In last week's comment we discussed at length the problems of the apartment and retail sectors of commercial real estate. We ended the report by stating that the other categories of commercial real estate were also having very difficult times. We just received the latest numbers from Ned Davis Research (NDR) for all segments of the market for the first quarter of 2009---the industrial, office, and hotel segments are just as onerous as retail and apartments.
Ned Davis sourced the NCREIF Property Index (NPI), which is a very prominent index for privately held commercial property investments. The index includes over 4,200 office properties at a market value exceeding $150 billion. The NPI income graph shows the return from the Net Operating Income (NOI) for the properties and the NPI capital graph shows the return from gain in value net of any capital expenditures. The NPI also shows returns and includes both NOI and capital appreciation. Returns are calculated by NCREIF quarterly based on appraised values and are shown on an unleveraged basis (as if properties were all purchased on an all cash basis).
Their index dropped 7.3% in the first quarter which was slightly lower than the fourth quarter of 2008's record decline. The Apartment segment dropped the most at -8.7% followed by Hotels at -8.6%, Office at -8.0%, and Industrial at -7.5%. The last segment, Retail, was down only -4.3%, but that decline seems to be understated since, as we discussed last week, the vacancy rates were 9.1% in the first quarter and that was up from 8.3% the previous quarter. Also, the amount of occupied space in U.S. shopping centers and malls declined a net 8.7 million square feet in the first quarter of 2009 according to Reis, Inc. In addition, we discussed last week how correlated commercial real estate was to the unemployment rate- to see the correlation on a chart, just click on the first attachment to see how clearly the NPI correlates with unemployment rate. Since unemployment correlates so closely to commercial real estate prices, and the U.S. capacity utilization just declined below 70%, any recovery we have in the economy very likely will be a jobless recovery. With excess capacity most businesses are slow to hire new employees and even to increase wages until the capacity becomes tighter. Therefore, we don't expect a recovery in commercial real estate any time soon.
If we were to just focus on the price declines as we do with residential real estate the attached charts from NDR will be useful. The total NPI is down a record -14.7% from a year ago, which is a record low and declines ranged from -10% for Retail to -18% for Hotels (see the attached Ned Davis charts).
The bottom line for commercial real estate is that rents continue to fall as vacancy rates are rising and cap rates (capitalization returns) remain low (see the attached charts from NCREIF). The index declines and vacancy rates are clear. The cap rates are figured by dividing the NOI by the purchase price. For example, if you paid $1,000,000 for a retail store and the NOI of that store is $100,000 your cap rate is 10%. As you can see the cap rate has been just about cut in half since the 9% + returns in the mid 1990s to 5.5% presently. The combination of property values declining, lease rates declining, cap rates declining, and vacancies rising is not a recipe for near term success. It seems to us that the commercial real estate market is lagging residential real estate by about two years and has a long way to go before turning the corner.
Keep in mind that the total debt relative to GDP is the problem, and it is the deleveraging of this debt that will restrict the economic turn-around anytime soon. Until the $38 trillion of total private debt declines substantially and/or real incomes accelerate sharply this economy will struggle to grow at numbers close to the 3% average growth.
As far as this counter trend rally is concerned---we stated earlier that we expected a rally that could take the market up 20-25%. Now that the rally has exceeded the 25% we stated that we did not expect the rally to break through the resistance of 877, but if it did, we didn't expect this rally to exceed the January high of 944.