New Construction off to a Shaky Start in 2023

According to a recent GlobeSt article, the US construction industry should prepare for a 3% drop-off in construction starts (i.e. new construction projects) in 2023. This follows on from a complicated couple of years for the industry in 2021-2022, as soaring materials prices and supply chain disruptions kept developers guessing about their next steps. 

GlobeSt was reporting on data from the Dodge Construction Outlook Conference which took place in November 2022. The Dodge Construction Network provides data analytics and insights to construction executives and industry leaders across the US, and the annual conference is cited as: “the leading economic forecast event for commercial construction.”

Multifamily set to slow

As is often the case, the expected decline will affect specific real estate sectors in different ways. GlobeSt notes, for example, that the value of multifamily construction may see a large decline (around 7% when adjusted for inflation).

In their own report on the data, industry news site Engineering News Record (ENR) adds: “In the multi-family sector, starts are expected to finish the year [2022] up 16%, but will drop 9% next year.”

Mixed bag for Retail, Office and Industrial

ENR also notes that the increases in retail and manufacturing starts seen in 2022 are likely to taper off, though it’s worth pointing out that the manufacturing industry saw gains of 196% over the year.

Quoted in the article, Dodge Chief Economist, Richard Branch, noted that despite an anticipated 43% drop for manufacturing construction, “that is still historically a very strong record level of activity.”

Meanwhile the dollar value of office construction is in for a “slight decline” of 1% in 2023, as remote work trends and the tight labor market continue to put pressure on the sector.

Niche sectors still offer respite

Despite these generally downhill trends, other predictions made during the conference include ongoing strong performance from some of the niche CRE sectors we’ve seen rise to prominence in recent years. As Archinect reports:

“While traditional school construction is set to fall, life science buildings and healthcare projects, including outpatient clinics and hospitals, continue to rise.”

These are assets we’ve seen big things from over the past year, and it seems they’re set to continue attracting investors in the year to come.

Recession effects

As the above predictions show, there are still many factors in play that will influence how things shake out for the construction sector in 2023. Arguably the biggest determinant is the likelihood and severity of a potential recession.

In Branch’s words: “We’re walking the razor’s edge here. In our estimation, there is a very, very, very narrow path to avoiding a technical recession in 2023.”

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Conflicting Signals: What do Layoffs Mean for the Labor Shortage?

In recent news from the Washington post, tech giant Meta is cutting around 11 000 jobs, representing 13% of the company’s workforce. Twitter is also continuing with layoffs, after already slashing jobs drastically earlier in November.

Meanwhile Forbes reports large-scale layoffs at Amazon, adding that multiple other major companies – from Disney to Barclays, Salesforce, and Lyft have all already cut jobs or have announced cutbacks and hiring freezes.

With all of these changes incoming, the question that’s top of mind is: How will this affect the labor shortage we’ve seen since 2021?

In larger context

The names above are some of the biggest players (and employers) in the market, so it’s natural to assume that these cuts mean the labor shortage is inevitably reversing. Before making that deliberation, however, it’s worth taking a look at some of the figures from the U.S. Chamber of Commerce (USCC) to get a sense of the bigger picture.

In October, Stephanie Ferguson, the USCC Director of Global Employment Policy & Special Initiatives outlined the magnitude of the shortage, stating: “We have a lot of jobs, but not enough workers to fill them. If every unemployed person in the country found a job, we would still have 4 million open jobs.”

State and sector

The shortage stems, Ferguson says, from the unprecedented number of jobs added in 2021 – approximately 3.8 million. At the same time, the labor force has shrunk, with many workers retiring early, and workers quitting their jobs in unprecedented numbers as part of the Great Resignation.

USCC data shows that these shortfalls are  largest in Northern and Eastern States, and that certain industries, like hospitality and healthcare, have disproportionately high levels of job openings.

All of which is to say, that while the big moves happening in the tech sector right now are certainly concerning, they still form part of a much larger, and more nuanced, picture.

CRE concerns?

For the commercial real estate (CRE) industry, the effects are likely to be similarly varied, depending on where and what type of business we look at. We have already seen some sharp downturns for specific Proptech companies. Redfin, for example, has cut a further 13% of its staff, following on from an earlier round of layoffs in June.

Other Proptech outfits are facing similar difficulties, as 2022 shapes up to be a tough year for CRE startups.

Labor market outlook

What these cuts ultimately mean for the labor market, and CRE operations in the Bay Area where many tech companies are concentrated, is still unclear.

For now, it seems that worker availability, even in tech, is still falling short of demand from employers. Amid the current economic uncertainty, however, that situation might well change as we head into 2023. As always, we’ll be keeping a sharp on the trends, and potential impacts in CRE markets.

The Winner’s Circle

Alec J. Pacella, CCIM

Last month, we continued our “back to school” theme and started a discussion regarding capital accumulation. And equally important, we took a walk down memory lane, discussing slot car racing sets that were a part of my childhood in the 1960s and ’70s.

If you read last month’s column, you may recall that although Internal Rate of Return (IRR) is a well-established measure of an investment, it has some deficiencies. This is particularly true related to what I called the investor’s total pile of cash. IRR only cares about money in the deal and gives no consideration to money that comes out of the deal – even though an investor can reinvest these cash flows. Interwoven in that discussion was the story of AFX, a leader in the slot car racing scene of the ‘60s and ‘70s, and upstart Tyco, which proved to be a worthy alternative. This month, we are going to continue this discussion as AFX vs. Tyco isn’t the only battleline being drawn. This is the last period before our lunch break so let’s go! Modified Internal Rate of Return (MIRR) was initially developed in the 1960s and primarily used by businesses to make a more accurate comparison between investment alternatives. It addressed one of IRR’s main limitations of ignoring cash flows produced from a primary investment by introducing a couple concepts. If you recall, last month I used the analogy of putting money produced by an investment in a mason jar and burying it in the back yard. This would equate to a reinvest- ment rate of zero, as the money in that jar would be earning nothing. But we can do something more productive with those cash flows – like redeploy them at a realistic reinvestment rate, usually a rate comparable to the firm’s cost of capital. Also, any additional outlays that would be needed to cover anticipated shortfalls (i.e., negative cash flows) over the holding period are assumed to be funded upfront at the firm’s cost of debt. Figure 1 illustrates the MIRR process, using an 8% cost of capital and 4% financing cost. As you can see, the $10,000 negative cash flow anticipated to occur in year three is acknowledged at the beginning of the investment by dis- counting the shortfall back to time period 0 at 4% and adding this to the initial investment. Meanwhile, all of the positive cash flows are reinvested at 8% to end of the fifth year. As a result, the $108,890 initially invested is anticipated to produce $201,501, which equates to a MIRR of 13.10%.

Figure 1

Capital accumulation is newer, developed in the 1980s. While the basic premise is the same as MIRR, the concept is more specific to a real estate investor and introduces a few twists. A primary difference is the treatment of negative cash flows. MIRR eliminates future anticipated deficits by setting aside the additional capital necessary upfront, at time period 0. Capital accumulation discounts negative cash flows back one year at a time, offsetting it against any positive cash flows produced in the preceding year(s) until the deficit is eliminated. This is done at a “safe rate,” which represents the rate of a secondary investment that can confidently be achieved. After eliminating any negative cash flows, the remaining positive cash flows produced by the primary investment are assumed to be reinvested at rate representative of an investment alter- native readily available to the investor. But rather than compounding the positive cash flows produced each year to a corresponding future value at the end of the time horizon, capital accumulation only compounds each annual cash flow forward to the following year. This is added to any cash flow expected to be released in that following year and then the entire sum is again compounded forward one year. A second, related nuance is that capital accumulation can have multiple, or tiered, reinvestment rates. A higher reinvestment rate may be available as specific dollar thresholds are met. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized. This acknowledges a premium in return as a result of the aggregate amount being reinvested. This kicker is a concept similar to “jumbo CDs” of years past. By compounding cash flows one year at a time, the opportunity to exceed any established thresholds can be realized.

Figure 2 illustrates an investment with the same series of cash flows but utilizing the capital accumulation approach, with a tiered reinvestment assumption of 8% for positive cash flows up to $50,000 and 9% thereafter as well as 4% safe rate for negative cash flows. Note the differences in handling of both positive and negative cash flows as compared to Figure 1. Capital accumulation uses periodic positive cash flow in year two to offset the discounted shortfall from year three. It then compounds the remaining positive cash flows one year at a time, which allows it to take advantage of the higher 9% return as a result of exceeding the $50,000 threshold in year four.

These subtle nuances have a significant cumulative impact on the results; the $100,000 initially invested is anticipated to produce $190,077 by the end of year five, resulting in a capital growth rate (CGR) of 13.71%.

AFX slot car racing has several similarities to MIRR. Both are more established and set a standard in their respective worlds. Both have a wide following. And both take a more conservative approach. Tyco and capital accumulation also have several similarities. Both are upstarts and offer some twists to their more established counterparts. Both have a niche following. And both take a more unconventional approach. By understanding these nuances and choosing the path that best fits your needs, you will be in a better position to end up in the winner’s circle.

What I C @ PVC                

STILL HOT Investment sales, particularly industrial warehouse product, continues to achieve record pricing. Last month, a 125,000-square- foot facility in Middleburg Heights sold for $13.7 million or $109 per square foot. This is the 12th industrial investment sale to break the $100 per square foot mark this year. –AP

From December 2022, Properties Magazine

SIOR report shows sentiment waning in Office, Industrial

Despite a red-hot streak that’s outperformed other commercial real estate (CRE) asset classes, it seems that bullish sentiment on the industrial sector is finally cooling off. A recent report from the Society of Industrial and Office Realtors (SIOR) indicates that realtor confidence in the market dropped to 5.5 (out of 10), compared to 7.7 in Q1. Office sentiment fared poorly as well, with a 32% drop in confidence from 6.5 in Q1 to 4.4 in Q2.

Declining activity  

While general factors, such as prevailing economic conditions, played a role in the flagging sentiment, SIOR reported specific indicators of a downturn between Q1 and Q2 as well.

For industrial, these included:

  • Only 31% of members reporting an active leasing market (down from 61%)
  • An increase in “on-hold” transactions (from 10 to 14%) and canceled transactions (from 7 to 11%)
  • 69% of members reporting “booming” or “average” development conditions (down from 81%)

Meanwhile, office realtors reported a similar shakeup, with SIOR noting that:

  • 37% reported “little” or higher leasing activity in Q2 (down from 58%)
  • Canceled transactions jumped from 7% to 11%, and
  • There was a 61% reduction in the number of members reporting a “booming” or “average” development environment in their area.

SIOR adds that uncertainty around inflation and potential “economic turmoil” were the main drivers of the downturn. Or, as one of the survey respondents put it:

“Consistent commentary among clients is that the future is very uncertain and a recession likely coming.”

Concerns in context

Sentiment analysis across the broader US market indicates that the general consumer outlook continues to drop as we progress into Q3. This makes July the third consecutive month that consumer confidence has taken a knock.

Economic sentiment indicators in Europe show similar retractions, with confidence in the industrial sector declining by 3.5% in the region. Challenges such as the high cost of energy and gas shortages are hitting Europe particularly hard. In July this year, Reuters reported that Germany, the region’s industrial powerhouse, could be on the verge of recession.

For sectors like office and industrial, these reports indicate that there may be strong headwinds incoming.

SOCIAL: How have the industrial and office sectors performed in your region in recent months?

Stabilizing employment rates good news for commercial real estate?

Employment numbers are up according to a recent news release from the Bureau of Labor Statistics (BLS). In their analysis, BLS announced that the unemployment rate had dropped to 3.5%, with 528,000 new jobs added over the course of the month.

These figures mean that, for the first time, unemployment measures have returned to their February 2020, pre-pandemic levels. BLS also noted that the gains were led by the leisure and hospitality industry.

Strong recovery in hospitality

Reporting on the figures, Real Deal pointed out that hiring at hotels, restaurants and bars was responsible for a large percentage of the 528 000 jobs created in July. Together with construction and healthcare, these sectors accounted for 43% of the overall job gains posted. Quoted in the article, Mortgage Bankers Association Chief Economist, Mike Fratantoni added: “This is not a picture of an economy in recession.”

Mixed results for other sectors

Though the construction industry was a strong performer, with an additional 32,000 employees hired, it’s worth noting that this figure would likely have been much higher if there were more workers available. The sector is still deep in the grips of a labor shortage that has put pressure on projects across the US, and led to a slow-down in new developments.

Meanwhile, the office sector also faced constraints, with the percentage of workers staying remote due to the pandemic remaining at 7.1%, exactly the same as in June.  As one of our NAI Offices recently reported, the future of offices has generated some strong dissenting opinions among those in the know, and exactly how the situation is going to pan out remains unclear.

Shifting sands

Though some of these figures certainly seem to indicate an upturn, it’s worth bearing in mind that there are still many indicators of a possible recession. As recently as a month before these figures were posted, there were announcements of cutbacks in the residential sector, and some experts were predicting a drop-off in employment rates.

For other experts, the picture is more nuanced. Lawrence Yun, Chief Economist at the National Association of Realtors (NAR) puts it like this:

“It would be one of the most unusual recessions — if it [the economy] does technically reach it — in that there are worker shortages. Some industries will lay off workers, but there could still be more job openings than the number unemployed throughout the recession.”

Long-term prospects

How the current job situation plays out, and how this affects Commercial Real Estate professionals, remains to be seen. We do know that the employment numbers we are seeing now exceed predictions that were made just a few months ago. If the positive trend in hospitality and construction continues, there could be a lot of new projects, and prospects, on the cards.

SOCIAL: How have hiring trends impacted commercial rentals and development projects in your area?