There are ten issues that will impact commercial real estate construction in 2007 and beyond, suggests a new report by Dr. Mark G. Dotzour, chief economist for the Texas A & M Real Estate Center.

1. Slower growth in corporate profits is likely to slow hiring and reduce absorption of office, industrial and retail properties.

"Corporate profits have grown at a double-digit pace for the past four years. However, with high interest and fuel costs and the rising cost of labor, profit growth is expected to moderate. Standard and Poor's in their August, 2006 Economic Outlook forecast S&P500 earnings per share to increase annually by 2 percent or less in 2007, 2008 and 2009. In this environment, management will become even more aggressive in containing costs, and will be less likely to hire additional staff."

2. The principal business risk to all U.S. businesses is that the inverted yield curve will cause a recession in 2007 or 2008.

"The yield curve first inverted at the end of December 2005. Consequently, we have had a flat or inverted yield curve for nearly nine months. Federal reserve economists have noted that the yield curve has inverted in each of the last eight recessions, while giving only one false signal. Harvey Rosemblum with the Federal Reserve Bank of Dallas stated that the inverted yield curve "has often been a precursor to a recession occurring within a year."

"Whether we have an official recession or not, every day that the yield curve remains inverted is another day that job growth is likely to decline. Hence, the growth rate of absorption in commercial real estate is likely to slow down."

3. Outsourcing and offshoring will continue to lessen demand for industrial real estate.

"Industrial manufacturing jobs are continuing to be relocated to lower-cost areas of the world. Most of the focus is currently on China. As wage rates rise in China, further production will shift to lower-cost markets such as Viet Nam. Mexico is experiencing a renaissance as well because of its proximity to American consumers. The auto industry will increase its rate of offshoring dramatically in the near future."

4. Outsourcing and offshoring will begin to lessen demand for office buildings as well.

"The latest emphasis is business process outsourcing (BPO). Major corporations are being enticed to outsource their entire Human Resource functions, including benefits, personnel and purchasing. In addition, accounting firms are starting to offshore tax returns. Recently the accounting industry established guidelines for notifying their clients if their returns are outsourced overseas."

5. Real estate is still preferred by investors over stocks and bonds.

"A Roper survey for TIAA-CREF completed at the end of 2005 found that 69 percent of investors believe that real estate is a better investment than stocks. In a low-yield global investment environment, investors have turned from stocks to real estate, commodities, hedge funds, art ... even "muscle cars." Since the start of 2000, the Dow is down 2 percent and the S&P500 is down 10.6 percent. During the same time period, the REIT average is up 142.1 percent. Mail REITs are up 271 percent."

6. High profile corporate fraud and accounting scandals continue to temper investor enthusiasm for public equities.

"Beginning with Enron and continuing with Fannie Mae, Americans have been skeptical of corporate ethics and accounting. The Roper survey done for TIAA-CREF at the end of 2005 found that 51 percent of American investors believe that recent corporate scandals are "just the tip of the iceberg." Only 9 percent say financial services firms are "very trustworthy," and this is down from 14 percent a year earlier. Only 13 percent find the largest public accounting firms "very trustworthy," and only 39% of investors are confident that CEOs practice ethical behavior.

"The Refco IPO and sudden bankruptcy within two months of going public continues the trend. And then the recent revelations of "back-dated" stock options will continue to disturb thoughtful investors. As long as investors are skeptical of Wall Street, real estate will continue to be an attractive investment alternative.

7. There is still way too much money around the globe chasing investment yield.

"The world is flush with investment capital coming from everywhere. Australia has paid off all of their government debt in the past 10 years. Their mandatory retirement program generates billions in investment capital.

"American corporations have saved over $560 billion in retained earnings and are flush with cash. Lacking sufficient investment alternatives, many are using the cash to increase dividends or buy back shares.

"Yield-seeking investors have migrated to alternative investments. Globally, hedge funds now manage a total of $1.5 trillion. Institutions have invested between $100 and $120 billion in commodities, up from $6 billion in 1999.

"The Bank of Japan has been providing the world with liquidity by offering bonds with interest rates below 1 percent. Borrowing money in Japan at 1 percent and investing it in U.S. Treasury bonds at 5 percent is very enticing.

"The Chinese savings rate is 44 percent of GDP. The Chinese government cannot spend their profits fast enough. They have accumulated almost $1 trillion dollars in foreign reserves, which they use to buy U.S. government bonds."

8. Endowment associations are seeking higher yields with alternative investments.

"Webster's dictionary will have to add a new definition to the word "staid." Today's endowment associations have greatly increased their allocations to hedge funds, commodities, real estate and private equity. Real estate investment and development are now on their menus."

9. Pension funds are seeking higher yields with alternative investments.

"Like their cousins in the endowment world, pension funds are also scrambling to find higher yield. Recent financial economics literature has indicated that institutions should allocate between 6 and 12 percent of their portfolios to real estate. Many have been increasing their exposure to real estate in the past five years, but are well below their investment goals for this product. Expect them to be aggressive buyers in the coming years. A recent transaction in which TIAA-CREF was able to outbid a TIC buyer for a portfolio of apartments in Houston and Arizona is illustrative."

10. Pension funds and REITs are unable to get sufficient yield from existing property investment. They are convinced that they can get higher yield by developing property rather than purchasing existing buildings.

"A Standard and Poor's recent survey of 20 larger cities found that the average level of pension funding fell to 85 percent in 2004 from 99.8 percent in 2000. Philadelphia has assets equivalent to 56 percent of its long-term liabilities. Boston was at 63 percent and Chicago was at 65 percent. The San Diego pension fund scandal led to the resignation of the mayor and indictments on five former pension fund officials."

In a quest for higher yields, pension funds are looking to get into the land development business. Oregon Public Employees Retirement Fund and California State Teachers Retirement System have both teamed up with Regency to do development deals.

Says Dr. Dotzour, "These ten issues indicate that the underlying fundamentals of commercial real estate will continue to strengthen over the next two years. Positive absorption (while slowing down) will continue to reduce vacancy rates and help rental rates to improve. The principal risk to existing real estate owners is overbuilding. The fact that yields are low already will not cause developers to turn away.

"The entrance of REITs, pension funds and endowment associations into the development arena is likely to produce excess supply in the next few years. Hence the outlook for commercial construction for the new few years is bright. This focus on development will continue until one of two things occurs: 1) overbuilding drives real estate yields into the ground, or 2) the stock market regains its attractiveness and diverts investors' focus on real estate," he says.

Based on comments delivered at the National Association of Business Economics Annual Meeting in Boston on Sept. 11, 2006

Published: September 19, 2006

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