Annual Report, 2009 – Cohen Asset Management
We are pleased to provide the following report for the year ending December 31, 2009.
In last year’s investor letter, I referred to the speed in which the market sentiment turned negative; “Whether it is the crisis in the credit markets, increase in availability rates, deflation in rents or impairment of values; we are planning our business for a tough environment.” One year ago we knew we were facing challenging times however, it is now a year later and what has transpired was largely unprecedented and virtually inconceivable. We did not know when the downward spiral would end or the full extent of the damage it would cause, but we did know that we had to prepare for what we believed would be a severe economic downturn and one of the toughest times for the industrial real estate sector. Stated bluntly, 2009 was one of the worst years for the U. S. industrial real estate market with record amounts of industrial space vacated and the national industrial availability rates surpassing its previous peak. The worst case scenarios played out in terms of a) severely weakened leasing environment with a spectrum of tenants adversely impacted by economic conditions, b) dormant investment sales market and, c) dismal lending conditions. The macro markets for industrial real estate in the United States have experienced significant challenges throughout 2009 including, but not limited to, deteriorating property fundamentals reflected in reduced demand for space resulting in lower occupancies and rental rates. The slack that has built up in the utilization of space will continue to be a significant impediment to improving fundamentals as these conditions are expected to continue at least through 2010.
GDP has come in at healthy levels in each of the last two quarters. Much of this growth was due to a rebuilding of inventories, whether this came from from business to business or business to consumer tenants. Whether this a temporary or sustainable feature of the economy, with the exception of government activities, production is expected to be headed in a positive direction across most, if not all sectors of the economy. This said, growth is forecast by CBRE-Econometric Advisors (“CBRE-EA”) to continue in a positive direction even after the rebuilding of inventories begins to slow. A very hopeful sign in the 4th quarter figures is the fact that without the help of government incentives seen from the Cash for Clunkers program in the 3rd quarter of 2009, consumers still increased expenditures by 2% on an annualized basis. That the growth was in the services and non-durable goods sector shows a populace that is comfortable with spending on necessities, but still is not purchasing durable goods if those purchases can be put off.
A recent pickup of trade and export demand is also an early indicator of healthier times ahead in the industrial property market. Container traffic increased 0.8% in the 4th quarter of 2009 from the same quarter a year previously. Likewise exports were up 14.3% year over year and while both sets of figures were still down for the calendar year 2009, the positive momentum is helpful.
The key issue in recent figures impacting the industrial property market however is the trend in the inventory cycle. Firms began liquidating inventories in 2008 and have started to rebuild them as we approached the end of 2009. As the economic rationale for industrial real estate space is to handle the production, storage and management of goods from the point of origin to the point of final consumption, any factor which influences this flow of goods is going to impact the demand for industrial space. Through our informal tenant surveys, we expect to see both inventory growth and business capital spending growth in 2010.
Into the 4th quarter of 2008 inventories plummeted at a record pace such that non-residential investment alone accounted for 60% of the decline in GDP. Non-residential investment fell even further in the 1st quarter of 2009 with inventory reductions representing 120% of the decline in GDP, which was only buoyed by trade flows in the quarter. The recent rebuilding of inventories however constituted roughly 60% of the growth in GDP for the 4th quarter of 2009. This rebuilding of inventories is a promising sign on a number of fronts. Changes in inventories were at such extremes as the credit markets had shut down and firms were unable to borrow to access operating capital. Firms liquidated inventories, sometimes at rock bottom prices, simply to access operating capital. However, the fact that these same firms are now able rebuild inventories suggests that this inability to borrow is a thing of the past. With firms able to borrow and add to inventories, the potential now exists for firms to take on new space to manage these inventories.
Potential demand for industrial space is one thing; demand that is actually realized with positive net absorption is another. As of the end of 2009, national industrial availability rates have increased in each of the last nine quarters and are now at their highest overall level since reliable tracking of data for the industrial market began. Expect availability rates (read vacancy) to go higher.
At the worst point in the current downturn, demand for industrial space across all markets tracked by CBRE-EA shrank at an average pace of 87 million square feet per quarter in the 1st and 2nd quarters of 2009. Demand had never contracted so quickly; even during the dark days of the 4th quarter of 2001 in the wake of the combined shocks of the Internet Bust and 9/11. This sharp contraction in demand was, among other issues, caused primarily by the shock of the inventory cycle that started in late 2008. With manufacturing orders and then inventories significantly contracting, industrial tenants faced far less need for space in early 2009 when opportunities were present at lease expirations; these firms downsized their space requirements. Others, particularly retailers and housing-related service companies, simply went out of business. The combination of downsizing firms and those businesses that went out of business has pushed the demand for industrial space to extreme negatives. Space market fundamentals remain weak and occupancies and rents will continue to be pressured.
While still not positive, the situation exhibited modest improvement during the second half of 2009 despite the continued rise in industrial availability. While the rate of the increases in availability has moderated, all four Target Markets posted negative net absorption in the 3rd and 4th quarters. As the pace of inventory reductions slowed, the pace of cutbacks in demand for industrial space did as well. The decline in the 4th quarter was by far the shallowest of the downturn, signaling that while demand appears not likely to return to robust growth levels in the near term, its rate of deterioration is abating. The nascent recovery in Gross Domestic Product provides hope that demand will return and while we are being cautiously optimistic, our research providers are forecasting that net absorption of industrial space, not rent growth, will again turn positive towards the end of 2010. Still, the final damage to the industrial market will be pronounced with national industrial availability peaking at over 15% while historic normal levels would be more in the 9% to 10% range. Keep in mind that market fundamentals for large warehouse, research & development and smaller industrial space are showing early signs of stabilization, though it is proving to be fragmented geographically and is likely to be choppy throughout 2010 and 2011 as the slack in the utilization of space is taken out of the market.
Our prognosis is that the recovery of industrial demand will initially be very weak with the economists at CBRE-EA predicting that on a national basis we expect only 24 million square feet of positive net absorption per quarter starting in early 2011 whereas, historically, a healthy market recovery phase would see demand in the range of 40 to 50 million square feet per quarter. Despite the anticipated initial anemic pace of demand in the recovery period, industrial availability rates should begin to decline as the shortage of new construction will help the market to recover moving forward. Helping this situation is the significantly increased yields on costs to justify development have increased sharply since 2007. Given the risks surrounding the lease up of a newly developed asset and the illiquidity of debt in the financial markets, this should keep any speculative development in check in the near-term with less supply contributing to the inventory of space going forward in each of our Target Markets.
Capital Market Situation
Although overall commercial real estate sales transaction activity in the United States reached its trough in the first half of 2009, the recovery to date continues to be very muted and uneven across different markets. The dislocation in the capital markets has created a favorable environment for new commercial property investments, but has made it very difficult for owners that purchased assets in 2006 and 2007, as properties are being discounted significantly on both an absolute and a relative basis. While discounts are to be found in the institutional industrial markets as well, in some respects the strain from financial factors is not as bad in the industrial sector as it is in other real estate sectors which are more capital intensive.
The Moody’s/REAL Commercial Property Price Index (CPPI), which measures price changes based on an index of repeat sales transactions, indicated that on a national basis, peak to trough, industrial property values have fallen by more than 37% from 2007 into 2009. However values on closed transactions have actually increased since the 3rd quarter of 2009.
Corresponding to the change in property values, cap rates on industrial property sales transactions have also risen sharply since late 2007. In broadest measures, during the latter half of 2009, cap rates on industrial property sales have increased by more than 200-350 basis points from their 2007 lows in a vast majority of markets. Nevertheless, based on actual transactions that we are seeing in the marketplace and according to data from Real Capital Analytics, cap rates for industrial sales have actually declined since the end of the 3rd quarter 2009 by 25-75 basis points. On average, we believe, the cap rate expansion cycle that began in 2007 appears to be approaching its completion. As we have seen, the market is a discounting mechanism however, it doesn’t always discount reality. In difficult times it discounts the worst case scenario and in good times it discounts the best case scenario. Today, although times may not look nearly as difficult as they did one year ago, they certainly don’t look great yet. While cap rates have risen sharply since 2007; when these figures are compared to a benchmark such as the yield on the ten-year U.S. Treasury bond; industrial real estate valuations are increasingly attractive relative to longer-term historical trends with room for further increases in values.
While a further decline in industrial rents and operating fundamentals may place upward pressure on cap rates, we believe that a large portion of the reset in cap rates has already taken place. The factors driving this belief include, (i); recent easing in the constraints associated with the debt markets, (ii); recent normalization in the risk premium that investors associate with investing in institutional industrial real estate relative to other asset classes, (iii); institutional investors continue to allocate capital to the asset class with the expectation that industrial property will be the steady income-producing investment and portfolio diversifier it was always meant to be, (IV); the institutional industrial sector is underrepresented in the pool of troubled assets due to the sector’s historic low leverage stability and low level of CMBS financing, and (v); the scarcity of high quality leased assets available for sale in the marketplace coupled with a shortage of industrial product in many institutional investor’s portfolios.
While the worst of the recession appears to be over, the industrial market recovery is further out on the horizon. Tenant’s inventory growth is expected to resume as we move forward into 2010, but businesses have adopted leaner inventory management practices. We believe the conservative management practices adopted by our tenants (lean inventory/IT efficiency) coupled with a record high availability rate and a tepid job market will delay any rent recovery until at the earliest late 2011. Furthermore, much of the recent resurgence in manufacturing and inventory replacement is more a result of the need to restock severely depleted inventory levels than of a significant increase in domestic demand from consumers and businesses.
Moving forward, the pace of availability increases should continue to moderate. Sustained weakness in the industrial real estate market will push availability rates higher before they move lower and prior to demand being strong enough to begin burning off excess availability in each market. The economic environment that we witnessed was unlike any we have seen in our careers and will continue to present challenges to industrial landlords over the next couple of years. Rent growth will take longer to recover as a record amount of industrial space sits vacant and a great deal of economic activity will be required to fill this industrial space. The longer term prospects for global traffic, absent a trade war brought on by protectionist sentiment, remain solid. The U. S. will continue to play an important role in the globalization of trade, which bodes well for industrial fundamentals over the long run. Right now however, challenging times are ahead in the short-term.
Bradley S. Cohen
Cohen Asset Management, Inc.