation space; in essence, they can fill a temporary niche of virgin second-generation product – old enough to be had at a discount, but not carrying the baggage of former tenants and tenant improvements.

On the other, they may find themselves candidates, in due time, for redevelopment. The market, finding it has no use for so much single-tenant office or light industrial, decides it needs land for the developments that it does need in the future. If the latter is only partially true, we can expect to see a new floor on just how low vacancy rates can go for commercial product. Ultimately, though, we need to investigate whether theory is reality.

During the boom, we discovered vacancy “floors” of approximately 4 percent for industrial product, 8 percent for office and 3 to 3.5 percent for retail. The industrial market now has approximately 3,000,000 square feet of space that has been vacant for 4 to 6 years, corresponding roughly with the final phase of the construction boom and the initial phase of the Great Recession. If we were to assume that this space was so undesirable that it would never be occupied, it would represent about 3 percent of the total industrial inventory, and would thus push that vacancy “floor” from 4 percent to 7 percent.

For office product, about 2.5 million square feet, or approximately 6 percent of office inventory, has been vacant for 4 to 6 years, potentially increasing office’s vacancy floor from 8 to 14 percent. Clearly, office product has a more serious problem than industrial. For retail, the figure is 3 percent, potentially increasing the retail vacancy floor from 3 to 6 percent.

A full break-down of vacant commercial space based on its time-on-market follows:

While this investigation is not as thorough as it would need to be to classify it as fact, it is suggestive that even with normal demand for product Southern Nevada’s commercial market is likely to see elevated vacancy rates for the foreseeable future.