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Marc Louargand, PhD
is managing director,
Cornerstone Real Estate
Advisers, Inc. He is
responsible for investment
strategy and research and
oversees the firm’s public
market investment programme.
A co-founder of Cornerstone,
he was formerly a professor of
real estate finance and
portfolio theory at MIT’s
Center for Real Estate. He
has had an extensive career in
the academy and business,
having served for two decades
as consultant to US
corporations and domestic and
foreign governments. Dr
Louargand is co-editor of the
Journal of Real Estate
Portfolio Management, and an
Editorial Board member of
this publication, as well as the
Journal of Real Estate
Literature and the Journal of
Corporate Real Estate.
Marc Louargand
Managing Director, Cornerstone
Real Estate Advisers, Inc.
One Financial Plaza, Suite 1700
Hartford, CT 06103 2604, USA
Tel: 001 860 509 2237
Fax: 001 860 509 2222
[email protected]
Regular features
The US economy: A mid-year
review and outlook
Marc Louargand
Received: 14th July, 2001
The US economy is in a generally weak condition at mid-year 2001.
Virtually all manufacturing-intensive regions are in recession. The
share of the labour force filing new unemployment claims is
running just below the levels attained in the 1991 recession.
Corporate profits have declined substantially in the past four
quarters. Corporate profits in the USA grew at an average rate of
7.4 per cent since the 1991 recession. During the past four quarters
they have declined by 3.7 per cent. With the exception of the
petroleum, chemicals and fabricated metals industries, all
manufacturing sectors have seen profitability declines. Retail trade
is continuing to eke out meagre gains, while the financial sector
profits grew by nearly 8 per cent in the past year.
As the US expansion crawls weakly into its tenth year, the
inevitability of job losses and inventory build-ups in the face of any
slowdown in consumption or economic growth can be seen. The past
ten years have seen astounding increases in productivity compared to
any previous expansion. New technologies have combined with new
business models to unleash powerful forces in the world’s economies.
However, technological innovation typically produces productivity
gains that create excess capacity and the need for exit. That exit takes
the form of declining profits, lay-offs and eventually bankruptcies by
those firms that are unable to adjust to their changing environment.
The excess capacity may lie fallow for some time, but it is more likely
that innovative uses will be discovered and excess capacity will be
soaked up quickly by them. This cycle of creative destruction and
rebirth depends heavily on the free flow of capital to support
innovation and product and market development. In recent years in
the USA, this type of capital has been supplied by venture capital
(VC) firms which raised their funds from institutional investors —
primarily pension plan sponsors. It is thought that the amount of
capital flowing through this channel grew so rapidly it created a
leasing bubble in the property markets.
During the years 1996–98, VC funds flowed at a rate of between
US$10bn and US$17bn. During those three years, the VC fund
# HENRY STEWART PUBLICATIONS 1473-1894 Brief ings in Real Estate Finance VOL.1 NO.2 PP 177-184
Five sectors received 67% of all VC
funds in these years.
Source: PricewaterhouseCoopers; Cornerstone
Figure 1: Share of VC flows by industry: 1996–2001Q1
Rapid increase in
venture capital fund
Funds concentrated in
a few industries in
only a few markets
flow was growing at a rate of 7 per cent per quarter, or over 30 per
cent per year. In 1999, VC firms placed US$46bn in investments,
over 2.6 times the investment of the previous year. In the first
quarter of 2000, VC firms placed over US$26bn. They were on
track to exceed US $100bn for the year. Before the year’s end, of
course, the technology bubble broke, the IPO window was shut,
and VC funds began to slow down significantly. Yet the group
finished the year with a total investment of US $87bn, slightly more
than the previous four years combined. In the first quarter of 2001,
they have placed over US$10bn, a pace less than half of last year.
What are the implications of this massive influx of funds into a few
industries in only a few geographic markets?
One can see that these funds were concentrated into a few
industries, with communications/networking and consumer and
business services receiving nearly 40 per cent of the total. These two
sectors represent the explosive investment in broadband
communications — fibre optic lines, switching gear and the like —
and investment in World Wide Web content and platforms — the
B2B, B2C, U2Me etc that everyone has read about so much in the
past few years. Where did this money go? It was remarkably
concentrated. Figure 2 shows that 36 per cent went to Silicon Valley
firms1 and another 11 per cent went into New England. Virtually all
of that portion went into the Boston area. Interestingly enough, the
relative shares are nearly proportionate to the relative size of the
two areas. The Boston area population is about 5 million, while
northern California is home to about upwards of 12 million people.
If it is assumed that the typical company in these industries had
an occupancy cost equal to 6 per cent of their total burden, then
# HEN RY S TE WA RT PU B LI C A TI O NS 1 47 3-1 89 4 B r i ef i ng s i n R ea l E s t a te F i na n c e VO L. 1 N O. 2 P P 17 7– 1 84
A mid-year US review and outlook
During this period, 81% of total
VC flows went to firms in these
eight markets.
Silicon Valley
New England
NY Metro
Source: PricewaterhouseCoopers; Cornerstone
Figure 2: VC flows by locale 1998–2001Q1
Newly rich firms took
up excess space
Tenants borrowed
from future years’
the funds advanced in the year 2000 could have supported over 50
million square feet of office absorption each year for three years. In
a national market that had been absorbing something in the order
of 85 million square feet during the expansion, the additional
leasing demand created a classic bubble. Newly rich firms set out to
lease space in ever-tightening markets. The natural response was to
acquire space at any cost and to acquire as much of it as might be
needed in the foreseeable future since there might be none available
at that time. In the San Francisco Bay area, rents shot up from US
$40 to over US $100 in two years. During the year 2000, the US
market had over 114 million feet of absorption. In effect, tenants
borrowed from future years’ demand in order to secure space. The
link between VC flows and leasing is shown in Figure 3.
The leasing bubble that resulted can be seen very clearly in
Figure 4, which shows the net absorption per capita for each new
office worker between 1994 and 2000. Tenants took down nearly
twice the usual amount of space as they added staff.
The stock market — unfortunately — chose this moment to
understand that valuation multiples in the hundreds were not
sustainable, especially when people realised that rapid expansion in
several technology areas had created significant excess capacity. The
bitter fruit of these events was that firms suddenly had far too
much space on their hands and began to throw much of it back
into the sublease market. Larger players who had commissioned
bespoke buildings for their expansion also began to feed that space
into the multi-tenant market.
# HENRY STEWART PUBLICATIONS 1473-1894 Brief ings in Real Estate Finance VOL.1 NO.2 PP 177-184
% change in VC Flows
% Change in Absorption
Source: PricewaterhouseCoopers;Torto Wheaton; Cornerstone
Figure 3: Per cent change in leasing and VC flows
Leasing bubble
square feet
Source: Torto Wheaton, Economy.Com, Cornerstone Research
Figure 4: Square foot consumption per capita of new office workers
# HEN RY S TE WA RT PU B LI C A TI O NS 1 47 3-1 89 4 B r i ef i ng s i n R ea l E s t a te F i na n c e VO L. 1 N O. 2 P P 17 7– 1 84
A mid-year US review and outlook
Excess occupancy
came back to market
as sub-leasing space
As the economy entered a slowdown and corporate profits were
squeezed, cost cutting began to ripple through the property
markets, notably the office and hotel sectors. Leasing has come
nearly to a halt in most major US office markets as decision makers
wrestle with both excess capacity and uncertainty about the nearterm future.
In anticipation of a slowdown at some point, the author’s firm
had examined the potential impact on property markets about a
year ago.2 At that time, it was concluded that US property markets
were in pretty good shape to weather a recession. It was estimated
that multi-family and warehouse property markets would be the
most resilient and that the hotel and office sectors would see lower
occupancies but would not suffer substantial rent declines. A quick
review should indicate the accuracy of the estimation.
US office market will
be flat at best in 2001
Vacancies will rise
and rents will be flat
or slightly declining
Institutional capital is
not active today
As discussed above, the office market is moribund at mid-year. US
absorption was negative in the first quarter and anecdotal evidence
in the second quarter indicates it will also be flat or negative.
Because of the leasing bubble in 2000, it is unlikely that enough
leasing will take place in the second half to put up large positive
numbers. Net absorption in the USA is expected to finish 2001 at
between 7 million and 15 million square feet. As of the end of
2001, first quarter, office vacancy stood at 9.5 per cent. The
forecast for slow growth and a slow recovery from the leasing
bubble calls for a rise in vacancy to a level of 13 per cent in 2004.
Little or no rent growth is expected during 2002 and only a modest
rise in the following years as sublease space begins to lose its
attractiveness due to its short remaining term. The good news for
office owners is that current achievable rents are below what
occurred during the bubble, but are at or above rents signed in
1999. Thus, most buildings have significant ‘loss to lease’ embedded
in their rent rolls. The evidence of this can be seen where public
real estate companies announce large revenue increases on a samestore sales basis.
In most cases, institutional investors have left the office market.
Office buildings make up the largest portion of most institutional
portfolios. As the common equity markets have retreated, investors
find themselves over-allocated to office buildings. In addition to
their allocation problem, investors are reluctant to jump into an
uncertain environment. As a result, the office sector offers
tremendous buying opportunity if owners who are compelled to sell
can be found.
America’s multi-family market is in good shape at mid-year.
Occupancy in buildings owned by institutional investors is 96 per
cent. Rents are expected to grow by 3 per cent to 4 per cent in most
# HENRY STEWART PUBLICATIONS 1473-1894 Brief ings in Real Estate Finance VOL.1 NO.2 PP 177-184
Multi-family is
proving its reputation
as a defensive
metropolitan areas. Some softness is showing in northern California
markets, but most areas are in balance. Supply is forecast to grow
by 0.6 per cent while demand will expand by 1.2 per cent per year
for the next three years unless the economy enters a severe and
protracted recession. The US population has some interesting
demographic characteristics for this sector going forward. In
addition to the well-known Baby Boomer group, there is the Echo
Boom group. They are approximately the same size. Among
affluent Boomers, there is a rental preference on the part of about
30 per cent of the households. Among the Echo Boomers, who are
beginning to turn 21 at the rate of 3 million to 4 million per year,
about 80 per cent to 90 per cent will be renters for at least some
portion of their twenties. The combination of these two groups
leads to a demand forecast in excess of 400,000 new units per year
for several years. The multi-family outlook is quite positive.
Warehouse market is
in equilibrium and
should remain so
R & D market will
The US industrial market is divided into manufacturing, warehouse
and R&D sectors. The warehouse sector is often further sub-divided
by making a distinction between ‘big box’ regional and national
distribution warehouses and smaller local distribution or transshipping and assembly uses. This firm’s focus is on the big boxes.
The big box warehouse has become a super-efficient logistics
machine. Technological advances in racking, automated storage and
retrieval systems, and wire or radio-guided towmotors, keep this
sector in flux. Since an economic slowdown is typically accompanied
by an inventory build-up, this sector actually does better as things
begin to slow. During the slowdown, tenants are unlikely to
abandon space that has been selected as part of a highly
sophisticated distribution strategy. Therefore, this sector is perceived
as being quite stable through the cycle with an expansion of demand
lagging behind the general recovery. One exception would be a
persistent consumer slowdown that dragged on for several quarters.
Those circumstances would lead the third-party logistics companies
to begin to give space back to the market. Currently, this market is
92 per cent occupied. Cornerstone forecasts supply growth of 2.3 per
cent against a two-year demand growth rate of 1.2 per cent. This
mismatch will bring the vacancy rate up to 10 per cent, which is still
within a comfortable economic equilibrium.
The R&D market is another story. This product type is found in
large quantities in the northern California, Los Angeles, San Diego,
Austin, Dallas, Washington, DC and Boston markets. R&D space
tends to be quite volatile with respect to the technology cycle and
this slowdown is no exception. Northern California with roughly
150 million square feet of stock has an overhanging sublease
availability in the order of 10 per cent of the stock. It is expected
that this sector will show increasing vacancy and rent softness for
the next year, but may offer substantial buying opportunities if the
market discounts the outlook for technology heavily.
# HEN RY S TE WA RT PU B LI C A TI O NS 1 47 3-1 89 4 B r i ef i ng s i n R ea l E s t a te F i na n c e VO L. 1 N O. 2 P P 17 7– 1 84
A mid-year US review and outlook
Retail will remain a
troubled product
Retail real estate differs dramatically across the various subcategories. In general, retail is prone to difficulty from three factors.
In the short run, consumer spending fluctuations have an impact on
demand for space, level of percentage rents and the ability of noncredit tenants to pay. In the longer run, retail real estate is
vulnerable to changing retail formats as well as to retailers’
tendency to saturate markets with stores as a competitive tactic. By
cannibalising their own sales, they lower the value of any particular
location, driving down achievable rents.
The regional mall companies have already felt the effects of an
economic slowdown. The ‘big-box’ or ‘category killer’ retailers like
warehouse clubs or electronic superstores and the non-credit
independent retailer will all be hurt by a continued slowdown.
Recent data on same-store sales by retailers are discouraging,
showing declines in department, clothing and footwear stores.
While sales are still growing in the wholesale club, discount and
electronic stores, it is expected that consumers will postpone large
purchases and reduce impulse buying if the slowdown continues.
The perennial bright spot in retail is the grocery-anchored
neighbourhood centre with a modest amount of side shop space. If
the anchor has room to expand to a modern footprint of 50,000 to
80,000 square feet, these centres produce consistent returns.
Neighbourhood centres in affluent areas have the ability to draw
top rents because the grocery anchor can dramatically increase its
net margins by shifting to a higher-priced mix of goods. With the
recent closure of the USA’s two major electronic grocery stores, the
neighbourhood shopping centre looks solid for the foreseeable
Hotel occupancy is
down but more due to
new supply than
reduced demand
Hotel economics
remain sound
As mentioned above, the hotel market is feeling the effects of a
business slowdown to a greater extent than most people expected.
During the recession of 1991, occupancy fell in the USA by about 3
per cent. But that was in the face of substantial new supply. Actual
demand rose by about 1 per cent during that period. This time, US
business has been quicker to put constraints on travel costs. Cost
cutting takes two forms. Planned meetings are being cancelled or
downsized. Meeting planners are also trying to rein in their
booking pace, committing much later in the planning cycle to book
the hotel than previously. The second effort is to contain costs of
travel. Firms may ask employees to go ‘downmarket’ in their choice
of hotels, or they may approach a hotel with whom they contract
and ask for a rate reduction. Despite the softness, the US hotel
market is in good shape. Occupancies are in the 70 per cent range
for most full service hotel brands and revenue per available room
(REVPAR) is flat or up to 3 per cent from the year 2000. Much
like the office leasing bubble, however, these properties are doing
‘on trend’ when compared with 1999. The economic bubble of 2000
# HENRY STEWART PUBLICATIONS 1473-1894 Brief ings in Real Estate Finance VOL.1 NO.2 PP 177-184
simply was not sustainable. The hotel market is also like the office
market in that capital has left the scene and transactions are few
and typically non-institutional. Full service and mid-price without
food and beverage properties are very attractive investments at
current pricing, but sellers are generally scarce.
In summary, the US real estate markets are feeling the effect of a
slowdown in the economy that may become a full-fledged recession.
Those product sectors most closely linked to business activity in
real time are the hardest hit, hotels and office buildings. Those
products most closely allied with the still resilient consumer —
multi-family, retail and distribution warehouses — are showing
more signs of strength. In all cases, the economy will have an
impact on property performance going forward. The good news is
that the markets enter this phase in very good condition with high
occupancy levels, rents that have risen substantially in the past four
years and resultant operating leverage that allows for some slippage
in occupancy and/or rent in the short run. Cornerstone believe that
the latter half of 2001 and early 2002 will offer very attractive
investment opportunities in US property markets.
To be fair, the Silicon Valley definition used here includes the city of San Francisco and
the areas between it and San Jose, the centre of the Silicon Valley.
See Louargand M. (2000) ‘Real Estate and the Next Recession Revisited’, The Pension
Real Estate Quarterly, Winter.
# HEN RY S TE WA RT PU B LI C A TI O NS 1 47 3-1 89 4 B r i ef i ng s i n R ea l E s t a te F i na n c e VO L. 1 N O. 2 P P 17 7– 1 84
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