Feb 25, 2020
James:
Hey audience, this is James Kandasamy from Achieved Wealth Through
Value Add Real Estate Investing podcast. And today we are doing a
slightly different format. We are doing a podcast plus a webinar
and I have Dr. Glennn Mueller here. So Dr. Glennn is someone I have
been following for many, many years looking at his real estate
market cycle studies and he's a professor at University of Denver.
He has been doing this almost 36 years, if I'm not mistaken, has
gone through many, many different market cycle. And, Dr. Glennn,
why not tell our audience what I didn't cover in terms of
introducing yourself.
Glenn:
Sure. So I've actually been in the real estate field for the past
45 years. Started out as a loan analyst at United bank of Denver
and by chance got put into the real estate group after a couple of
years, realized that real estate people made a lot of money, went
out and started my own construction and development companies and
built custom homes for about seven years and then decided that I
wanted to have a change and a different lifestyle. So I went back
to school, got my PhD in real estate and started teaching at the
University of Denver. I hired away by a big institutional investor,
Prudential real estate investors and then onto a Jones Lang
LaSalle. And then started working on the security side with Wreaths
Real Estate Investment Trusts at Lake Mason. I ran the research
group there and then one of my client's black Creek group invited
me to come and head up research for them. And I've been with them
now for the past 15 years and at the same time teaching as a full
professor at the University of Denver. So I guess I'm a typical
real estate type A personality running two jobs at the same time.
But a lot of my research is focused on real estate market cycles,
which is what we're going to talk about today.
James:
Yes, yes, correct. And real estate is very interesting because
sometimes it's very hard for us to make it into a very analytical
format. And when I look at your charts and the work that you do,
you have really break it down to science. I mean, of course,
definitely there's art in real estate but there's a lot of science
to it as well. And it comes from years and years of research, like
what you have done. And that's very important for people like us
who are basically active investors who are buying deals day in, day
out and going to different market cycles and it's also more
important for people who have never gone to a full market cycle.
Like, even for me, I've not gone through a down cycle yet and there
are tons and tons of people who have not gone to a down cycle, so
we always wonder how this different cycle is impacted by different
property types. What do you call us, like industrial, self-storage,
apartments, office and retail and few other things. So this
presentation that you're going to be doing on the webinar and
throughout the podcast, we're going to try to clarify some of the
slides that's going to be covered here so that the people who are
listening to the podcast is going to be able to follow too as well.
And this going to be difficult [03:26unclear]
Glenn:
So do you want to...
James:
Go ahead doctor?
Glenn:
So if you'd like, if you want, I've got my slides ready to go. We could probably go to that. I can start in.
James:
Let's start, I mean I'm going to name this podcast, A State of the
Union of Commercial Real Estate
Property [03:46unclear] so let's go through it.
Glenn:
Throw the word cycles in there someplace because I do real estate
cycles. So let me actually bring that to full screen size to make
it easier to see. Is that clear for you?
James:
Yes that's awesome.
Glenn:
Okay, great. So basically I believe that real estate is a delayed mirror of the economy as the economy goes, so goes real estate when the economy is doing well, real estate does well. When the economy turns down, real estate lags by about a year and about a year after the economy starts to turn down, real estate will turn down. You can see that here in this first chart and on the demand side of real estate, there are three key things we look at. The first one is population growth. The US population is growing at nine tenths of 1%. We are 330 million people. So we're actually growing by 3 million people every year in this country; and let's put that into simple real estate terms. That means that we need to build one city, complete city the size of Denver, Colorado, which will actually hit 3 million people this year, to give them a place to eat, sleep, shop, work, play, pray, store things, et cetera.
So here you can see GDP growth, the great recession in oh nine and
the beginning of 2010 with negative GDP growth. And then it has
rebounded and it's been running at this nice average of right
around, just a little over 2%. And the forecast is that that looks
like it continues forward with a little bit of a dip here in in
late 2020. But to be honest, economists are always wrong. Their
numbers never perfectly accurate and there's a fairly high
probability that doesn't happen. The reason for that dip is
actually the employment growth below, which again, you can see the
negative number back in 2009. It starts to recover and go positive
in 2010 and has been running about 2%. And then you see the
forecast for a slight decline back to down to close to zero in
2021. That's actually a mathematical calculation of the number of
baby boomers like me getting to retirement age of 65 versus the
number of millennials who are just coming out of school.
The only thing and one of the reasons I believe that that number is
wrong is that most baby boomers like me, we enjoy what we do and
we're not necessarily retiring or if we do within six months to a
year, we're out with another job. It may be a totally different
kind of job. I love up here in the mountains of Colorado and a lot
of my friends that retired are working as ski school instructors or
driving a shuttle bus or my wife is a host and tour guide, Arapaho
area ski area. So those people are still working. So that decline
in employment growth sort of forecasted decline in GDP growth, my
guess is that doesn't happen. And a lot of economists now are
saying maybe we're in the lower for longer term. As you probably
all know. We just hit 10 years of economic expansion. So we're in
the longest economic expansion in modern history and a lot of
economists do say, well, it can't go past that, but I don't believe
that because right now the country in the world that's had the
longest economic expansion is Australia and they're in their 28th
year of expansion with no recessions. So I believe that the
way that we're set up with this more moderate growth is something
that is potentially sustainable as we go along.
James:
So let me recap that because that's very important point because
that's a lot of notion out there that we are too long in expansion
cycle, we must come to an end, it's cyclic but what you're saying
is the way the employment growth and the way that GDP growth has
become moderate right now for the pass many how many years we have,
and that's a good thing. So what you're saying is with that
moderate growth, we might be able to go longer on expansion cycle.
Is that right?
Glenn:
Right. We're at the beginning of the longest ever.
James:
Correct. So when you talk about Australia, I mean, I know it's one
of the longest expansion cycle and things are getting very
expensive there, but is that the same case in Australia? Were they
like moderate growth for very long time and that's how they're able
to sustain it?
Glenn:
Yes.
James:
Okay. Got it. Got it. And what's driving the 0.9% population
growth, where is the growth coming from?
Glenn:
That is new births over deaths plus legal immigration.
James:
Okay.
Glenn:
And so we're actually growing at a higher rate than that from illegal immigration as well. But there are more people; we're at a very low unemployment rate at this point in time. So anybody that wants a job, basically you can get a job and that's a good thing.
James:
Okay. I'm going to ask about inflation and you are showing the chart on inflation, okay let's go to inflation.
Glenn:
So on the flip side of the coin is as we look at, and this talk that we're talking about, by the way, we're talking about income producing real estate, not homes, not home ownership. So we're focusing on the income producing side of this as we go along. So the two things that we look at, so we've got good demand as we put up new properties for people to us. On the cost side inflation is running at again about 2% and has been since the great recession when it was actually negative and that is expected to continue. And then we look at interest rates and of course we are at, actually, I'm going to jump ahead here to a different graph, I think. No, I'll wait on that because it's too far ahead.
We're at a very low interest rate. As a matter of fact, the lowest
interest rates in 60 years. And then in income producing real
estate, commercial real estate you can't go out and get a 30 year
mortgage on an office building. The longest you're going to see is
10 years. And so we look at 10 year treasuries, US treasuries as
our benchmark. And here you can see that 10 year treasuries and
these graphs are actually wrong, they forecast going up to 4%, 10
year treasuries are running a little under 2%. So if you're going
to go out and get a commercial loan, you might get in a 10 year
treasuries plus a 2% premium. So that would be a, today, 10
year treasuries are running right about one seven, one eight. So
you would be getting a 3.8% 10 year loan on your property, which is
a very low interest rate. Hence good return to equity on investment
after the loan amount.
James:
So the chart that you showed is basically a forecast but we are running much lower than the forecast I guess?
Glenn:
Yes. Yup. We are.
James:
And who came up with the forecast?
Glenn:
Every economists forecast what is going to happen. The forecast that we look at many times are the congressional budget office. So that's cbo.gov, if you want to go get their stuff; they do 10 year forecasts on GDP growth, limit growth, interest rates, all kinds of different things. So that's a very good place and it's free to go look at what's happening. And just underneath that they've got a lot of different things. Just click on the economy one and all that information will come up.
James:
And why do you think the economists are wrong? Why were they forecasting at 4% [11:41unclear] 1.7?
Glenn:
It's a statistical method called reversion to the mean. Interest rates over 60 years have averaged close to 6%. So now that it's low, it has to go back up.
James:
Got it, got it.
Glenn:
And every single year they did forecasting within two years, 4% and every year for the last 10 years they've been wrong.
James:
Last 10 years they've been wrong. Is there a chance for them to be
continuously being wrong?
Glenn:
Again there's an old saying for kindness, forecast often.
James:
Well, the reason I ask is because every year people are forecasting
the interest rates are going up or coming down when everybody's
wrong all the time.
Glenn:
Yes.
James:
And it's very important for interested for investors like us, like where we are predictive because we do exit cap rate and we have buying deals, hoping on the cash flow, but also this market appreciation would be a bonus for us, so that's why I asked.
Glenn:
So let's actually go right to talk about real estate and my market
cycle analysis. So I believe there's really two cycles in real
estate. The first one is the physical cycle, which is demand and
supply for real estate. So people renting and space available for
rent and that drives the occupancy rate which is just the inverse
of vacancy. I like using occupancies and you'll see why here and
occupancy drives rent growth. So if my occupancies are up, which
means there's more demand, I can raise my rents. If we're in a
recession and occupancies go down, people aren't renting. Landlords
are going to drop their rents. And if I add occupancy and rent
together, so if I get an increase in occupancy, in other words, I
rent more space and I get an increase in rent, those two together
will tell me how much income I'm going to get off my
property. That's the physical cycle.
The financial cycle talks about the price of real estate and we're
going to do that second and we're going to do it separately. So
here's my market cycle analysis and you see that I've got four
quadrants, just like the account, just like an economic cycle or
recovery and expansion. I have a supply and a recession phase.
There are 16 points on the cycle because historically real estate
cycles have lasted 16 years and so at the bottom we've got
obviously declining vacancy on the way up and increasing vacancy on
the way down. We don't build much there in the recovery phase. We
build a lot in both the expansion and the hyper supply phase. And
then we don't start anything but we complete buildings that have
been started in the recession phase. So actually we'll go to this
slide.
So the study that I've done and published that I get quoted on all the time is the fact that if you know where you are in the cycle, you'll know what kind of rent growth you might expect. So you can see here at the bottom, I don't know if my arrow is showing up here or not, but at the bottom of the cycle points one and two, you've got negative rent growth, so landlords are dropping their rent. So if it was $10 a square foot last year and it's going down 3%, 3% of $10 is 30 cents or it's going to go down to $9.70 a square foot to rent. As we start to come up through the cycle and occupancies increase you can see rent growing and at positions six, at the long-term average there, 0.6 is on the long-term average dotted line; you can see that rent growth was 4% and during this historic cycle time, inflation was running 4% then. So when you get to long-term average, you get basically the rate of inflation.
Then in the green shaded area here, which is the expansion phase,
you can see rents really rising quickly to a peak and a high of
12.5% in position 10. Then when we hit the peak of the cycle, which
is the highest level of occupancy after that, rent still grows
positively, but it starts to decelerate or slow down, back to
around inflation at 0.14 and then low and negative again at the
bottom. And then one of the things to notice here is that 0.8 on
the cycle is green and because that is the cost feasible rent
level. By that I mean that if it costs $400 a square foot to build
a new office building here in Denver and investors are looking for
a 10% rate of return on that $400 investment, 10% of 400 is $40 a
square foot. So rents in the market have to hit 40 before we can
cost justify building the new building. Makes sense?
James:
Got it. Makes sense. Makes sense.
Glenn:
Okay. So every quarter I look at the major property types, look at that demand and supply, look at the occupancy levels and as you can see today five major property types office downtown or suburban office is at 0.6, downtown offices at 0.8, retail, which will surprise everybody at 0.9, industrial at 0.10 and retail industrial warehouse up at peak occupancy rates. And the only property type that's over the top into hyper supply is apartment. An apartment is there not because of a decline in demand, we've got all these millennials coming out of school and so every year demand is going up for apartments, but we're just overbuilding it a little bit. So for my company and for other investors, what I do is I analyse the 54 largest cities in the United States and where they are in their cycle.
And as you can see here they're kind of spread up because demand and supply is very local in nature. Notice what's happening in New York office, which is driven by the financial sector and the stock market is going to be different from what's happening in Boston or Chicago or in New York or any other city. So you can look at the companies that are there, the industry that's driving the growth and what you see here is national average at 0.8. But some markets moving up the cycle and some markets over the top. And I'll give a quick example here. We've got two markets that are in the hyper supply phase, Austin and Houston, both in Texas
James:
[18:19unclear]
Glenn:
The Austin market is driven by technology companies. A lot of tech companies like being there because they can hire young people that want to live in Austin, It's a cool city. Actually [18:31unclear]
James:
I'm in Austin. It is very cool to live here.
Glenn:
And so, what's happening there is since that's been going on for a few years, the developers are putting up just a little bit more space than you need. So the occupancy rate is starting to come down just a little bit because there's too much space there. So that's a situation of too much supply. Houston is exactly the opposite. It's a place of declining demand because the oil industry is driving Houston and with low gas prices, the amount of exploration and other things going on has dropped off and they've laid people off. So that's a position of declining demand. So since you're in Austin, let's watch Austin as we look at this. So that's where office is, here's where industrial is. So warehouse space, again, Austin is just one point over the top. A lot of markets are at their peak, demand for an industrial warehouse space has been very strong because of Amazon and people buying things online.
So we've got a huge demand growth on the industrial side and there
are some cities again where it's easy to build. So we're
overbuilding just a little bit. Now we look at the apartment market
and Austin is at the top at the peak point at 11 because you aren't
putting up apartments fast enough for all these millennials moving
in. But you look at, there's a lot of other markets where they are
putting up a little bit too much space. In other words, we're
oversupplying almost half the market. So the national average is
just a little over the top. Every time I talk to developers I'd say
if you just back off on building apartments by about 10% of what's
being built, you'll come right back into balance and be back at
peak equilibrium point 11.
When we look at retail, you can see that the majority of the cities are at peak and Austin is there as well. This is the one surprising thing because everybody hears about retailers going out of business and we’ll talk about that a little bit more in just a second. And then finally hotels here you can see that hotels, the majority are in the expansion phase with some over the top. And again, Austin, you're oversupplying by just a little bit. So what I want to do now is jump to and looks at the historic cycles. As you said, you haven't been through a full cycle yet. Well here we're going to go back to 1982 and that's a point in time at which I was building. And you can see that occupancies in office were very high. They came down and bottomed out in the early 1990's with a small recession and we'd actually over oversupplied a lot.
They peaked in 2000 with the technology boom, they bottomed in 2002 and three, with the technology bubble bursting; came up to a lower peak in 2006 and seven as the economy was doing well, bottomed out in the great recession in 2010. And today has come back and are reaching a kind of a lower level equilibrium occupancy level than we've seen in previous times. But it looks like it's going to last for at least another two or three years. So the other line that you see here is the rent growth line. And you can see that those two are very highly correlated. As a matter of fact, they're correlated by almost 80%. So if occupancies are going up, rents are going up, if occupancies are going to go down, rents are going to go down. Pretty simple and straightforward to look at.
So let's look at my forecast and here's the forecast and it looks very much like the monitor. And you can see that markets are again, majority in the expansion place. Austin, as you can see there is in the hyper supply phase at position 13. And again, that's because I'm forecasting that you've got a lot of new properties coming online, so your occupancy levels are actually going to fall a little bit in the coming year. If we look at industrial, you see basically the exact same cycle of occupancies and rent growth and we've got this really nice equilibrium that happened back in the mid-nineties and another one that's happening today. Rent growth has been really high in industrial because of the, I call it the Amazon effect up at 7% more than double the rate of inflation and we expect that to kind of work its way back down over the next few years back to kind of a more normal by 2017 we expect to see kind of inflation type things there.
So again, half the markets at peak or equilibrium, the other half
building just a little bit too much, but that's the way it is and
Austin, again, just one point over the top. Oh, one other thing is
you notice I've got some numbers after each city and those numbers
tell you if the city is moved from the previous quarter, for
instance below Austin there you've got Cincinnati at a plus one. So
Cincinnati was at peak number 11, and its occupancy occupancies
dropped enough for me to move it forward to position 12. So it's
rent growth is going to be decent
James:
And the bolded city are the biggest cities?
Glenn:
Right. Okay. Yeah. So the bolded cities make up, one of the things
I found was there are big concentrations. So in each of the
different property types there is anywhere between 11 and 14 cities
that make up 50% of all the square footage in all 54 of these
markets. So what city is bolded may not be the same in each case.
So like Riverside is here in the industrial, but it's not in any of
the others. Las Vegas will be in hotels, but it's not a big city
for office or any of the other property types. When we look at
apartments, you can see that we actually hit a peak in occupancy
back in where am I?
James:
2019.
Glenn:
Yeah. We had a peak back in 2014. It looks like we had another peak here in 2019, but because of the overbuild; we slowed things down a little bit. But going forward, we just have a lot of it in the pipeline and so we're going to overbuild it looks like for next three or four years and hence rent growth, which was as high as 5% back in 2015 has dropped off. And in 2019, I think it's going to run about two and a half percent.
James:
But looking at that chart, you're predicting 2019 after 2019, rent
growth is going to slow down because of the oversupply stage?
Glenn:
Yes. Yup.
James:
Got it.
Glenn:
Exactly.
James:
And does it matter on which class apartment is it? Which location? Which city? Tertiary, primary market?
Glenn:
Oh, well. So here are the cities for apartments. And you can see
Austin I think is still at its peak. You're not putting up quite
enough. Most of the other cities are in that hyper supply phase.
Where they're putting up a little too much. And so they're
occupancy levels are dropping. Denver had a number of years of 8%
rent growth. And because we're over building and you can see Denver
way over, further down the cycle there at a position 13, our rent
growth now is only running about 3%.
James:
Yeah. So for example, like the city on the hyper supply, I mean
going to the recession on the point 14. So what you're looking at
is you're looking at the supply that's coming into that city and
looking at the demand for that city and that's where you're
determining the point 14 for that particular city.
Glenn:
That's right. Yup. Because when I combined supply and demand, I can
then forecast the occupancy level. Okay.
James:
Got it.
Glenn:
So there were no cities of Memphis, Miami, Orlando, and San Jose. I don't expect them to get anything more than inflation, which is we're right about two percent.
James:
Oh, you mean rent group, right about 2%.
Glenn:
Right. So their rent growth is only going to match inflation.
James:
So at point 14 is supposed to be deaccelerating rent growth and recession. It should be like almost negative rent growth.
Glenn:
12, 13 and 14 are decelerating rent growth. And point 14 is when
rent growth should only be running at the rate of inflation, which
if you remember back to your economics class, we have nominal
inflation and real inflation or nominal growth and real growth. All
that is, is nominal growth if the price of something goes up,
that's inflation. So if we have 2% inflation, if you've got like
GDP growing at 3%, that's nominal GDP growth. So 3% nominal GDP
growth, subtract inflation of 2% and real GDP growth is 1%.
James:
Got it. So what about at point 11, the cities who are estimated to
be at the final phase of expansion, still in expansion where; what
is the percentage of expectation of rent growth for that kind of
cities?
Glenn:
Well it will vary by city, but it's probably going to be, well,
let's back up one slide there. And when you're at peak occupancy,
you've seen historic rent gross as much as here's four and a half,
here's almost 5%. This little peak here is that 3%. Okay. So again,
and I do this model that you see here individually for each
city.
James:
Okay. How do we get access to that data to get a rent growth prediction for each city?
Glenn:
So, well that's what researchers do is we model and project things
and I get my historic data from CoStar, the company that does all
the major property types and I get supply information, demand
information, occupancy levels, rent growth. So I can model every
city.
James:
But your model of forecast is not available for public consumption,
that's mainly for your research, I guess?
Glenn:
This is my forecast report that you're looking at here. And my
regular market cycle report I give away free. It's actually on our
website at the University of Denver. So if you go to du.edu/burns
school, I'm in the Franklin Burns School of Real Estate, scroll of
the bottom of the page and you'll see my market cycle forecast so
you can get those for free. We sell a subscription to my forecast
report that comes out four times a year. It's only a thousand
dollars and that money goes into a fund to support research on real
estate and sustainability.
James:
Got it, got it. So my question is on a specific city, for example,
I'm buying a deal in Memphis and I'm trying to do a five year
projection on my performer to show it my investors and raise money
for you. So usually a lot of people use a 3% or 2% rent growth for
next five years. But what you're saying is that's not correct,
right? Because that's not how it's being forecast.
Glenn:
They need to take a look at the city where it is in its cycle and it might be doing better and might be doing worse than that.
James:
So how do we get that number rather than saying three or 2% blindly, is there a place where we can go and say it's 3% the next one year but after that it is going to be 1% for year 2 or second year or third year?
Glenn:
Yep. So CoStar, you can subscribe to CoStar.
James:
Okay.
Glenn:
They do projections on all this stuff. City by city property type by property type.
James:
Okay. CoStar for projections. Got it. Got it.
Glenn:
Okay. Also Jones Lang LaSalle has their own research and forecasting group, so you can go there as well. For your individual investors who probably aren't doing enough to spend that kind of money on research. Most of them are probably working with a broker when they're looking to purchase properties operate the properties, lease the properties, et cetera. When they're talking to a broker, they should ask, do you have CoStar access for your city and your property type. And the broker is allowed to share that information and those forecasts with them.
James:
Got it, got it. And what about the cap rate? I mean, when we talk
about rent growth, deaccelerating it's also meaning cap rate being
expanding, right? So is there a place...
Glenn:
Okay, so we're almost there. Let me just finish this and then we'll
jump right over to the financial cycle. Okay, here's retail; and
the key thing here is that you can see that we are at the highest
level of occupancy ever in retail. People go that doesn't make
sense, got all these companies going out of business and everything
else. So series is going out of business. What am I students family
owns a mall in Macon, Georgia and series goes out of business. They
open up the center of roof of the building on one side they put an
experience retail, two restaurants, a movie theater and an escape
room. On the other side, they're building four stories of
apartments on top of the space. So they're actually going to have
higher occupancy and rent going forward. We're replacing these
department stores with experience retail and remember supply; we're
not building a lot of new retail, number one, but we're also
repurposing a lot of retail.
So many times a retail center that's not working, convert it to
office space or today Amazon is trying to get that last mile
delivery to you on the same day, convert that into closed in
warehouse space where you can deliver it to someone the same day.
So retail is doing well because it's got a low level of demand
growth, it does have some. But it has an even lower level of supply
growth, hence the high occupancy rate. But you can see that the
rent growth is really pretty low too. It's only one and 2% going
forward.
James:
So retail is more of a play off, people have given up on retail and
there's not many people building but it's still a demand there
that's why the occupancy is much higher.
Glenn:
Right, right. So again, most of the markets at the peak and then
hotels, we are again at the highest occupancy rate we've ever seen.
That's because millennials like experiences versus things. So
they're doing a lot more travel. And we're in the process because
hotels are extremely profitable at that high occupancy rate. We're
seeing a lot more new hotels being built. So a lot of markets kind
of heading over the top and Austin being one of those, where you're
actually putting up a lot of new hotels. So when you think about
it, the one property type that's the best in Austin is actually
apartments at this point; highest occupancy, highest rent growth.
So that's the income side of real estate. All we talked about is
occupancies and rent growth. How much income can I get?
James:
Yes.
Glenn:
Now let's talk about the financial cycle and its capital flows that drive the prices and we look at that as cap rates. So the blue lines is the real estate cycle, the black lines, the capital flow cycle, and it should work as when things aren't very good, not much capital. The line's flat there at the bottom. As things get better, capital goes up. The highest rate of growth is when we go through that 0.8 now yellow where we reach cost feasible rents; capital flow peaks out in the hyper supply phase and then drops off very quickly. Now remember that we've got two types of capital flowing in the real estate. The green shaded area up here is capital flows to existing property. So if you buy a property from me for a higher price than I paid that's more capital flow. The other capital flow at the bottom is capital flows to new construction, adding more buildings in, so producing more properties. Real estate, I consider it a separate asset class.
So we've got stocks, equities, bonds, and commercial income producing real estate. It's about 20% of the marketplace. So for me, as I talk to and have worked with for 25 years, institutional investors, they should have a separate allocation to real estate. You should have a separate allocation to real estate in your retirement account. If you could only do public equities buy rates. Directly you can buy into funds or you can actually own properties yourself. But remember, when you buy a property, you just bought a business. You've got to operate it, you got to rent it, you got to take care of it, you got to maintain it, pay the taxes, you're operating a business. So when we look back over history, here's the history of ten year treasuries, you can see it going from 2% back in the 50's to 15% in 1982 to today, back to 2% with the forecast that it's going to go up but of course for the last 10 years, that's exactly what that forecast has looked like and it's always been wrong.
We've been running in the 2% range since the year 2010. So notice
the total return between 1981 and 2017 is 8.4%. That's because as
interest rates go down, bond values go up, your bonds appreciate.
But if you think bonds are a good place to be today, go to the left
hand side and when you go from two to the long-term average of
five, eight, the total return has only one nine because if you
bought a bond at a 2% interest rate, $1,000 bond at 2% and interest
rates go to four and you want to sell that bond, the new buyer is
going to want a 4% yield. So they're going to give you $500 instead
of a thousand for that bond. So you're going to lose money on your
bonds.
So that's why today bonds kind of don't make any sense. Real estate versus stocks and bonds. It's only had five years of negative returns versus over 20 for both stocks and bonds, and it is capital flowing. That money coming in that makes a difference. So here's a company, real capital analytics that collects data on every commercial real estate transaction in the US over two point $5 million. The bars go up, the bars go down and their price index, which is along the top there, you can see follows that pretty closely. So as more people buy, prices go up. When people back off, like during the great recession of oh nine prices come down.
James:
Is that the international money coming in or is that local money coming in or it's just [37:20unclear] you're easing
Glenn:
I will be answering that question in two slides. When we look at the cap rate, which is the simple way to describe that, it's like a bond yield or cash on cash return. Back in 2001 cap rates were around eight to 9% and then as prices went up, cap rates dropped to a low in 2007 of around six to 7%. Great recession happened, property prices drop, cap rates go back up, so you're getting a better cash yield when you buy. Since then cap rates have been coming down and they're down at a low of mainly in the six and a half to 7% range except for apartments which are at five and a half. Now of course hotels are higher because they're riskier at eight and everyone says, well, so interest rates have to go up, therefore cap rates have to go up. Not true. All the historic studies done, and I've done some myself show that the correlation between interest rates and cap rates is no more than about 20% that's not what drives it. It's capital flow.
As a matter of fact just came from a conference where two different
real estate economists say we expect cap rates to go even lower
next year because there's so much money out there around the world
trying to find yield, trying to find income and bonds don't have
it. Today the US stock market [38:51unclear] 500 dividend
yield is 1.2%. The 10 year treasury, which is risk-free, is 1.7%;
corporate bonds are running around three to three and a half and
you can buy into properties earning six. So that's quite different
isn't it?
James:
So what you're saying is the capital is going to continue, I mean your prediction is the climate is going to continue to go down in apartments and any, is it within all asset classes...?
Glenn:
Cap rates are most likely going to be staying about where they are or coming in and it depends upon the property or coming down just a little bit. They probably won't go down in retail because people don't believe that retail's coming back yet. So one way to look at this as take the risk free rate of the 10 year treasury, ask how much additional yield income am I going to get over that risk free rate of the 10 year treasury. So that's the spread above the 10 year treasury. Here you can see that the spread was 375 back in 2001 it dropped down to only 150 basis points in 2007 but today you're getting somewhere between 275 and 600 points over the 10 year treasury for taking that additional risk of investing in real estate. So from that standpoint, real estate looks like a very strong buy as an investment and because of that, what we see is real capital analytics collects data from all over the world and this shows money going from one country to another.
So at the top you see the United States in 2018, we don't have the 2019 yet numbers yet, sorry; into Spain, put $11 billion into Spain, that was 15% higher than the previous year. Because they believe the Spanish economy has finally figured itself out and is going well. The next one was France coming into the United States with money. $8.8 billion of French investors buying us real estate. The next one, the United States going in the UK, a $7.9 billion, that's a 20% decrease. Why do you think it went down?
James:
Because of the Brexit?
Glenn:
Yes, everybody has...
James:
[41:03unclear]
Glenn:
When Brexit happens, the economy in England will go down and hence if the economy slows, occupancy rates will go down and rent rates will drop. So you can see that money moves around the world and the most expensive property in the United States today, would be a class A office building in downtown New York City. It will go for a 3.8% cap rate. In London, the same size class A office building will go for a 2% cap rate.
James:
Got it.
James:
In Tokyo or Singapore, a class A office building will go for a 1% cap rate. So an English investor looks at the US and says, Hey, I can buy a top quality property for half price and an Asian investor goes, wow, I can buy a property in the US for a quarter of the cost in Asia. So we are the largest economy in the world. We're the safest economy. We have good laws that protect investors. In China you could invest there, but the government, since it's communists, could next year decide that oh, we own everything anyway, we're taking it away from you. So capital is flowing in the United States and I believe that keeps prices high and cap rates low.
James:
What about this trade war with China? I mean, I know it's a bit
cooling down, but it's cooling down and heating up; so how is that
going to be impacting the money flow to the US?
Glenn:
Well we've already hit the first level of agreement on it and it
certainly did not hurt our economy in any major way. If you look
here down at number seven, China and the United States $8.375
billion up 8% back in 2018 when it was first in process and our
president was threatening. Chinese investing in the United States
went up not down. Why? Because Chinese investors are trying to get
their money out of their country where they thought it might slow
down and move it into our country or where it was safer.
James:
Correct.
Glenn:
Okay.
James:
So this is a very awesome slide because it shows where all the
money flows in the world and you can clearly see that a lot of
money coming to the US which is important for capital flow too or
real estate prices.
Glenn:
Right. So here's a slide from NAREIT, the national association of
real estate investment trusts; you can find this on their website
and they're showing historic cycles at being 17 years long. So the
first cycle there from 1972, which is when they start having data
through 1989, the green line, the total average return per year for
publicly traded rates was 13.9%. The next cycle, 1989 through 2007,
just before our great recession total return was over 14% a year.
And here we are kind of halfway through the next cycle. 10 years in
and so far the average return has been 3.9, but that's because of
that big drop during the great recession and you had to recover the
money that you lost. So I believe we're kind of mid cycle and a
fair amount of expansion to go.
James:
So we are not going to die of old age I guess. Not because of the
cycle is too long and we are due for a correction.
Glenn:
Correct. So that's my story and I'm sticking to it. If you want, we
can do a quick summary or any other questions you have?
James:
I have a few questions. So in terms of development, so in this
market cycle, let's say for example in apartments, if you look at
the apartment, the market cycle that we put in, we are in hyper
supply. I mean, of course you say we have like 10% additional
supply it's not because there's no demand, but is this the right
time to do development? Because I saw somewhere in your studies
that the best time to start your development is 75% on the
expansion cycle. If I'm not mistaken.
Glenn:
Right. I would love to be developing at points six seven eight on
the cycle
James:
That's 0.6 or 67% of the whole cycle on the upward trend before it
reached the equivalent, right?
Glenn:
Well, I know, let's go back to my cycle graph and we want to be,
let's go to the apartment one as a matter of fact. So I would like
to be developing points 6, 7, 8 and maybe 9 in the cycle. What's
happening is a lot of people are over here putting up new
properties at 12, 13, and 14.
James:
So right now, I mean, your chart shows the apartments at the 13,
which means it's not the best time to really do development
ideas.
Glenn:
Correct.
James:
And what about people, I mean, some of the investors who are doing like bridge loans or long-term loans. I mean there's pro and con in both, but what would you recommend in this market cycle?
Glenn:
Well, when you say a long-term note, you mean give me a mortgage on
a property?
James:
Yeah. Getting a mortgage with agency debt or fixed rate long-term
versus a bridge loan, which is a short term financing.
Glenn:
So bridge loans are basically taking the risks that properties
being developed or redeveloped and that it will be successful upon
completion. Whereas a long-term mortgage you get the first money,
so the rents that come in and have to be high enough to pay your
mortgage payment and if there's nothing leftover, then the equity
investors aren't making any return in those years. So again you can
buy an apartment and it most likely is going to cash-flow but it's
a full time job to manage a big property, make sure it's done
right, and finance it properly and everything else. That's why
pretty much every university in the country today has a real estate
program. We are actually at university of Denver, the second oldest
real estate program in the country started in 1938. Where you are
both an undergraduate or graduate and an executive online program
so you can be at home and get your master's degree in real estate
from us.
James:
Got it. Got it. Right. Wow really, I should probably look at that.
But the other question I have, especially on this chart, why is it
not symmetrical? I mean, I know during the recovery and expansion,
it's just a longer cycle and update like a slight down.
Glenn:
Great question; and that's because historically we've had 11 years
of up cycle and only three or four years of a down cycle. As a
matter of fact, I'll go back to the, one of the slides that I
bounced past earlier on, and that is this here you can see previous
economic cycles, they last anywhere from 5 to 10 years historically
and recessions are normally one to two years long. The great
recession at two and a half years was the longest recession that
we've seen since the great depression in the 1920s.
James:
Got it. Got it. And what about the the industrial office and other
property types what do you think would try for in the next, I mean
other than apartments, among all these property types, what would
be the best property type to invest for the next five years? I
would say from your perspective.
Glenn:
Here's the chart. Office has got the longest run in the expansion
cycle followed by retail. Power centers doesn't mean that stuff
can't sit at the top for a long time too. So if it keeps going, I
believe we've got a good five year run of demand for industrial
space going forward.
James:
Got it. By is office being driven by some factor. I mean,
technology, right? I mean, a lot of technology people work from
home too, right? So I'm not sure where that drive is coming from
for office.
Glenn:
Basically more and more of the jobs in the United States are office
using jobs and people start going crazy sitting at home and we're
social animals. And so being together with other people and that
social interaction actually benefits the work for every company,
that's why we work. When you start a company, instead of working on
your garage, you can now go and rent some, we work space on a
daily, weekly, monthly basis. They charge you plenty for it, but
now you've got a space to be in, all the amenities that are
necessary there. There's a receptionist, there's copy machines,
there's all the different things that you need to be successful;
collaboration, conference rooms, all those kinds of things. So most
new companies start out by going to you short term office rental
space. Last year that was 10% of the demand in office.
James:
Got it. And what about the Amazon effect? Is that just on the
industrial? Because I read somewhere that they own like 25% of
the...
Glenn:
Last year Amazon rented 25% of all warehouse space, new warehouse space rented in the United States. That's how much they're growing. They opened a 1 million square foot warehouse North of Denver and hired 1500 people.
James:
Wow. What about this boom in marijuana and all that happening on some of the coastal cities is that impacting any of these property types?
Glenn:
The, I'm sorry, the?
James:
Like, they have this marijuana, right? Like you know like medical
marijuana and...?
Glenn:
So yeah. Well Colorado was one of the first and it created a huge
demand for warehouse space here in Denver and drove our rents from
$3 to $6 over a two year period. I can see if you went to basically
100% all the old crappy warehouse got rented up to grow marijuana.
And since we're one of the first States where marijuana tourism
became very big. Now that other States are picking it up, less
people are coming and we've had a couple of marijuana companies go
out of business and so all of a sudden, and we built a lot of new
space for them and so now we're in the hyper supply phase because
that economic base industry in Denver is shrinking.
James:
Got it, got it. What would you advise an investor, let's say for
example an apartment investor who are more in the hyper supply
stage right now, what would you advise that person to be cautious
of as we move forward for the next five years? If keep what? Keep
on buying or do you want to be more defensive?
Glenn:
Well, if you believe that there is a recession coming, then what
you want to do is have what we call defensive assets. You want to
be in the best markets, the highest, the bigger markets like the
ones that I show and the ones that I have in bold and italics. You
want to be in higher quality properties that can attract and retain
tenets and you want to try and get the longest term leases you can
get to bridge you through the next down cycle.
James:
Got it, got it. And what about tertiary market? Is it a good idea
to go into tertiary market looking for yield? Because I know some
of the tertiary market is [52:52unclear]?
Glenn:
Yes, but you have to be careful and very selective. You need to
look at what is the economic base industry that's driving the
growth in that market. So for instance, an economic base industry
produces a good or service it exports outside of the local market
that brings money in. So in Detroit, Michigan for decades it was
auto, the auto industry did well, so did Detroit. When the auto
industry turned down and we got a lot more foreign competition,
Detroit became pretty much a ghost town. Now you've got a
billionaire, a tech giant who came in and started buying up a bunch
of office space in Detroit to run his company out of at next to
nothing and hire people in saying, come here and live in oh, by the
way, you can go buy an existing house here in Detroit for like
10 or $20,000. So instead of spending 3000 or $4,000 in San
Francisco and rent, you can have a mortgage that's only a couple
hundred bucks a month. So Detroit is starting to turn around
because of the new economic base industry. This tech company
creating demand for office and when you create demand for
employment, then people buy things. So retail goes up and the
demand for rental goes up, it just, it moves everything up and
plenty of growth is the number one key thing to look at for demand
for real estate.
James:
Got it. Got it. What about some of the government controls like
rent control and some of the cities, some of the States that's
happening right now, how is that going to be impacting the cap rate
and the rent growth?
Glenn
Right. so rent control is the government interfering with the free
market and it has shown that when that happens it severely
restricts supply because no one wants to build if they're going to
end up with rent control on their property where they can't raise
rents to at least meet inflation. And so every place where that
kind of stuff is coming into play, investors aren't buying and
property prices are going flat. In the long-term they will hurt the
market. It will create exactly the opposite. They're saying, oh,
we're trying to make apartments more affordable for people. Well,
it does just the opposite. People that are there end up with a
lower rent and then they sit on it even when they now have a good
job. And I'll give you an example. I have a good friend who owns an
apartment building in San Francisco. He has four of his 20
units are rent controlled. One of the people in it was a guy that
when he got in, he was in school. Now he is a very wealthy person
and he continues since he had it, it can't be released. His rent is
less than 25% of what market would be on his property. And he's
there maybe one or two nights a month. And my friend keeps asking,
why do you rent this for the month when you're only here two
nights? He goes, because it's cheaper than a hotel. So it's bad
government policy in my personal opinion.
James:
Yeah. It's crazy [56:25unclear] like, so does that mean
some of the cities which doesn't have rent control will have a lot
more price run up because a lot of people want to be investing in
like for example, in Texas or maybe Florida, which doesn't have a
lot of space doesn't have rent control. Would that mean that a lot
of people from the East coast or West coast will be investing more
on these states?
Glenn:
Potentially, yes.
James:
Okay. Okay. So I think I covered most of the questions that was
asked in the Facebook group. If audience and listeners, you guys
want to join this multifamily investors group in Facebook and we
have almost 4,000 people there and now we are recording this as a
podcast and a webinar, so you should be able to get the webinar as
well as you register. So Dr. Glennn how do people get hold of you
and get in touch with you? I believe you mentioned it halfway
through, but...
Glenn:
Right. Yup. So they can go to the university of Denver website,
which is du.edu/burnsshool, and a scroll to the bottom and they'll
be able to see my cycle reports there. And there I've got my
profile and all the other information there. That's the easiest way
to do it.
James:
Awesome. Thank you very much for coming into the show and doing the
webinar as well. Thank you very much.
Glenn:
Okay, thank you. Have a blessed day.
James:
Have a good day.
Glenn:
Bye.