2018 BL Outlook: State of the Redevelopment Space as it Roars to Record Heights
The U.S. economy is heating up as the millennium's second decade starts winding down. Are markets melting down? What’s on the horizon in 2018?
The state of the redevelopment space is stronger than ever. Brownfield demand is at a record high. The average price for large industrial lots doubled in 2017. As strong as markets may be, innovation is an equally awesome force opening new possibilities for old sites. End use options for underutilized property have never numbered so many thanks to ever-improving technology.
But now the U.S. recovery has run so strong for so long, Robert Shiller, Sam Zell and a growing number of others found reasons last year to proceed more cautiously. BL too struck a note of caution last fall. Tom Barrack recently told Bloomberg that hardly any real estate is underpriced. James Stack, who correctly predicted the housing crash, now says his “Housing Bubble Bellwether Barometer” of homebuilder and mortgage company stocks is flashing a red warning sign. It jumped 80% last year, according to Bloomberg.
“It is 2005 all over again in terms of the valuation extreme, the psychological excess and the denial,” said Stack. “People don’t believe housing is in a bubble and don’t want to hear talk about prices being a little bit bubblish.”History shows that these conditions are more likely to “come down hard” in the next recession, he told Bloomberg, and that interest rates rising quickly "raises the risk that today’s highly inflated housing market will again end badly.”
This week Alan Greenspan spoke out about bubble conditions he sees in both the stock and bond markets. The former Federal Reserve Chairman is famous for coining the phrase “irrational exuberance” ahead of the dot com bubble.
Many forget that Chairman Greenspan made that comment on December 5, 1996—more than four years before the bubble peaked on March 10, 2000 (when the NASDAQ peaked) and more than five years before it ultimately popped. So, exuberance can run on for some time, no matter how irrational. What’s different in this cycle is that the structural forces shifting America’s way again are so strong. Now President Trump’s tax bill promises to be so big for private investment—most especially real estate—that America’s world-best recovery seems set to boom on a bit longer.
Pent up growth spurt?
It could be that the tax bill will ultimately prove to be too big a boon to commercial real estate; adding too much fuel too late in the already long economic cycle. On the other hand, former President Obama had also worked on corporate tax reform to encourage greater investment, including repatriation of the trillions in corporate profits piled up overseas in the American-led recovery, which were at record levels then driven by record corporate profits. Standing at even higher levels of private cash reserves now, it seems as good a time as any to tap the cache of private American capital idled aboard.
Plus, it comes as a time when the economy is evolving beyond old systems en masse. Technological change is accelerating and planning in all sectors is at a high point. Firmly in the rear view mirror now, the Great Recession really looks like the Great American Reset. America’s relative outperformance compared to its regional economic counterparts around the world can only be described as dominant. In the post-2008 recovery period, almost everything pivoted America’s way and it emerged perhaps stronger than ever before.
Sources of American weakness became strengths. Dwindling energy reserves, for example, sapped the U.S. economy for a generation before doubling during Obama’s eight years in office. Domestic production recently reached record levels above 10 million barrels of crude oil per day. Combined with enough new natural gas supplies to double or triple the total amount in global trade in the coming years, the U.S. has emerged once again as a dominating force in global energy markets in a dramtically short period of time. And in that short decade, the real cost of renewables collapsed. Solar costs fell 80% to become the cheapest form of electricity in the world and are still falling. Technology is enabling a diversification of the U.S. energy portfolio unlike anything we've ever seen, and it's enjoying the cheapest electricity rates in the world as a result.
Sources of American strength became stronger. Technology has also unleashed the American consumer, which has been a primary driver of the global economy for generations already. But Amazon Prime managed to move the peak shipping day for the holiday shopping season by an entire week when it was introduced in 2013. Now the U.S. has enjoyed six record-breaking holiday shopping seasons in a row. Many of which were so disruptively large, package shippers couldn’t delivery every gift on time.
Thanks to mobile devices, apps, voice recognition, artificial intelligence, big data, the internet of things and a whole host of other innovations working their way into our homes and offices, the original promise of the internet is finally being realized. No longer confined to the online virtual world, the information age has enabled an age of application with new technologies coming to market and creating evolutionary real world impacts with viral speed. The sum of their collective impact is changing our way of life today reminiscent of past golden periods, such as the 1880’s-90’s when inventions like the lightbulb and steel frames forever changed the way we saw our world and the buildings we inhabited.
Social media, for one, seems to be changing the our very sense of ourselves. And our politics.
In his "State of the Union" address this week, President Trump said that this is a "new American moment" full of unprecedented opportunity. "There has never been a better time to start living the American Dream," the President continued. He's not wrong. By all measures the economy is breaking out to new levels of achievement. Both business and consumer confidence are soaring. Retail sales have never been higher. Shippers have never shipped more packages. U.S. industrial production reached a new all time high at the end of 2017. The aggregate American manufacturing machine has never produced so many proverbial widgets. Manufacturing jobs are increasing in an uncharacteristic moment of post-1970 growth.
Overall U.S. wages have begun rising again meaningfully in recent years, also for the first time since 1970, and exhibit signs of structural strength. U.S. poverty is down to record lows (just 14%) because median household income improved markedly in 2015 and 2016—led by gains against child poverty. Children are far better off than they were a generation ago. Infant mortality, high school graduation rates, smoking and alcohol use and teen births have all made substantial improvements over prior generations—although new threats from opioid abuse are on the rise.
Yet, notwithstanding a drug epidemic, crime is hovering near historic lows. Global warfare and terrorism are also down. By all objective measures, this is the safest time to be alive in the history of the world.
This morning’s surprising jobs report revealed that wage growth in the U.S. grew at the fastest annual pace since the recession ended (2.9%). Nonfarm payrolls rose 200,000 and the jobless rate held steady at 4.1% percent, which is the lowest level since 2000.
Jobless claims continue to hover near 50 year lows. And while the U.S. economy created enough new jobs to replace the ones lost in the Great Recession by April of 2014—which was more jobs than the rest of the developed world combined had managed to create at that point—it wasn’t until August of 2017 that the U.S. jobs gap accounting for population growth and retirement had closed. Still, according to a study of financial crises (like 2008) by economists Reinhart and Rogoff, this U.S. recovery is one of the best in financial history (PDF).
The U.S. housing market has also completely recovered and then some. In the most recent figures, national home prices continued rising higher in November, up 6.2% according to S&P CoreLogic Case-Shiller's index—the fastest pace of growth since the hot summer of 2014. Nationwide home prices are now 6% higher than their 2006 peak.
The U.S. stock market has been even hotter, until this week—although it’s worth noting that gains in global stocks outpaced U.S. markets in the last year or so. Around the world masses of people are entering the middle class at an unprecedented rate in the most rapid expansion of the middle class the world has ever seen. It is estimated that 160 million people will rise into the global middle class for the next five years.
Over the last half decade, the U.S. has benefitted from the greatest surge of foreign direct investment ever and became the top global destination for capital investment in 2013, according to AT Kearney’s survey of 5,000 decision makers. It has held the top spot every year since. But while U.S. capital investment has been substantial, it’s often been bemoaned during the recovery as a bit of a laggard. That is until 2017 when private companies began writing bigger checks to invest heavily in equipment, facilities and intellectual property—in the best annual average growth rate since 2011 when the economy really began to reignite.
So, while this has been one of the most hated recoveries and most Americans today will tell you the U.S. is on the wrong track by a 2-1 margin, the objective position of the U.S. is currently one of overwhelming advantage. GDP may be lagging, but the old metric may not be keeping pace with growth in the new economy.
Record breaking numbers in metrics across the board belie GDP’s indicative power and obfuscate the high quality of the post 2008 recovery and structural rejuvenation the U.S. has enjoyed. The entire North American continent has enjoyed a structural revitalization good enough to avoid a depression and lead the global economy to new heights.
In BL’s 2017 outlook, we noted that caution would reign in 2017, which seemed warranted given the length of the economic expansion and policy uncertainty at the time. But caution continued to be sidelined last year, as the volatility indexes were flattened and the stock market roared onward and upward.
We also said, however, that the 2008 hangover hit the real estate world too directly for a repeat to come too soon. Total dollar volume of real estate transactions actually declined in 2017, below 2015 and 2016 levels, although not by too much. Among the reasons why, as we wrote in the last BL outlook, was: “the painful lessons learned after the lofty heights of the last bubble are still fresh in the minds of most everyone.” The 2017 outlook continued:
Thanks to the favorable treatment real estate investment received in the tax bill, discussed above, as well as the banks, the real estate world has the fuel to continue to feed the boom. And there is real demand even at this late stage of the cycle, unlike in 2007-8, with supply crunch the current condition in many markets.
In general, U.S. developers are still holding back. New residential development has returned, certainly is many hot markets, but nationwide acticity has so far failed to add units at levels seen at the peak of the prior cycle.
Another sign of this cycle’s maturity is the extremely tight labor market. It’s a topic we covered in the last BL annual outlook—asking ”where are the workers”—and a story that has only grown in significance. Labor shortages are being reported in every corner of the country and in practically every segment. Good people are hard to find, but finding anyone suitable at all has become quite a task. Labor constraints have become problematic enough to begin curtailing economic growth.
Millennials are now the largest segment of the labor force, and the largest generation in the U.S. overall, but Boomers are retiring faster than their younger replacements are coming in. It's been a huge drag on the labor force participation rate. Most recently, however, that stubborn labor force participation rate has started to tick up overall, even for men (the participation rate for women has fared much better). Workers return to employment, but there are increasing questions as to how much slack is left in the labor force. It's one of the reasons why there is still a record number of open positions available in the U.S. (shown right).
Rotation accelerates to secondary markets.
In BL’s 2017 outlook, we wrote “the rotation toward secondary markets, near core and next-core properties that we forecast last year will accelerate because prime and core assets have reached near term limits.” And noticed that “some forecasters are calling for a return of the suburbs and the end of an urban migration bubble, but there will be opportunities and pitfalls in both transects.” Last year, Richard Florida, the urbanist extraordinaire, released his new book The New Urban Crisis: How Our Cities Are Increasing Inequality, Deepening Segregation, and Failing the Middle Class and What We Can Do About It essentially arguing that the great urbanization was over and critiquing some of his own work in his seminal Rise of the Creative Class.
But the re-urbanization trend is only beginning, quite literally yet in many communities. As we wrote in BL’s last outlook:
As 2018 begins, we only see recent trends firming up, even if maturing and evening out geographically. Successful secondary cities may continue to outperform for some time to come. And it’s a breakout moment for opportunistic and well-positioned tertiary cities as well.
The new tax bill’s preferential treatment for real estate investment will help developers grow into these new opportunities. The leaked Trump administration infrastructure plan would also direct project funding into less populated areas, which could provide another relative tailwind for rural areas, exurban markets and edge communities.
The forces of reinvention are also finally reaching rural and suburban areas. Everyone is starting to understand the benefits of redeveloping walkable streets and more traditional modes of development, particularly on "Main Street."
But beyond Main Street change is happening in almost every segment and every business. The rules of real estate and economic geography are changing. And secondary cities are starting to win on this ground as well.
Right now demand for “last mile” storage space— the last link in the logistics chain before a package reaches its final destination—is growing as robustly as online sales. A new Colliers report highlights ten cities most ready to seize this opportunistic moment in logistics, while noting the fastest growth is in secondary markets “with growing populations, economic rental rates and land available for development, as well as close proximity to logistics hubs.”
Like the strong and ongoing logistics redeployment, noted in BL’s last outlook and a recurring theme on our blog, we expect to continue to see outsized opportunities in secondary cities as demand pressure siphons off superheated urban cores.
A similar, but substantially different shift emerged in 2017: Sun Belt population growth hit a snag. Meanwhile, many Snow Belt states experienced unexpected growth.
It could be a blip on the demographic radar, or it could a sign that the Sunbelt is losing its edge and that the great population rotation out of northern cities is reversing. Thriving urban areas to the north are leaning into the amenity war and making their cities cool, livable and the place to go find a job. Office vacancy in Chicago’s downtown loop is at generational lows and has millions of square feet of office space in the pipeline to meet intense demand from employers in Chicago’s transit rich urbanscape. Notwithstanding cold winters, frail state finances and diminishing Illinois population, Chicago is leading the country in corporate relocations four years in a row. Companies are following millennials and workers who are flocking to Chicago’s core—populations in some downtown neighborhoods have doubled and tripled in the last decade or so—and taking advantage of all of Chicago’s other urban amenities.
Similarly, New York City continues to boom on in the face of high living costs and terrible traffic. According to Cushman & Wakefield, Manhattan will add more than 12 million square feet of new office space this year and next—more new office space added in any two-year period since 1985 and 1986—with 22+ million square feet more in the pipeline over the next five years. From Seattle to Boston, America's north cities are booming.
The economic power of America's cities have pulled population northward before. And today's cities have absolutely dominated job creation so far this millennium, which leads us to some of the negatives.
Negatives and downside risks
As strong a year as 2017 proved to be, 2018 could be stronger. But this is not to say that there are not big, glaring weaknesses in the U.S. outlook this year.
Workforce development is so absent and labor so scarce, it seems to be pushing businesses to adopt labor-replacing technology even faster. So, while capital investment is coming on, as mentioned above, the tightening labor market makes human resources scarce relative to technological solutions to boost productivity. This will boost investment in equipment and software but eliminate jobs, thereby excaerbating the problem.
Aiding this technology resource preference, the timing of new tax reform could incentivize businesses to spend even more on available solutions to the detriment of the laborers currently in the human workforce. If businesses invest now, they will invest in solutions available. And that is certainly not labor. Worse, productivity growth is also underperforming and economists wonder if the great productivity boom of recent decades is over. Eventually, if large segments of the labor force continue to lag, it will slow gains in wages and eat at living standards.
In many places across the U.S. this is already the dominant story, perhaps most places according to the Distressed Communities Index.
Only 25% of the new jobs created since 2000 were available to workers in the bottom 60% of U.S. ZIP codes. That means that 40% of U.S. ZIP codes, the ones with large cities and more urbanized areas, created three out of every four jobs. Distressed communities have experienced zero net gains in employment and business establishment since 2000. And people in distressed communities die 5 years earlier on average
The much discussed inequality gap can be seen clearly in the country’s geography. Unfortunately, America’s urban-rural gap seems to still be growing larger. Worse, many of these same underperforming communities are experiencing a double-whammy. An opioid crisis is killing people in epidemic proportions. More Americans died of drug overdoses in the in 2016 than died in the entire Vietnam War.
Unfortunately, this is all happening at a time when American mobility is at a low point. For some reason, contemporary Americans are much less likely to pick up their stacks and pursue better opportunities beyond the borders of the communities where they grew up.
So, while the U.S. consumer is at record strength and poverty is down, many Americans have been left out of meaningful gains in real turns and left behind in the old normal of American underperformance. In the leaked infrastructure proposal, the Trump administration seems to have heard the call that less dense areas are having a hard time pulling themselves up by their bootstraps. And the administration shows signs of responding to a chorus of advocates in the public and private sector calling for a surge of workforce development and join in a major overhaul in how the U.S. retrains its workers.
Even with major policy action, the skills gap and the labor shortage are very likely to persist. This is likely already inhibiting growth and may also continue to function as a wet blanket on the expansion plans of firms in multiple sectors.
High prices in the housing market may also become an impediment to further growth eventually. Strong employment and very tight supply should continue to maintain upward pressure on home prices. Supply is becoming generally recognized as a “crisis” in the eyes of many analysts, and this is to say nothing of the affordability crisis that is hurting large segments of the U.S. population who are priced out of the housing that does exist. Without additional supply, home price appreciation is likely to continue to substantially outpace inflation, which is a condition that cannot last indefinitely without dramatically accelerated and widely distributed wage growth. We saw such wage growth in this morning’s surprise jobs report, mentioned above, which panicked markets because the Federal Reserve is very likely to raise interest rates to cool such hot growth down. Ironically, good news is bad news.
So far, home prices are still benefiting from very low mortgage rates, but the Goldilocks days for the U.S. housing market appears to be over. Mortgage rates are moving up rapidly and pinching housing affordability. This is especially hard for debt-saddled millennials to absorb. And they are the ones trying to form households at this moment. (And they aren't doing so well—first-time homebuyers made up only 29% in November, matching cycle lows).
Speaking on debts, Millenials aren't alone. Americans are taking on lots of debt again and saving less. The latest data on the saving rate showed the lowest U.S. savinng since the peak of the last bubble in 2007, another warning sign that could hurt the housing market.
These Goldilocks moment spoiling effects could be compounded this year by the provisions of the new tax law that limits the deductions for property taxes and mortgage interest. Although rising interest rates stand out as the most significant threat to growth in 2018, which is a reality that seems to be settling in this morning with the DOW Jones Industrial average down hundreds of points.
Taken together, it's easy to build scenarios with signficant downside risk for the U.S. real estate market in particular, and the broader markets in general. As we mentioned at the start, legendary bubble caller Alan Greenspan sees bubbles in stock and bond market—though he could be five years early, again. If James Stack “Housing Bubble Bellwether Barometer” is as accurate as in the last real estate downturn, markets might have another year before peaking.
BOTTOM LINE: Expect more of the same, but more volatility.
There’s plenty to be concerned about and reason for caution. Yet, with the tax overhaul so clearly aiding capital investment, it seems likely that the already long U.S. expansion will continue—although not in the straight course up the recovery has charted thus far. Macro conditions have reset and a new long cycle has taken over from the 1970-2008 period of relative U.S. underperformance, but there are downturns and recessions in every cycle.
In a note this fall, BL warned that markets could find an excuse to get spooked. We wrote:
In general, BL maintains its constructive view in the long term. Most forecasts call for continued growth in residential commercial and industrial markets. The American Institute of Architects' semi-annual consensus report, for example, expects nonresidential construction activity to jump 4% in 2018 and in 2019—led by office construction (+4.6%), education-related projects (+4.9%) and industrial (+5.2%). And North American has the best of everything one would want to compete and win economically on a planet with 8 or 9 billion people on it, and billions in the middle class. A correction may come, but it will likely have a shallow bottom because the overall forces of change are overwhelming and ongoing (thus resistant to recession),
But a major down draft could put markets under pressure suddenly. Sources of stress could emerge from international markets, which have seen their stock markets run even higher than U.S. stock markets and could be a source of disappointment or shock.
As we were reminded by today’s massive market selloff, however, the most clear and present danger is from the threat of inflation and rising interest rates. The danger to the real estate space from rising interest rates are all too real, though it is likely much more prepared and resilient than the last real estate bust in 2008.
Nevertheless, barring some big and disruptive black swan event, like war with North Korea, a global tariff spat that becomes a trade war, or a political crisis in the U.S. or EU, we expect more of the same steady economic progress in 2018. If a recession begins, it promises to be structurally shallow even if violent and unpredicable in nominal terms. As the bitcoin's volitility recently indicates, corrections can manifest today with amazing speed.
With so much in flux, 2018 is a hard year to forecast. You may want to buckle your seatbelt because the recovery seems to be running out of smooth road.
Futurecasting: what’s next?
Utilities beware: micro-production and the microgrid are poised to transform the status quo in electricity
A cleaner, greener, more reliable and more resilient energy grid is on its way. And it will be integrated into all your other gadgets. Already, entire islands are building their own microgrids incorporating multiple power sources and industrial scale batteries (from the likes of Tesla). It’s a game changer that’s only begun, but will make an immediate impact on the resiliency of data centers as well as hospitals, schools and other facilities with sensitive receptors where even brief brownouts can cost money or take lives.
Speaking of Tesla: the transport system is electrifying. No, really.
Elon Musk’s original dream of an affordable electric car is finally here and the Tesla Model 3 is generating iPhone-level consumer product buzz about his electric cars and even massive pre-sales (very uncommon in the automobile space). But the story is much bigger than Tesla. Mr. Musk has made cars cool and taken the technology to the next level; and now every other car company is working like crazy to catch up by innovating again. Consumers will benefit most of all, second only to the environment.
The Battery wars have begun and it's a really big deal.
Just like everyone has followed Tesla into a race into electric cars, Elon Musk has also triggered a race for battery technology. And the race is already heating up and delivering difference making products to market.
It wasn’t long ago that most people thought lithium batteries would never be powerful enough to pull “big rig” trucks. But that was before Tesla’s day tripper with 500-mile range was revealed in 2017.
Better still, three different groups (including one led by Professor John Goodenough, inventor of the lithium-ion battery in the 1980’s) filed patents for solid state batteries last year--the next generation of battery tech that is cheaper to produce, three times more powerful and will charge in 10% of the time.
A new generation of gigafactories is on the way--from Tesla already, with much more soon from China. Where are we going to get all the electricity to power this Jetsons’ world?
Are flying cars next?
We've known that one of Google's co-founders has been working on a flying car for some time, the Kittyhawk, as have many others including Boeing, Airbus and NASA. This week the concept became a lot more real when the news came that Intel was leading a $100 million funding round in startup Joby Aviation.
Wireless charging is already here.
Imagine your life without power cords. Apple will be adding wireless charging to its devices. Soon everyone from coffee shops to manufacturers might start building wireless charging pads into everyday life.
An infrastructure plan is coming, but it won't be big enough.
The leaks have begun. The consensus is there and the last election found bipartisan harmony. On this, the future of American economic, environmental and social performance depends… so hold your breath (and call your representatives).
Augmented reality is here and already reshaping the real world.
Pokémon Go put augmented reality (AR) onto everyone’s radar, but this year AR will try to go mainstream. Retailers, educational institutions and many professional fields are testing new ways to benefit by enhancing the real world with layers of digital information. For Toys-R-Us, as an example, AR is a central pillar of its post-bankruptcy reinvention plan.
BONUS BETS for 2018
- Lower oil prices by the end of 2018. U.S. shale producers will increase production into any substantial price appreciation, such as that seen in the last few months.
- An increase in state and federal fuel taxes. Increasingly, infrastructure will be funded with revenue.
- Increased U.S. exports of refined oil products and natural gas.
- Higher electricity prices (potential very high, but for a recession).
- More than one 500 year flood (but Houston will be spared its 4th 500 year flood in a row).
- U.S. dollar appreciation: After an extremely anemic 2017, which gave a big boost to producers’ sales to overseas customers, a strong reversal and strengthening dollar could hurt large multinationals and trim profits from record levels.
Check out BL's ongoing greyfield series:
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