The First Facility Management Blog

The first day of The TFM Forum/LiveXchange got off to a breezy, yet upbeat start on Sunday, October 18, 2009 at the Sanibel Harbour Resort & Spa in Fort Myers, FL. Events for the group began mid-day, with some opting to play golf (see photo below, at right) and others heading off to the historic Edison & Ford Winter Estate (interestingly enough, the tour coincided with the anniversary of Edison’s death–10/18/1931).

Fortunate participants in the estate tour (myself included) were greeted by Brandon Anderson, education coordinator, who immediately took the group through the grove of massive banyan trees and provided a little bit of background about the estate. (See photo below, at left.)

After the group (pictured below) finished lunch, Anderson spent more than two hours taking the group “behind the roped off areas” (as long as we wore blue shoe coverings or went in bare or stocking feet) in the three main properties: the Edison residence, the guest house, and the Ford residence.

While appreciating the historic, aesthetic aspects of the structures, some participants observed facets of the property that the layperson would more that likely overlook. For instance, one guest asked about the fire/smoke detection system in the primary Edison residence, which incorporated the very early smoke detection apparatus (VESDA) supported by a mist/fog suppression system.

Ed Kosmoski, Jr., R.P.A., vice president of facilities for the Center for Hospice & Palliative Care in Cheektowaga, NY, said, “I really enjoyed the tour. I found it very interesting and was impressed by the overall level and quality of maintenance, particularly from a historic preservation perspective. We have a property of this nature in downtown Buffalo, which is why I found this so relevant.”

Shortly after the golf and tour groups completed their outings, the networking reception began. The evening concluded with dinner and discussion, as attendees, speakers, and sponsors refueled and prepared for the start of Monday’s activities.

On 5/27/09 IPD, the global real estate performance analysis and benchmarking specialist, published its first ever annual commercial real estate index and quarterly indicator for the U.S. backed by 10 years of historical data.

According to the IPD U.S. Annual Property Index, capital growth was -12.2% in 2008. For the 12 months to the end of December 2008, all property income return in the U.S. was 5.4%, contributing to an overall total return of -7.4%.

The Annual Index is born out of IPD’s core U.S. Portfolio Analysis Services, which has been measuring the relative performance of individual funds against peer group benchmarks since 2005. The U.S. IPD office has amassed data on $121 billion worth of U.S. commercial real estate portfolios for the first Annual Index, data which is expected to expand substantially in coming years.

The inaugural IPD U.S. Quarterly Indicator, which monitors quarterly movements in U.S. commercial real estate value trends and returns, revealed that capital growth was -10.5% for the quarter ending March 31, 2009. Over the same three month period, all property income return in the country was 1.4%, contributing to an overall total return of -9.2%.

Annual sector and regional returns
For the annual period, the Office sector fared the worst, with capital growth of -12.8%. For the same one year period, the Industrial and Retail sector capital growth was -11.7% and -11.4%, respectively.

At the regional level, Western states posted the largest decline with a capital growth of -13.0% for the 12 months ending with December 2008. Capital growth results were similarly negative for the East, South, and Midwest, at -12.3%, -11.1%, and 11.0%, respectively.

Simon Fairchild, managing director at IPD US, said, “A clear feature of these U.S. results is the apparent synchronization in the downside performance. Whatever manner in which we analyze the data—either across regions or sectors—market values have been written down at broadly the same rate.”

The IPD U.S. Property Index measures returns to direct investment in U.S. commercial property. It shows total return on capital employed in market standing investments (i.e., properties held from one monthly valuation to the next) but excludes any properties bought, sold, under development, or subject to major refurbishment in the course of the month.

It is no surprise that the continuing economic uncertainty throughout world markets and the lingering impact of a global credit crunch are seen as the greatest risks faced by real estate companies.

“In this time of great economic uncertainty and lack of liquidity, many companies are proactively looking for ways to manage risk, streamline operations, and enhance their business relationships effectively so they can hit the ground running when markets begin to stabilize,” says Howard Roth, Global and Americas Real Estate Leader, Ernst & Young.

The 2009 Ernst & Young real estate business risk report, produced in conjunction with strategy consultancy Oxford Analytica, itemizes the 10 top business risks faced by the industry as ranked by leading sector analysts. The top 2009 risks in order are:

1. Continued uncertainty and impact of the credit crunch. Tighter credit is just one threat to real estate from the crunch; the economic downturn is affecting commercial vacancy rates as well as property valuations.
2. Global economic and market fluctuations. Due to capital flows and business expansion, the real estate industry has become a truly global industry and, as such, is increasingly susceptible to global market fluctuations.
3. Impact of aging or inadequate infrastructure. Particularly in the U.S., but also in other markets around the world, a lack of key transit and utility infrastructure is a threat to economic and real estate growth. (This is huge for the facilities profession!)
4. A global war for talent. Globalization of business has also created a worldwide talent pool with countries forced to compete for human capital.
5. Changing demographics. Aging and urbanizing populations are changing competitive dynamics and creating new markets in real estate.
6. Inability to find and exploit non-traditional global opportunities. With competition increasing worldwide from sovereign wealth funds and others, many global investors face a tough time sourcing new deals that will meet return expectations.
7. Pricing uncertainty. With few transactions taking place in the real estate market, valuations are a problem for existing owners as well as buyers and sellers.
8. Green revolution, sustainability, and climate change. Real estate is at the forefront of the green movement with pressures intensifying to build and operate in sustainable ways and minimize the carbon footprint throughout all types of real estate. (Another huge issue for facilities.)
9. Economic vulnerability and regulatory risks in developing markets. Developing markets are a key focus for global real estate firms but regulatory risk in these markets is constantly changing as authorities seek to jump start economies.
10. Increasing energy costs. Few analysts expect more than a temporary respite from high oil prices as new supply will be unable to meet renewed demand. (Probably one of the most relevant and tangible for fms right now.)

Given the risks outlined by analysts in the report, it is time for owners, investors, and users of real estate to use the time afforded by this lull in real estate activity to prepare their businesses for the next period of economic growth.

“There will be a fundamental shift back to traditional real estate underwriting principles, including comprehensive cash flow analysis and prudent levels of debt and equity in consummating real estate transactions. This ‘back to basics’ movement will lead to the greater transparency necessary to restore confidence between buyers and sellers,” says Roth.

The real estate sector has felt the tightening conditions in credit markets perhaps more than any other sector due to its heavy reliance on capital. Financial conditions for real estate projects are undoubtedly worsening, and the current financial market landscape is expected to persist for the next couple of years.

According to Mark Costello, America’s Leader of Ernst & Young’s construction and real estate advisory services practice, “Real estate is typically the second highest cost item on an income statement after payroll and so provides excellent opportunities for companies to unlock hidden value, particularly through a back to basics approach.”

On the construction side of the industry, two out of three capital projects are currently over budget or behind schedule, according to Malcolm Bairstow, Ernst & Young’s Global Advisory Services Leader for the real estate and construction sectors, which he adds is a statistic exacerbated by the uncertainty surrounding the economy and the availability of financing. “Yet, deploying risk mitigation or accelerated delivery methods after careful assessment of a project can also reduce risk and cost and bring in projects on time and on budget,” Bairstow adds.

“The real estate industry as a whole is focused on simplicity, transparency, and quality deals. However, when things are going really well, it tends to mask organizational inefficiencies,” says Costello. “Companies which address those issues now and solidify their businesses will be in a much better position to address future risk threats.”

Battered by the U.S. economic recession, the commercial real estate market is struggling to maintain values across all property types and geographic areas, kicking a growing number of investors into survival mode as they painfully watch the value of their existing portfolios decline, according to investors and real estate professionals surveyed as part of the first quarter 2009 PricewaterhouseCoopers Korpacz Real Estate Investor Survey(R).

Real estate investors do not expect a rebound in any of the commercial real estate sectors until well into 2010, according to the survey. In the meantime, property owners are faced with limited financing options, declining tenant demand, rising overall capitalization rates, and deflated confidence. They are looking to protect the value of their existing properties in order to compete and survive in an increasingly challenging environment. To mitigate value loss, landlords are being more proactive about signing tenants to new leases, expansions, and renewal, in some cases offering leasing incentives and lower rental rates. In addition, some are attempting to cut property costs and better position assets in a rapidly growing tenants’ market.

“Tenants are in the driver’s seat, and landlords are in survival mode, trying to preserve revenue streams in one of the harshest ownership environments ever encountered,” said Tim Conlon, partner and U.S. real estate sector leader for PricewaterhouseCoopers. “It will be survival of the fittest going forward, with owners who are able to remain financially strong being better positioned to capitalize on the buying opportunities that are to come.”

Positioning For The Rebound
Although sales have been weak, investors surveyed by PricewaterhouseCoopers expect buying opportunities to emerge in the coming months as commercial loan defaults increase and the number of distressed assets on the market increases. In fact, some investors are preparing for potential acquisitions by boosting their liquidity through de-leveraging, joint venture partnerships and select dispositions of current holdings. However, the bid-ask pricing gap remains wide between buyers and sellers, pricing is opaque because of limited sales activity and financing remains scarce.

Also making acquisitions difficult is the fact that recession conditions in commercial real estate are not expected to ease until 2010 at the earliest for most major property types. One exception to this recovery is the U.S. apartment sector, where demand increased with the rise in foreclosures as many homeowners turned to rental properties as a housing option. As demand for multifamily housing catches up with supply, the apartment sector is expected to emerge from the recession phase of the value cycle ahead of the other sectors, according to the survey

“In recent months, even the most optimistic real estate investors have conceded how challenging today’s economy is for the industry. Their confidence has been battered and it could take years to regain it,” said Susan M. Smith, editor-in-chief of PricewaterhouseCoopers Korpacz Real Estate Investor Survey(R) and a director in the PricewaterhouseCoopers real estate sector services group. “The one certainty they can hold on to is that there will be a recovery, but, until then, they need to determine how to survive under some very tough conditions.”

First Quarter 2009 Sector Highlights
As investment risk has increased, the average overall capitalization rate increased on a quarterly basis for all surveyed markets with the exception of the Washington, DC and Houston office markets. The Pacific Northwest, San Diego and Denver office markets posted the largest quarterly overall cap rate increases in the office sector. Most of the real estate professionals surveyed as part of the Korpacz Real Estate Investor Survey(R) project overall cap rates to increase over the next six months.

Among the significant developments in select sectors during the past quarter:

• Regional malls flatline - Sale transactions have nearly come to a standstill in the national regional mall market, with investors wary of performance and having trouble pricing assets. The average initial-year market rent change assumption dipped to 1.71% this quarter, 92 basis points lower than a year ago and the lowest average ever reported for this market.
• Power centers struggle - With consumers curtailing spending, national power center property owners are struggling to maintain occupancy levels and rental rates. The overall cap rate increased by 41 basis points in the past quarter, to 7.98%, the second straight quarterly increase of at least 40 basis points.
• Office markets crumbling - Demand has weakened for office space, and many traditionally strong markets are seeing vacancy increase. As supply outpaces demand, the average initial-year market rent change rate remains on a downward trend in the office sector, dropping roughly 260 basis points over the past year in the surveyed office markets. Furthermore, property values are expected to drop as much as 30% nationally over the next year in the CBD and suburban office markets.

This quarter’s report also includes a review of the local market outlook for 18 major U.S. office markets including Atlanta, Boston, Charlotte, Chicago, Dallas, Denver, Houston, Los Angeles, Manhattan, Northern Virginia, Pacific Northwest, Philadelphia, Phoenix, San Diego, San Francisco, Southeast Florida, Suburban Maryland, and Washington, DC.

The Building Owners and Managers Association (BOMA) International commends the U.S. Treasury for taking decisive action to restore liquidity to the financial system and create a functioning credit market for commercial real estate. Last week, Treasury Secretary Thomas Geithner announced a plan to unlock the nation’s frozen credit markets that includes expanding the Fed’s Term Asset-Backed Securities Loan Facility (TALF) to include newly originated AAA commercial real estate securities.

The Treasury’s new plan is a significant and positive step that will thwart potential mass foreclosures in the commercial real estate industry that many experts fear. In a letter BOMA sent in collaboration with 11 other national real estate organizations to the Treasury last November, it was estimated that more than $400 billion of secured and unsecured debt will mature before the end of 2009. The strategy will go a long way to foil the widespread detrimental effects on local communities that would have resulted without the plan.

“We congratulate Treasury Secretary Geithner on a productive first step in office that will help prevent a further tailspin in our economy,” stated BOMA International Chair and Chief Elected Officer Richard D. Purtell, portfolio manager, Grubb & Ellis Management Services, Inc. “BOMA looks forward to working further with the Treasury, the Obama Administration and Congressional leaders to develop strategies to bring about full economic recovery.”

BOMA International has been responding to the credit crisis since it began, advocating for policymakers to enact measures to energize credit markets, restore bank lending capacity, support American businesses, create jobs, and restore the economy. In July, Purtell testified before Congress on the ramifications of the credit crunch, emphasizing the importance of credit availability to the commercial real estate sector. Since then, BOMA has consistently urged policy leaders to recognize commercial real estate’s contribution to the local tax base, the central role the industry plays in job creation and the benefits of a healthy real estate industry to the overall economy.

The U.S. warehouse market contracted during the third quarter of 2008, posting a slight drop in occupied space and a sizeable increase in vacancy, according to Colliers International, a real estate services firm. This ongoing notable weakness suggests that the industrial real estate market will continue to be impacted by recessionary conditions.

A combination of weak demand and rising completions pushed the Q3 vacancy rate up 27 basis points to register 8.71%. Market polling results showed that 42 markets surveyed by Colliers posted a rise in vacancy, while 14 markets posted a decline.

In terms of new supply, 41.6 million square feet (msf) was completed during the July through September period — down from the 43.9 msf injected during Q2. Year-ago third quarter completions came in at 44.9 msf.

Industrial developments under construction dropped noticeably during the third quarter, registering 107.1 msf of space. This compares with 124.4 msf at the end of the second quarter and 153.5 msf for the year-ago quarter.

Absorption remained negative during Q3 2008. Occupied space contracted by 0.4 msf. This, however, is an improvement from the negative 9.8 msf recorded in Q2. For the same period last year, absorption measured 36.1 msf.

The debilitated industrial market comes as little surprise in light of the slide in many demand drivers — highlighted by the September ISM manufacturing index, which registered 43.5 (well below the psychological “50″ level), suggesting the manufacturing sector is currently undergoing a significant contraction. In addition, construction, housing, the auto sector, and the retail sector all continue to battle strong downward pressure.

“The warehouse leasing market keeps struggling in the face of a rapidly slowing economy,” remarked Ross Moore, executive vice president and director of market & economic research at Colliers International. “Manufacturing, and in particular the auto sector, were key sources of weakness — with output dropping dramatically over the past few months. Exports remain a bright spot; however, this is sure to change with the increasing possibility of a global recession and the expected decline in demand for products destined for ex-U.S. markets. In addition, retailers have been paring inventories, and this serves as yet another drag on the warehouse market. Colliers predicts industrial leasing conditions will remain sluggish through at least the midpoint of 2009.”

Rents for industrial space were marginally lower during the third quarter, with a 0.7% decrease, bringing the national average to $5.59 per square foot (psf). This leaves us virtually unchanged from the year-ago period, with rents dropping just $0.01 psf.

Jones Lang LaSalle’s Mid-Year 2008 National Industrial Real Estate Market Report, which analyzes activity in industrial properties 50,000 square feet and larger, shows that while both warehouse and manufacturing sectors have been impacted by the slowing economy, the national industrial real estate market experienced overall positive net absorption in the first half of the year, exceeding most forecasts.

U.S. industrial markets absorbed approximately 5.6 million square feet in the first quarter of 2008 and 125,000 square feet in the second quarter, significantly lower than historical first-half performance. Jones Lang LaSalle views the slower growth as a consequence of uncertain economic conditions.

According to Craig Meyer, managing director and national brokerage leader of industrial services with Jones Lang LaSalle, “There is a myriad of economic issues causing this slowdown in activity—soft unemployment, increasing fuel/transportation costs, lower retail sales which have a rippling effect on warehousing needs, and our nation’s overall recessionary trend—contributing to the declining activity in the overall industrial real estate market.”

The national industrial vacancy rate ended the second quarter at 9.1%, up three-tenths of a percentage from the first quarter 8.80% rate. Markets that experience positive net absorption can also see vacancies increase due to the delivery of new developments.

“Most major industrial real estate markets nationwide felt the softening of conditions during the second quarter as companies avoided unnecessary moves and focused on cost control, flexibility, and short-term solutions,” said Meyer. “In the short term, this creates negotiating leverage for tenants still in growth mode, while over the longer term, a cautious stance helps the market maintain stability and avoid overbuilding.”

The Jones Lang LaSalle report showed that occupancy growth during second quarter was minimal when compared with 2006 and 2007 levels. While Chicago, Dallas, Houston, and Philadelphia posted occupancy gains between April and June, several major markets including Atlanta, Los Angeles/Inland Empire, and northern New Jersey, experienced negative net absorption.

Despite this downturn in absorption, however, Los Angeles/Inland Empire—the nation’s largest industrial market with a total industrial base well over 1.6 billion square feet—remained among the tightest markets in the country with a 6.1% vacancy. Overall, vacancy rates in Los Angeles County were just 3.8%.

Houston, one of the few markets to see continued healthy tenant activity in second quarter, also posted a tight 6.1% vacancy rate, as strength in the oil and gas industries and population growth drove demand for business and consumer goods that pass through warehouse/distribution facilities.

 
While Houston was badly hit by Hurricane Ike, the damage to industrial facilities was minimal compared to the destruction caused by hurricanes Katrina, Rita, and Wilma throughout the Gulf Coast in 2005. Ike’s primary impact on business functions following was a lack of electricity.

“The real impact from the storm will most likely be on oil production and distribution,” said Meyer.

Nationally, new industrial construction has dropped considerably compared to historical standards. Just 22 million square feet was delivered in second quarter, and there is only 35 million square feet in the development pipeline.

“We’re looking at the lowest construction pipeline in 15 years. In fact, we could be down by as much as 70% from 2007 totals,” Meyer added.

Rental rates have held steady, according to Jones Lang LaSalle, with the national overall average standing at $4.73 per square foot. Asking rates for warehouse and distribution space increased an average of just 0.3% from mid-year 2007.

Los Angeles topped the scale at $6.69 per square foot, followed by northern New Jersey at $5.68 and Houston with an average of $4.67 per square foot.

Outlook: Rising Vacancies/Dropping Rental Rates Expected to Round out 2008
“We are facing highly uncertain market conditions as we head into 2009. The credit crisis, bank failures, and bailout will definitely have a negative impact on the industrial real estate markets,” Meyer conceded. “We’re looking at the storm clouds on the horizon and just don’t know right now if it’ll be another Katrina or a summer shower. Fortunately, there have been signs of an economic slowdown for several months, so tenants and developers have had time to adjust their strategies, unlike past economic cycles that took many by surprise.”

He added that while the industrial real estate market fundamentals seem to be functioning fairly well, the prognosis is circumspect. “If we can continue to muddle along as we have been, we should be pretty well positioned by 2010.”

Overall, national industrial vacancy rates are expected to continue to climb through the remainder 2008 and reach 10% by year-end. Vacancies for the distribution sector, which currently stand at 13.1%, should rise to 14%.

While some markets may experience modest pricing growth, rental rates for the most part are expected to come under increasing pressure in response to recoiling demand. Rental rates could drop between five and seven percent by year-end, adding to the increasing pressure on landlords to retain and land tenants.

“The name of the game for the remainder of 2008 and into 2009 is ‘occupancy.’ Landlords must act quickly and decisively in this competitive market to stay in the game,” he added. “More than ever, tenants will be focused on shorter terms, flexibility, increased concessions and speed to market at the lowest possible occupancy costs.”

Construction will be minimal throughout the remainder of the year and into 2009.

“While building will continue, the challenging financing environment and the uncertain economic outlook will certainly curtail new starts across the board,” said Meyer.