By Chris Rising
Where Are We Now?
Economic metrics indicate that the economy is “on fire” with the lowest unemployment rate in 50 years. Headlines read: “Trump tax breaks giving companies more profits!”. The data shows the fundamentals of the economy are strong overall. In actuality, our view is more like an old cheeky television ad: things are “good, but not great”.
Our primary focus is value-add and core office investment in major Western U.S. CBDs and their adjoining suburbs. In all these markets, we are seeing positive absorption of vacant space...but it is not overwhelming. Given the stimulus of the Trump tax cut and the growing number of jobs staying in America, it would be natural to believe that both large and small businesses are gearing for growth and taking healthy real estate footprints.
However, when it comes to a key indicator of the health of the office investment market, absorption, we cannot point to any overwhelming lease up statistics. We certainly are not seeing the massive absorption of the 2000-2002 tech boom and bust period. Rather, we have experienced consistent, but slow, positive absorption in our markets. Additionally, in the last three months we have seen an increase in the number of leasing tours. Yet, to date, the pace of absorption has not correlated to the overall economic growth in the economy.
The lack of correlation between economic numbers and absorption has been perplexing in the context of our investment discussions. However, we believe we understand why the pace of absorption has not kept pace with the fervor of the economy.
We recently met with a key leader at WeWork in their corporate headquarters in New York. It was an amazing experience. Their corporate headquarters has 1,000 people across 6 floors in a beautiful, historic building with a large skylight and a large stairway through the middle of the entire building. On average, their layout is 1 person per 60 square feet. It is an unbelievable “bee hive” of people working from couches, bar stools, breakout areas and conference rooms. There are glass offices for senior executives and numerous breakout conference-type rooms. The efficiency of the WeWork headquarters space is beyond belief and it is the antithesis of the 1980s build out. Oh, and not a suit or tie to be found. Whether one buys into the WeWork growth story is not as relevant to our thesis as it clearly demonstrates there has been a radical change in how the square footage of an office building is used. The use of technology throughout the building - from sensors on every desk, chair and table to the large coffee/beer bar in the center of the top floor - this is not a space layout that shows the hierarchy of the management team.
We believe that the radical improvement of software with the continued shrinking and mobility of hardware means that an office experience is not going back to exterior offices with interior cubicles. We believe how people function in the workspace is so much different than the baby boomer generation that there is no realistic way office space will circle back to the layouts of one person per 250 square feet. Maybe this is not a novel statement given the hype of the last few years about “creative office”, but the stark difference we see is that “creative office” layouts are no longer just for the tech, advertising or entertainment firm, they are the “new normal”. So in essence, businesses are truly growing, but their overall space needs are just less.
So it is an odd analysis that we are faced with when looking at office investment in 2018. The typical encouraging factors are not demonstrating the same result as we have seen in our long history of office development and investment. We see so many reasons that office absorption should be “through the roof” and that vacancy should continue to reduce significantly in our markets…and it is, but slower than a traditional real estate economic algorithm would lead one to believe.
We feel this strongly validates the “Rising Way” philosophy of operating office buildings: the value of broadband and wireless networks, the ability to work inside or outside, and the option to collaborate as a group or find private space. These are all demands that landlords must meet in order to attract or renew tenants. The office experience for a prospective employee has become as important as the benefits package.
Most economists are predicting that there will be moderate economic growth through the end of 2018 and into early 2019. There is also a consensus that GDP will continue to grow. As recently as Q4 2017, GDP was growing at 2.9% and there are preliminary indications that 2Q 2018 will be close to 4%. In reading the market reports from the major real estate services companies, there is a consensus that there will be increased tenant demand, especially in markets that meet the needs of the newest and largest generation in the workforce, the Millennials.
Perhaps the greatest news in reading through reports from CBRE, JLL and Cushman & Wakefield is that the best U.S. markets are the markets we work in every day, the Western U.S.
Total demand increased in Q1 2018 as more than 8.1M SF was absorbed off the market, greater than the 7.2M SF absorbed in Q1 2017
The west region dominated 1st quarter absorption, capturing 7.0M SF of the total 8.1 MSF absorbed
Leasing activity was 65.6M SF, on par with quarterly average of 67.1M SF of the past 5 years
Tech and financial services captured 42% of all leasing
San Jose ranked 2nd nationally in leasing volume at 5.6M SF to Manhattan which had 5.9M SF
Three of the major markets in the country with the lowest vacancy were Midtown South Manhattan (6.5%), San Francisco (7.6%) and Seattle (8.1%)
Markets that saw large rent increases include Orange County, CA (+21.1%), San Diego (+8.6%) and Portland, OR (+7.3%)
We are seeing much more of a “have or have not” effect playing out in our Western U.S. markets. An owner either has a location that works for an employer or it does not. An investor has either made the broadband and fiber investments in a building or it has not. A developer has either delivered an amentized project that is exciting to employees or it has not. In our view, if one is on the “have not” side of the ledger, it is going to be difficult, if not impossible, to compete over the next few years, especially in a downturn. And since leases are always terminating and employers are always looking at their real estate costs in a downturn, we believe those buildings that are in the “have” column make it during a recession.
What Are the Identifiable Risks That Have Our Attention?
While it is always a “finger-in-the-wind” exercise when one tries to predict where the economy is heading, we certainly see signs that make us laser-focused on making smart buys that are not relying on overall market growth. In fact, we are seeing signs that make us feel this is the right time to be raising capital so that we can be ready to invest in opportunities as owners of out-of-date buildings are forced to sell. It won’t take much for current owners who have not made the effort to modernize their buildings to lose tenancy. The risks we are watching closely are as follows:
The Flattening Yield Curve. This is a subject getting a lot of coverage in the Wall Street Journal and similar publications. The headlines usually read that a flat or inverted yield curve (when the 2 year treasury is equal to or provides a higher yield than the 10-year treasury) has preceded all nine U.S. recessions since 1955.
As of this week, the spread between the yield on the 2-year and the 10-year has shrunk to .24%. There are lots of arguments on both sides, but history says (and was recently cited by the Fed Board) that on average, there is a recession within 16 months that last for approximately 12 months.
Protectionism/Trade Wars. This is a very difficult issue for real estate professionals to tackle, especially since tariffs can be levied and then pulled back by the stroke of a Presidential pen. It is difficult to see how protectionism and trade wars help the U.S. economy. Perhaps the President is relying on strong consumer confidence numbers to throw some punches and then pull back, but it is clear that a trade war will lead to higher consumer prices, which will have a negative effect on consumer confidence. Looking forward, the recently raised interest rates by the Federal Reserve raises even more uncertainty for the national economy, spilling over to the global economy. For the business of leasing office space, a company’s confidence in future growth is paramount to making long term leasing decisions. At Rising, any factor that affects economic confidence concerns us when making investment decisions.
November Elections. We will not know the direction of the country, given the potential turnover of the House and Senate, until late in the evening on the first Tuesday in November - which means we are unable to have a long view on issues like consumer confidence.
Technological Innovation. We are no better at predicting whether we will have driverless cars next year than we are at picking a winner in the midterm elections, but we do know that the pace of technology innovation is happening faster than it has in the history of the world. We have a workforce full of Millennials who have grown up with computers and software as essential tools in their daily lives followed by a generation coming fast behind them who have only known life with an iPhone. Because of this, we think innovation is going to have some immediate and overwhelming effects on the workplace and how businesses conduct the science (maybe it is better described as the art) of business. Whether it is the overall impact of co-working (think WeWork), electric scooters solving last mile congestion, or the disappearing keyboard, we believe technological innovation will have a dramatic effect on office investment. The divide between owners who “have” technology figured out and those who don’t will widen dramatically in the coming years.
Our Focus Going Forward
The data above leads us to the following conclusions for where we are headed over the next six months:
Our investment thesis is very focused on being in markets we know well. We have spent our careers investing, managing and operating in the Western U.S. markets. We are not going to move outside of the markets we know: California (San Francisco/Bay Area, Silicon Valley, Los Angeles, Orange County and San Diego), Denver, Salt Lake City, Portland and Seattle.
Our investments must allow us to either execute on a value-add strategy that completely transforms an asset or is a core/core-plus asset where we can incrementally improve the technology backbone and tenant experience. We will not be experimenting on new construction ideas or taking any flyers on assets we “think” we understand. Confidence in our ability to execute a plan to perfection is a must in our investment decisions.
This is the time to raise capital so that we can invest quickly and effectively when things turn. We are seeing the first signs of distress opportunities, where the lenders and operators are giving up on 10 years worth of extensions and repositioning. We want to move on those opportunities in the short term but we are especially focused on continuing to raise capital to our balance sheet and in separate account or fund vehicles.
We believe that creating value over the next few years is not just about “buying” right. There is too much investor competition to hope to buy at such a low basis that the market will solve for any mistakes. We are focused on upgrading more core assets so that a tenant is never lost to a newer and glossier competitor. We’re also focused on value-add opportunities in markets we know are in demand by companies who are positioned for the future technology impacts.