The Counselors of Real Estate Top Ten Issues in 2013

The growing integration of global and local economies, rising economic and political uncertainty, and the need for thoughtful analysis of industry trends inspired The Counselors of Real Estate to initiate its first annual Top 10 Issues Affecting Real Estate report in July 2012. The Counselors, an international group of high profile professionals, includes principals of prominent real estate, financial, legal and accounting firms as well as recognized leaders of government and academia.

Our 2013 Top Ten Issues Affecting Real Estate report is based on surveys of our members worldwide, independent research, and spirited deliberation in an effort to stimulate thought, debate and progress in moving the industry forward.

1. Low Interest and Capitalization Rate RisksThe Fed has signaled that interest rates will remain low through 2014. Historically, low interest rates have propelled capital to leave bank accounts in search of high returns. Real estate has benefitted from low interest rates because it employs a lot of debt. Cap rates continue to decline in primary, secondary and tertiary markets, but are especially low in global gateway markets, posing a serious risk to equity values were cap rates to rise significantly. There is fierce competition for core assets and so much capital chasing them that cap rates will likely remain low in the near term. However, inherent risk of equity investments premised on the continuation of low interest and capitalization rates could be a risky proposition in 2013 if higher rates lead to cap rate decompression.

   Key implications of interest and capitalization rate risks are that investors should be locking in low interest debt, reconsidering strategies based on significant price appreciation, and focusing and refocusing on meeting tenant needs and operating their properties more efficiently.

2. Health CareWhile it is too soon to gage how The Obama Health Care Plan will affect the American economy long-term, demand for medical services and facilities nationwide is expected to increase, including a need for more hospitals, more clinics, and more health care professionals. While there is always some chance the program could be rescinded or altered, the President’s re-election and the Supreme Court’s affirmation of its constitutionality seem to have quieted voices urging repeal, making the increased demand and related real estate consequences a likely reality.

   As the Program moves toward implementation, drugstores such as the Walgreens chain have announced plans to expand their role in the communities they serve, offering basic diagnostic services, in addition to filling prescriptions and providing simple inoculations. It is estimated that an additional 50 million Americans will be covered under the new plan.

   An associated factor also increasing the demand for health care services is the aging of the “Baby Boomer” generation which, with longer life expectancies, is rapidly increasing the need for assisted living communities, day-care facilities geared to the elderly, and modifications that enable senior citizens to remain in their homes well into their 80s and 90s.

   All of these factors will spur development of a variety of new healthcare facilities, different forms of housing, and expanded retail centers serving not only an aging population but those seeking access to the medical assistance and products to which they are now entitled.

   A significant challenge of the increased demand, and cost for health care, will be the burden it places on younger Americans, already saddled with enormous college debt, a weak job market, and aging parents who will rely on them for various forms of support.

   Of one thing we can be sure: a myriad of changes will occur as a result of expanded health care coverage and demographic change impacting the property markets (both residential and commercial), America’s fiscal environment, the delivery of medical services, employment opportunities, and the role of Generations X and Y in contributing to payment of the bills.

3. Capital Market ResurgenceCapital markets surged in 2012, with ample debt and equity in most major markets. Transaction volumes rose dramatically over those experienced in 2011. A major question in 2013: will the resurgence continue and grow even stronger or will growth be constrained by economic and fiscal problems at the Federal and State levels as well as financial issues and uncertainty in other parts of the world?

   Debt markets have fallen in love with real estate again and money is pouring back into the industry to finance new properties and refinance those that already exist. Debt is becoming widely available to borrowers in the form of whole loans, mezzanine debt and preferred equity financing. Underwriting requirements are becoming less stringent and LTVs are increasing.

   Secondary and tertiary markets are back on investors’ market screens as they seek yield, less competition and higher capital value growth. Capital is being drawn to attractive cap rate spreads that can be 400 to 500 basis points between primary, secondary, and tertiary markets. It is no longer only a coastal economic recovery story, but a heartland growth story with energy, agriculture and manufacturing leading the way. There is also more money for development projects (particularly multifamily), raising concerns of a return to the period from 2004-2007 where bad underwriting and overleverage prevailed.

4. Event Risks Dominate Today’s Headlines and Real Estate Risks“Event Risks” as a group–such as the terrorist attacks on September 11, 2001, and more recently the tragedy in Boston, weather or natural disaster catastrophes, financial meltdowns exemplified by the recent situation in Cyprus, the U.S .and European financial crises—always make the Top Ten List…often in hindsight. In 2013, the potential for a world-altering event with major consequences for real estate is so high, it ranks as a Top Ten Issue without having yet occurred. North Korean aggression and potential responses, continuing problems in Italy, Greece and other parts of Europe, continuing uncertainty and inability to compromise on fiscal issues in the U.S., and the ongoing threat of natural disaster are just a few of the events which could emerge. What and when? Without a crystal ball, we cannot know…yet it is likely that a major event will occur that will significantly affect how we think, live and invest.”
5.  Implications of Climate Change /Weather on Coastal Property MarketsWeather patterns have become increasingly unpredictable as of late, resulting in more frequent, more severe storms catastrophically impacting coastal cities and leaving extensive long-term damage in their wake (i.e. Super Storm Sandy, which immobilized parts of America’s Northeast and Middle Atlantic regions and Hurricane Katrina, which virtually leveled much of New Orleans). This extreme weather, regardless of its cause, has rendered some coastal areas more dangerous and less desirable (on a bluff overlooking the water is still good) — lowering the value of many coastal assets and reigniting intense debate about how new building and investing requirements will adapt to new realities.

   Whether or not one believes in climate change, potential tenants and buyers — and a majority of local governments — are taking seriously forecasts predicting significant water rise and weather turbulence in the next 10 to 50 years. As a result, these groups are taking action to properly position themselves and their communities to withstand the atmospheric conditions they expect. What this will mean to infrastructure, tenants, homeowners, businesses, and affected cities as a whole remains to be seen. Yet, change is in the works, precautions are being taken and cities and towns, particularly those in coastal areas, no longer have the luxury of thinking “it can’t happen here.” Realizing it can, the emphasis is on preparedness — geographically, fiscally and legislatively.

6. Echo Boomer Housing Demand Defines Winners and LosersThe largest generation of young people since the ‘60s is called the “Echo Boomers” because they are the genetic offspring and demographic echo of their parents, the “Baby Boomers.” Born between 1982 and 1995, there are nearly 80 million of them, and they are having a huge impact on entire segments of the economy. Echo Boomers are drawn to the urban lifestyle, unlike their parents and grandparents, who fled cities for the suburbs. Typically, Echo Boomers gravitate to the urban core with access to diverse activities, cultural amenities, restaurants, and perhaps most importantly greater employment opportunities. They are willing to trade size for location and are moving into smaller housing units proximate to employment and affordable mass transit options. In many locations (such as the San Francisco Bay Area), Echo Boomers continue to work in the suburbs, yet choose to commute from the City. This generation tends to be renters and is not necessarily seeking, or financially capable of buying a home. A highly mobile generation, they are not chained to their automobiles, as were their predecessor generations. Walking, bicycling, and car sharing are in their DNA.

   These and related Echo Boomer trends are exacerbating many of the current problems confronting suburban locations due to decreased housing and retail demand, transportation problems, a shrinking tax base, and a variety of related issues. Yet suburbs are not standing still, as they reinvest in parks, bike paths, and mass transit, and identify creative new uses for obsolete shopping malls and other antiquated symbols of a suburban lifestyle — which, for a younger, less possession-driven generation, has lost its appeal and affordability.

7. Implications of Increased Natural Gas and Reserves on the US EconomyNew technologies have enabled access to vast reserves of natural gas in North America, resulting in an economic boom throughout America’s heartland with strong potential growth in California and other states. This trend is marked by low unemployment and increased investment options in many secondary and tertiary markets where drilling is prevalent, creating an array of real estate investment opportunities associated with housing, offices, retail, hotels, and industrial warehousing. Natural gas exploration is not without risk and cost, including increased carbon emissions due to methane leakage, groundwater contamination from the fracking process, reduced economic activity in alternative energy sectors, and the potential for boom and bust local economies susceptible to rapid declines in production.
8. Global Real Estate Growth and RiskU.S. investors are becoming confident again, focusing not only on residential real estate in the U.S., but emerging markets such as China, Brazil and India, which reflect potential for higher growth and return. Investors are also looking to Europe, purchasing distressed properties and distressed debt. While, for many, the world remains a scary place to invest, U.S. investors have become accustomed to a permanent state of potential crisis and have not let uncertainty curb their appetite for investment abroad. At the same time, foreign investors, despite U.S. fiscal balance sheet woes, are finding the U.S. an attractive investment destination because of strong yields and returns, and the legal and institutional environment that protects property and individual rights — offering a level of transparency uncertain in many parts of the world.
9. The Impact of Technology on Office SpaceThe development of increasingly sophisticated and innovative technologies coupled with growing acceptance of flexible, less conventional workspace models have greatly reduced the demand for physical office space in the traditional sense—a trend that is likely to continue. The 21st Century worker is electronically connected 24/7 to the boss, one’s co-workers, clients, and prospects with the ability to effectively participate in “virtual” meetings, from home, the local Starbucks, the airport, or any location with a “Wi-Fi” connection. Workers are more interested in collaborative space and the flexibility to move their computers to the areas that best support their work that day, rather than fixed offices or cubicles. Collaborative meeting spaces, not individual offices, have become more prevalent. All of these trends have led to dramatic reductions in dedicated space per office worker from about 225 sq. ft. in 2010 to 176 sq. ft. in 2012, according to CoreNet Global.

   There has been some push back recently to getting rid of personal offices and cubicles, as certain research has shown that creativity and innovation are often best fostered in quiet contemplative work spaces. In some cases, employers are concerned that more chatting is going on than productive work. Like most trends, the best space configuration will depend on a company’s particular business and people, and the debate will continue, but trends towards reduced space use are forecasted to continue.

   Another, perhaps more important trend is the change in the workforce. As a greater portion of the work force moves from salaried to independent contractor status (an estimated 30% in 2013, forecasted to reach 50% in 2020, and a whopping 80% by the year 2030), will the home office become the “new normal” as the corporate headquarters becomes a smaller, more streamlined version of its former self? Countering this trend are recent announcements by companies such as Yahoo that have changed policies to encourage people to work at the office, believing that face to face collaboration and relationships are essential to firm productivity.

   Have we finally reached the point where forecasted declines in office space are a reality? How widespread is this phenomenon? Smart investors are examining these questions and taking action to both protect their portfolios and carefully consider new acquisitions.

10. Retail Malaise and RepositioningThe rapid ongoing growth of Internet retailing has reduced overall demand for physical stores, reshaping the type and amount of physical retail space tenants need. This has been particularly acute for retailers specializing in electronics, music, and books, but it is quickly affecting the way consumers purchase clothing, shoes and just about everything else.

    Retail space is becoming smaller with more attention to innovative display and “order capability” which is fast and user friendly. In this environment, retail that provides a rich, interesting, multi-faceted shopping experience is thriving. Successful shopping centers are designed with the pedestrian in mind, catering to an adventure the whole family can enjoy. It is increasingly imperative that the “physical retailer” not only provide an appealing selection and high quality product, but an engaging, pleasurable “in-person” experience unavailable to the online retailer.

    Rapid change has created losers, as many retail centers are dead or dying. Yet, opportunities abound for developers and investors with the vision and property savvy to create an appealing shopping and entertainment experience in the right location. Repositioning and even new construction opportunities exist for those investors who understand the trends—and are willing to take risks.

Conclusion

Many other issues were suggested, but, of course, we have limited our list to the ten issues we believe will have the greatest impact on real estate in 2013 and the years that immediately follow. We hope identifying these issues and their implications motivates productive discussion of how individuals, companies, and governments should respond to these and other changes in the investment environment that simultaneously challenge our industry while creating opportunities for growth.