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

Thought Leadership Women in CRE

Investing in Gender Equity is an Investment in CRE’s Future

When it comes to parity, commercial real estate (CRE) still has some ways to go in leveling the playing field for women in our industry. That’s the central message of the latest report from the Commercial Real Estate Women Network (CREW), a national organization with a focus on diversity, equity and inclusion in CRE.

Hidden figures

One of the biggest pain points for women in the industry according to the report is the culture of secrecy around salaries. Of the 1228 CRE professionals interviewed, 68% indicated they’d change jobs to work at a company with greater salary transparency (even with a similar salary offer on the table as what they currently earn). Around 82% said they wanted job listings to include wage and benefits information, with many adding this would give them more confidence in salary negotiations.

In an industry with a proven record of pay disparity, those numbers are especially telling and highlight an important point. Part of creating equity is building transparency into the recruiting and salary negotiation process.

Another concern raised was the disparity faced by women of color specifically, who, according to PayScale’s 2022 Gender Pay Gap data, typically earn far less (across a variety of industries) than white men or even their white women counterparts. CREW also noted in a previous report, that women of color were less likely to have a sponsor or mentor in CRE, blocking their opportunities for advancement in the industry.

Building better businesses

Besides the obvious social imperative to address these issues, investing in gender and racial equity is an increasingly important part of building business resilience.

As, Lily Trager, Head of Investing with Impact for Morgan Stanley Wealth Management, recently pointed out: “When our quantitative team analyzed global companies based on their percentage of female employees and other metrics of gender diversity, companies that have taken a holistic approach toward equal representation have outperformed their less diverse peers by 3.1% per year.”

Trager added that a growing requirement from Morgan Stanley’s “high-net-worth investors” is that Diversity, Equity, and Inclusion (DEI) be a priority for the companies they invest in.

Promoting equity

For us in CRE, the challenge is to address the historically low numbers of women both in our industry, and especially in C-suite positions. And while that process should be driven by everyone, it’s especially important that the policy decisions and changes we make to promote equity are guided by the experience and expertise of women in the space.

The CREW Network’s recommendations in this regard include:

  • Committing to pay transparent practices – In other words ensuring that both salaries and the processes for earning pay increases are clear and accessible.
  • Supporting professional development – Encouraging women in your organization to pursue professional development opportunities (and join women’s forums) and financing those opportunities.
  • Formal mentorship and sponsorship programs for women – We all know that in the real estate industry, mentorships are invaluable in shaping the trajectory of an individual’s career. For women, and especially women of color, we should incorporate and encourage mentorship as a central part of our business.

A commitment to gender equity

The legacy of gender, and other, inequities won’t be undone overnight. What’s vital to accelerate the process is that, as business leaders, we commit to creating workplaces that make Diversity, Equity, and Inclusion a reality. In doing so, we can build a CRE future that enables the best in our people and our business.

For more information about NAI’s own commitment to Diversity, Equity, and Inclusion,  please visit our page here, or find more information about the NAI Global Women’s Alliance here.   Or join us in becoming signatories to the CREW Network’s Pledge for Action![SR2] 


 

DEAD IN THE WATER

Joseph Hauman

Do you know where the saying dead in the water comes from? It was originally used to refer to a boat that was stuck out at sea with no wind. No wind means no movement and as you could imagine, no movement is not good for a boat in a large body of water. Over the last 2 years, people have been telling me that the office market in Cleveland is “dead in the water” as everyone from your nephew’s Lemonade stand to Google decide if they need more space or if they even want any space. To be honest with you I believed it for a little bit too. I thought there is no wind in the sails of the office market in Cleveland, but then I allowed myself to take a real look at the industry.

Sailboats are great but they need something to push them. A tide, current, or wind is needed to make a boat with no motor move. I believe that office rents in the Cleveland Market have stayed stagnant because they have been the tide, current, or wind in the sails of our largely vacant office market.  What do I mean by that? Owners in Cleveland often think that they are in competition with each other. They attract tenants to their buildings by offering a low price, free rent, and higher tenant improvement allowances than what they view are their competitor’s. That, in turn, makes other owners lower their prices and it becomes a price war at its most basic level. For years, that has been the reason why the office market continued to truck along with very few new buildings and stagnated rent growth. Lower prices and increasing free rent packages were the slow wind that was pushing the sails of a fundamentally broken office market.

Why are low prices so bad in an office market? The answer is they aren’t when they can be controlled and used to attract quality businesses that will help the area grow. That, however, is not the situation that the Cleveland office market is in. We are in a vicious cycle of rent reduction to attract businesses that don’t choose Cleveland because of the lack of amenities, in both buildings and the city, and because they don’t choose Cleveland both the owner and city miss out on valuable tax and rental income that could be used to pay for new amenities to attract new businesses. This is the reason why the Cleveland office market is “Dead in the water”.

Nobody cared about this issue until the past two years when work from home skyrocketed and tenants didn’t care how much you reduced their rent; they just wanted out. It was no longer a price war because price mattered very little anymore. It became an agent’s job to keep tenants from bull rushing out of a building. Any wind that was ever present, was lost. No hope, right? Wrong.    

Going back to what I had said earlier when technology advanced we learned that we could put an engine on a boat and we had no more need for the wind to propel us. The wind and the sail didn’t matter anymore because the fundamental idea of a boat changed. It was no longer difficult to maneuver, slow, or relied on something totally out of one’s control. Instead, a boat became fun, attractive, and a sign of success for most. Office buildings need a motor. The entire idea of an office building needs to be changed. Low rent and new paint aren’t enough anymore. You need a space that makes people want to come to work. If your building doesn’t do that, then you need to take a hard look at the future success and viability of that building. If you are a landlord you must know your effective vacancy on any building you own. I don’t mean how many people you are getting checks from every month or the number of available square feet you tell your broker to put on the flyer. I mean how many people are coming in and using your space on a DAILY basis? If you have amazing tenants that don’t want that stuff then, congratulations, you have won the jackpot. If you have large amounts of vacant space and are wondering how to change it, then hold on because I’m going to tell you.

ASK AND YOU SHALL RECEIVE

I know most office buildings or parks are purchased as a semi-passive investment which is great and I fully support it, but if you have a high vacancy you need to get a broker, or property manager or go yourself to each tenant and ask what they are looking for. Ask what your building lacks and where it could be improved. If you have current amenities in the building ask if they use them and how often. If you have someone that works in an amenity like a dry cleaner, food service, or gym, ask them how often people come through and what sort of mood they are in when they come in. If you have services in the building you need to find out if people are using them because the service is good or if it’s convenient. If tenants are using it out of convenience then that’s great, but it’s not enough to keep them there at your building. The true testament to the amenities that you provide should be if a tenant leaves and still comes back to your building to use your amenities. Obviously, not all amenities are offered to people that are not tenants, but ones that are, such as an open cafeteria or dry-cleaning service should be good tests. If you ask tenants for their opinion make sure they are valued and listened to. Asking them questions only to do nothing in hopes that they will stay is going to do you no good. If you want to have a low vacancy you need to get things in the building that people want. Let the ideas flow. Everything from a VR gaming setup, driving simulator, or golf simulator might be options that are relatively inexpensive in comparison to renovating a cafeteria or building out a new gym. Take the answers to the questions that you get from your tenants and mix them with your ideas and see if it’s possible. Maybe call me and let me come take a look and allow me to give you my opinion.

If your building represents a sailboat that is quickly or slowly losing wind then pull it out of the water and put an engine on that sucker because if you don’t make a change soon your boat will be dead in the office market water. 

Have something to say? Great, I would love to hear it. Shoot me an email at Joe.Hauman@NAIPVC.com or give me a call 440-591-3723.