Commercial Real Estate Checks into the Heartbreak Hotel
“I walk a lonely street.” Written in 1955, those five haunting words were all one man left of himself before leaping to his death from his hotel room window. According to a story that ran all those years ago in the Miami Herald, it would seem that he had heartbreakingly embraced the loneliness of being unknown and unmourned. What compulsion had driven him to destroy all identity leaving no trace of who he had ever been?
From that lonely man’s pain came a classic. “Everybody in the world has someone who cares,” wrote Florida school teacher and songwriter Mae Boren Axton. “Let’s put a Heartbreak Hotel at the end of this lonely street.” Though accounts vary, Axton and fellow songwriter Tommy Durden are credited with collaborating to write the song that would launch the career of a legend, one Elvis Aaron Presley.
For a different but more notorious legend, its last lonely and likely unmourned symbol has finally been laid to rest with the sale of New York’s Nylo Hotel. Marking nearly eight years since Lehman’s bankruptcy, the sale of one of the last properties in the storied investment bank’s exhausted portfolio thus closes the wound on the $691 billion bankruptcy, the biggest in U.S. history.
If eight years rings a bell for you, that’s because historically it’s just shy of how long economic cycles usually last. Commercial real estate (CRE) cycles tend to persist for a bit longer, about 10 years according to work by Christopher Lee of CEL & Associates, a real estate consultancy. Lee breaks typical cycles into four periods – Growth, Plateau, Crisis, and Transition. Good entry points tend to present themselves in the Transition Period while good exit opportunities arise six months before or after the peak of the Plateau Period. That seems intuitive enough. Get in close to the ground floor of a cycle. Get out before the crisis hits.
Given that the current cycle is well past Transition and Growth, let’s focus on where we are in the Plateau Period. Lee’s qualifier list is as follows: Overly optimistic underwriting standards, an increase in capital raising, aggressive competition for talent, blind entrepreneurism, low cap rates, supply and demand out of balance, protracted closing period, increases in ‘guarantees,’ high investment sales activity and generous lease terms.
From discussions I’ve had of late with real estate folks on the ground, just about all of those factors can be checked in the affirmative. In fact, lending standards have been tightening for the better part of a year, a sign in and of itself of what’s to come.
As for cap rates, the rate of return on a given property based on the income it’s expected to generate, they’ve leveled off since the start of the year with a few notable exceptions. Cap rates are to real estate as price-to-earnings ratios are to stocks, a valuation metric, except for the fact that the lower cap rates are, the pricier the property in question.
As to those exceptional sectors, industrial space remains hot, hot, hot – and why wouldn’t it be as Amazon continues to take over the world? Self-storage is also a sector that continues to increase in value, which stands to reason as Boomers start to downsize but don’t have it in them to purge a lifetime of belongings that just won’t fit into their newer, more compact living spaces. And then there’s Canada, the great alternative to the north (and due west) in the event election results don’t come in quite as the pundits expect.
It stands to reason that when cap rates level off, prices follow. Indeed, according to the widely followed Green Street Commercial Property Price Index (CPPI), national prices rose by a mere one percent in June, a marked decline from the past three months’ three-percent increase and the seven-percent rise seen over the last 12 months.
Delve into individual sectors and you really start of get a sense of how the tide has turned. Consider the darlings of the current CRE cycle – apartments and hotels.
While the multifamily sector is still up nine percent over the past year, its price performance has literally hit a wall, as in up one percent over the last three months and flat as a pancake over the past month. Recall that an imbalance between supply and demand can be problematic during the Plateau Period. A recent Wall Street Journal story noted that in 25 of the largest U.S. cities, multifamily permits had risen by 39 percent in 2015.
In all, some 395,000 apartments were started last year nationwide. That classifies 2015 as ‘abnormal,’ according to the National Association of Home Builders which considers a normal year to entail the construction of 331,000 units. This year promises another aberration with 379,000 planned starts, a figure expected to be one-upped by 2017’s pipeline of 402,000. Move over George Jefferson – we’re all gonna be movin on up. Or will we?
Yes, some 1.4 million renters were added to the pool of leasees last year, capping off the addition of nine million new renters over the past decade as homeownership crashed to the lowest levels in modern history. Millions of millennials aside, could the market nevertheless be reaching a saturation point?
No doubt, June’s payroll gains were sufficient to reach for the smelling salts. Still, job openings are at a five-month low. And payroll gains averaging 147,000 over the past three months compared to last year’s 229,000 monthly average just doesn’t jive with record levels of apartment construction.
Exacerbating the dynamic is that most units built in the current recovery have been at the high end of the spectrum. It kind of helps that leaning luxuriously helps hit rate of return bogeys when interest rates are nailed to the zero bound. In any event, high-end rent growth peaked at eight percent five years ago and has since slowed to three percent.
Speaking of the high life, hotel construction has also been one of the current CRE cycle’s ‘It girls.’ Over 100,000 hotel rooms are under construction in the country today. Over half a million are in the pipeline. Leading the charge are the mover-and-shaker digs. Add up upper-midscale, upscale, upper upscale and luxury rooms and you find these categories comprise 82 percent of what’s being built today. Ah, the suite life.
It stands to reason that geography is playing its own hand in driving the deluxe trend. National room supply accelerated from 0.9 percent in 2014 and 1.1 percent in 2015 to 1.6 percent in this year’s first quarter. But in Miami, supply is growing gangbusters, up by 3.5 percent. Due north, the Big Apple is on fire, with supply up a blistering five percent from a year ago.
When it comes to hotels, the proper profit parlance to employ is the term ‘RevPAR,’ or revenue per available room. To arrive at this performance metric, you divide a property’s total revenue by the number of rooms and the number of days being measured or multiply a hotel’s occupancy rate by its average daily room rate – one of those six-pack, half dozen affairs.
Here’s an example, care of Investopedia: A hot boutique property has 100 rooms that boasts an average occupancy rate of 90 percent. If the average room rate is $100 per night, its RevPAR works out to $90. Easy, breezy.
First, occupancy. PricewaterhouseCoopers predicts that occupancy will flat-line this year at 65.5 percent and fall in 2017 to 65.0 percent. That’s saying something considering occupancy has been on the rise since 2010. Corroborating this are data from Smith Travel that reveal occupancy has deteriorated for four of the past five months, the worst run since the tail end of the recession in 2009.
A separate report by CBRE Hotels concurs that for the current cycle, demand growth peaked in the third quarter of 2015. This would certainly help explain RevPAR growth slowing to 2.7 percent in the first quarter from last year’s 6.3-percent pace.
Costs have also been climbing in the sector, which is certain to make management nervous as RevPAR growth continues to slow. Total expenses rose by 4.6 percent last year, the fastest pace in 20 years. As if on cue, the number of aggregate hours worked by accommodation employees peaked in January. When it comes to rising costs in the face of top line pressure, something always gives.
Add in the monster supply coming on line and in the works and you begin to understand why lodging is the weakest sector in the CRE space, with prices down 12 percent over the last year. (Maybe the Chinese purchase of the Waldorf did mark a turning point after all.)
Of course, a peak does not necessarily translate into a slump for the overall industry. For a protracted decline to emerge, tourism would have to take multiple hits, business spending on travel and expense would have to be curtailed and U.S. consumption would have to falter.
On those counts, the strong dollar and the Brexit will certainly not be additive. But optimism still rules the day. A fresh report out of the Global Business Travel Association projects business travel to grow by 5.8 percent per year through 2020, an acceleration from last year’s five-percent rate. In all, $1.2 trillion was spent on travel in 2015. The forecast calls for that figure to rise to $1.3 trillion this year led by a continued acceleration in China. At $291 billion, China surpassed the United States last year for the first time, clocking annual growth of 11.4 percent compared to 2.2 percent growth in the U.S.
As for consumption, it’s worth noting that income expectations remain below their March 2015 peak even as credit card usage continues to rise over last year – a classic sign of household budgetary distress. The relatively rapid increase in savings vs. consumption also suggests caution ahead.
At the risk of contradicting everything that’s been written thus far, and care of New Albion Partners Brian Reynolds:
- The Pennsylvania Public School pension allocated $100 million into a real estate fund, $75 million into a real estate debt fund, and $75 million into a commercial real estate fund
- The Michigan state pension is sending $310 into real estate funds
- The Texas Municipal pension is investing $100 million in a real estate debt fund
- The Houston Firefighters’ pension is giving $25 million to a real estate fund
- The Missouri Local Government is allocating $65 million to an opportunistic real estate fund
- The Fresno pension has sent $30 million to opportunistic real estate, and
- The New Mexico state pension placed $75 million in a real estate fund
Reynolds figures that this late-stage money blindly chasing returns will give the real estate cycle legs, which would push the cycle to that 10-year mark if nothing else. “The duration and intensity of this credit boom will likely lead to a commercial real estate bubble,” Reynolds warns. “We seem to be on our way to that.”
Of course, this will end in heartbreaking tears. Of course the Federal Reserve will be to blame. Of course those most harmed will be the most vulnerable when the rent finally comes due. And of course, there will plenty of profits safely tucked away well before losses are incurred. As for the future guests at the Heartbreak Hotel. They won’t see what’s hit them until it’s much too late.
Originally posted on Danielle DiMartino Booth’s website.