In any given real estate market cycle, key factors provide information about the health of the office market. Past recessions can offer insight on today’s real estate market, including where the economy is headed and when a full recovery could begin. Even if the cause, economy, and market fundamentals -- such as rent, vacancy, leasing activity, and absorption – are drastically different, fluctuations in key indicators shed light on the typical real estate market cycle, including a trajectory for recovery. Though every downturn is “unprecedented” in some way, the sum of insights gleaned from each helps formulate theories about a recovery. In order to effectively theorize the current real estate market cycle, the following indicators must be analyzed and contextualized: GDP, consumer spending and confidence, port cargo volume, employment, and office sublease space availability.
Gross Domestic Product (GDP) is the leading indicator to determine if the country's economy is expanding or contracting. Typically, a year-over-year increase in GDP signifies that the economy is stable or expanding. Many factors make up GDP and without strength or growth in all of them, the economy isn’t able to expand. As with the rest of the world, the U.S. economy is weathering a massive contraction, currently -32.9% GDP year over year, and exceeding the YOY contractions in the last two extreme recessions (2008, 1975). Despite the U.S. GDP of $21 trillion ranking considerably greater than every other country, economic expansion is vital to a recovery. After stay-at-home mandates are lifted across the country and restaurants / stores fully reopen, the GDP will likely surge, but businesses utilizing physical spaces may lag that pace by about six months.
The economic picture is less bleak in California. With a GDP of $3.2 trillion in the first quarter of 2020, the state ranks as the largest economy in the U.S. and the fifth largest in the world if California was its own country. That strength could position California to recover earlier and faster than many other states.
Consumer spending makes up a significant part of the economy. In California, from March 16 to March 30, consumer spending decreased dramatically, by 36.9%, due to stay-at-home mandates. Consumers quickly turned to online food and grocery ordering and delivery services. To meet the demand, established delivery services expanded and new services emerged, resulting in a steady increase through August 2020, where spending levels ended just 12.2% below January levels.
When restaurants, theatres, and hotels closed down, spending decreased dramatically within higher income brackets. So much of the country's economy depends on shopping by the top income bracket; the lack of spending by 25% of the wealthiest Americans made up two-thirds of the total decline in spending in California since January. (Source: NPR)
Together with consumer spending, the Consumer Confidence Index provides a complete picture of American consumer sentiment, including perception of financial well-being and buying intentions. These two indicators have a tremendous impact on the economy and can help determine a path to recovery. According to The Conference Board, the U.S. Consumer Confidence Index declined to 84.8 in August, the lowest level since May 2014. When compared with the last recession, October 2008’s level plunged to 38, then the lowest level since the Index’s inception in 1967. Driven by the pandemic, closed businesses and schools, the 2020 consumer outlook has not strengthened, despite an increase in spending across most income brackets. Another round of stimulus checks could positively impact consumer confidence as it did in April.
Consumers also reveal their confidence in the economy through automobile sales. Car purchases are a relevant indicator because they signify the willingness or ability to take on monthly payments by consumers, providing insight into personal financial stability. Since below-average sales in April 2020, personal car purchases in the U.S. rebounded in August by 82%, possibly due in part to consumers preferring personal over public transportation.
Cargo container volume is another relevant component toward determining a recovery as it reflects consumer demand. Cargo containers at ports around the
country are measured in TEUs, with each TEU equivalent to 20 feet of cargo capacity. The pandemic forced many factories to shut down, preventing them from either manufacturing or shipping goods. Additionally, trade disputes around the world put further stress on cargo movement. Currently, there is an immense backlog of
full and empty containers that need to return overseas first before regular container traffic can resume domestically. Short-term spikes in cargo activity may occur,
especially as the holidays approach, but true port traffic may not normalize until next year.
Trade disputes between the U.S. and China have negatively impacted domestic container traffic since the beginning of 2019. Port of Long Beach TEUs fell 5.7% between December 2018 and December 2019. Port of LA fell 1.3% and Oakland fell 12.2%. Though inbound and outbound container traffic slowed significantly (down 32.5%) from January to May 2020, volume has recently increased. From June to July 2020, TEUs increased 25.1% at Long Beach, 23.8% at Los Angeles and 10.1% at Oakland.
California’s industrial market is heavily impacted by port activity. Historically a resilient product type, the industrial market has benefitted further in recent years from dramatic e-commerce growth. Across the state, industrial vacancy is rarely above 2%. The significant growth throughout the food tech industry as a result of the downturn further bolstered the industrial market, complementing the modernizations of e-commerce through the last cycle.
The newly emerging hybrid workplace model, a union of the physical and virtual office, can be a unique, flexible, and game-changing option for companies. The
pandemic has forced every company to adapt to remote work, but it does not tell the full story of the future of work, because this is the only option for a majority
of industries right now, especially among California’s knowledge workers.
The shift to a hybrid workplace has the ability to empower more people to choose to come into the office because they want to and it fulfills an important need rather than because it is an obligation. It can be a place for collaboration while more focused work can take place remotely. It also means companies can reach more talent with smaller offices in multiple markets rather than one large location. Additionally, a distributed workforce could spur or grow emerging markets, which would benefit from an influx of tech talent.
Los Angeles sublease availability has reached an all-time high of
6.2 million square feet (msf), 1.20 msf of which came online since April.
Closer examination, however, reveals that only 3.3 msf are actually vacant,
which is well below the 5.0 msf that devastated the market overnight following the dotcom collapse of 2001. The LA West submarket’s sublease availability makes up 60% of the total for the LA market. In the 2008 recession, sublease availability reached 6.0 msf at its height, approximately 2.0 msf of which
had less than two years left on their terms and simply became direct space.
With weak demand, however, that direct space lingered on the market for
12 quarters until job growth returned.
Currently, just 283,000 sf of vacant subleases have shorter than two years left on their terms, whereas available subleases (that may or may not be vacant) with two years and longer terms total 5.9 msf. Some of the shorter term subleases were listed before companies could assess how much space they would need to ensure proper social distancing once employees return to the office. The majority of subleases with longer terms, however, present a broader spectrum of opportunity than has been available in the past several years. Companies that are growing, requiring additional space to safely distance, or considering multiple locations to establish a hybrid workplace model, now have access to high-quality space at a discounted price.
Also, companies that have been waiting to move up to higher quality space with a more open floor plan or outdoor connectivity as part of a de-densification strategy now have more options.
Since January 2020, San Francisco sublease availability increased 181% to
7.7 msf. Currently, the average size of a sublease listing is 13,340 sf, compared with an average of 9,244 sf before COVID-19, still, 65% of new sublease spaces are smaller than 10,000 sf. Though the average term left on 2020 subleases is 34 months, 66% of sublease space on the market have more than two years
left. Sublease space has nearly tripled since the start of the year, compared with a 26% increase in direct space. Many tech tenants either outgrew their space
and moved into bigger offices or banked space for future growth, both of which increased the amount of subleases on the market. This trend increased dramatically in 2019 due to the explosive growth of the tech industry.
As supply increases and demand wanes, there will be further downward pressure on sublease space pricing. Landlords will also adjust pricing accordingly to compete with high-value subleases.
In 2020, 1.0 msf of new subleases came to market, half of which are vacant, bringing the current total on market to 2.0 msf. Unlike previous cycles, however, established companies now make up a large portion of the tenant base in Silicon Valley Peninsula, as tenants, owners and developers. After the dotcom collapse in 2001, the majority of the 3.0 msf of sublease space was vacant, left behind by low-credit tech companies, and it took approximately two years to work through that supply. In 2008, the amount of occupied sublease space on the market dramatically increased from layoffs and companies seeking efficiencies with office space. At the height in 2009, sublease availability once again exceeded 3.0 msf.
The new development in Silicon Valley Peninsula has remained constrained since the dotcom collapse. Deep-pocketed developers maintained discipline, which has kept the market tight, driving up demand and pricing while putting downward pressure on vacancy.
As of July, CA nonfarm employment decreased by 10.2% from January. The deepest decline occurred in April (14.8%), but small month-over-month gains offer some hope of a sooner recovery. May employment increased 1.0% over April, June increased 3.6% over May, and July increased 1% over June with growth across all industry sectors; Finance and Education sectors fared best. Since many job losses were a result of businesses shutting down, once they reopen, jobs should return.
These 20 U.S. companies have laid off 33,000 employees since the pandemic began and account for nearly 1.1 msf of sublease space on the market in San Francisco.
Prior to the start of the pandemic, the number of tenants in San Francisco, Silicon Valley, and Los Angeles in the market for office space totaled approximately 27.0 msf. Currently, companies are either delaying the decision to expand or are choosing to work remotely, which dramatically impacts the number of tenants in the market; approximately a third of the tenants in the market are still actively looking. Despite this decline, the pipeline for new tenants in the market could grow along with the expansion of many of California’s VC-backed companies. There are currently 9,575 VC-backed companies in the state, 3,850 of which have a positive growth rate and 1,250 of which have a growth rate of 1% or higher. Those tenants may start out with a smaller footprint but their demands will grow as their businesses do. Despite the current preference to keep working from home, in-person meetings remain crucial for company culture, creativity, collaboration, ideation, and growth.
One economic indicator that is relevant to a recovery, however less tangible, is the effect of an election year. Whether a Democrat or Republican wins, there is little direct effect on commercial real estate from the standpoint of leasing or investment activity. Companies may slow spending, pause hiring or expanding, or put off relocation decisions until after November, but the overall effect doesn’t correlate with concrete market activity. Some market effects occur with changes in policies, interest rates, or tax laws that can impact developers, landlords, and business owners. Below are a few relevant propositions on the November ballot:
California Proposition 15 (split roll) proposes to increase funding for public schools, community colleges and local government services by changing the tax assessment of commercial and industrial property. If passed, Prop. 15 would reassess commercial and industrial properties valued over $3 million and ultimately impacts both tenants and consumers.
In San Francisco, Proposition I proposes to double the city's real estate transfer tax on deals of $10M or more. Property transactions between $10 million and $24.9 million would rise from 2.7% to 5.5%, and deals $25 million or greater would increase from 3% to 6%.
Also, Proposition F would change San Francisco's business tax structure, including tax breaks for small businesses, increase gross receipt business tax rates across the board, and repeal the city's payroll tax.
In Santa Monica, Measure SM would raise taxes on property sales of $5 million or more to $6 per $1,000 of the sale price, excluding affordable housing projects, to fund essential services such cleaning, small business recovery and homelessness.
In Culver City, Measure RE would increase real estate transfer taxes to fund city services. Tax on property sales between $1.5 million to $2.9 million will increase 1.5%, $3 million to $9.9 million will increase 3%, and $10 million and up will increase 4%.
Once the economy fully reopens, a boost in consumer spending should follow
as well as a surge in employment. Consumer demand remains; the economy was in the midst of a historic growth cycle prior to COVID-19. The shutdown was the cause of retail, restaurant, hotel, and travel collapse and it will return, albeit slowly. After 9/11, it seemed that air travel would never rebound, but after just three years, the industry returned to pre-9/11 levels. Though heavy regulations were implemented, as there will likely be in a post-pandemic world, the world adapted and became largely comfortable with flying again.
After the economy stabilizes, the real estate market will likely take another six months to begin recovery. Despite the uncertainty around a full recovery, companies are making decisions now that they weren’t ready to make only a few months ago, alluding to a generally positive sentiment around the future health of the economy.
Historically, technological innovations have the most significant impact in pulling an economy out of a recession. As evidenced over the past six months with the growth of food, transportation and biotech startups, this pandemic is turning the U.S. into a nation of entrepreneurs. These and many other cutting-edge startups uniquely span office, flex, R&D and industrial properties, and are forecasted to occupy a great deal of physical office space in the future, which will help fuel the overall economy and ignite the real estate market’s recovery.