Documeent title on one or two
Awaiting
Cranes:
lines in the
Gustan
Book 24pt
Supply Discipline & Office Market Performance
TIAA-CREF
Global Real Estate
Strategy & Research
Martha Peyton, Ph.D.
Managing Director
Edward F. Pierzak, Ph.D.
Managing Director
Fabiana Lotito
Senior Director
The recovery in US commercial real estate that began in 2010 has been helped
along by a very constrained pace of construction. Of the four main property
types, only the apartment sector is generating supply inflows in line with
historical norms. But, as vacancy rates continue declining, accompanied by
increasingly strong credit availability, the stage is set for an upswing in
commercial construction. The specter of cranes on the horizon cannot be far off.
For investors, the key question is the potential impact on property investment
performance as construction returns. With this in mind, this report examines
the concept of “supply discipline” for US office markets and its relationship with
total return performance. The analysis shows that the “discipline” associated
with the best investment performance is composed of a combination of strong
demand growth that produces significant absolute rent growth and just enough
new construction to preserve that rent growth.
Market Discipline
Commercial real estate investors are likely to agree that “supply-disciplined” markets are
preferable locations to markets without supply discipline. Yet, when pressed to offer a
technique for identifying supply-disciplined markets, many are unable to do so, as their
assessments are often based on experience and intuition. In essence, investors know a
supply-disciplined market when they see one, but they have difficulty defining the concept in
a technical sense.
So, what constitutes a supply-disciplined property market? A simple definition is a market
where new construction has historically responded in a lesser, yet aligned, manner to
demand. This alignment can be measured technically using a metric from introductory
economics called the price elasticity of supply (PES).1 PES measures the responsiveness,
or elasticity, of a quantity supplied to a change in price. It is simply calculated as the
percent change in quantity supplied divided by the percent change in price. This concept
can be easily adaptable to the supply response in individual property markets. For PES
values less than 1, a change in price produces a lesser change in supply. In these
situations, supply is considered inelastic; a condition consistent with supply-disciplined
markets. For PES values greater than 1, supply is considered elastic; a likely situation for
markets that lack supply discipline.
Awaiting the Cranes: Supply Discipline & Office Market Performance
For the analysis described in this report, we focus on the office sector and calculate each
office market’s PES by dividing its average annual percent change in stock by its average
annual percent change in rent.2 The analysis includes only the nineteen metro markets with
full twenty calendar-year histories (1994 to 2013) for both CBRE Econometric Advisors
(CBRE-EA) and National Council of Real Estate Investment Fiduciaries (NCREIF) data.3
Figure 1 displays the PES values for the nineteen US office markets. The chart also shows
two horizontal lines that serve as breakpoints and allow for the assignment of each market
into one of three groups. Markets with PES values less than that of the US (roughly 0.5)
were assigned to the “low” PES group and those with values near or greater than 1 were
assigned to the “high” PES group; all other markets were placed in the “moderate”
PES group.4
Office Market Price Elasticity of Supply (1994 to 2013)
Figure 1
3.0%
16%
2.5%
2.0%
1.5%
1.0%
0.5%
PES=1.0 13%
High PES
Moderate PES
US PES≈0.5
Low PES
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Sources: CBRE-EA, as of 4Q13; TIAA-CREF
Perusing the list of markets in each PES group reveals few surprises; the results are very
much consistent with investor expectations for each of the markets. The low PES markets
include localities where new office construction is generally difficult for one or more
reasons. For example, limited site availability and long development approval processes are
clearly factors in both New York and San Francisco. In contrast, Atlanta, which is in the high
PES group, is physically unconstrained and relatively friendly to developers. Washington, DC
lies somewhere between these two extremes; it is physically constrained within the District
itself, but close-in suburbs with excellent public transportation do offer substitute locations
where building is easier.
The one market with an unexpected PES result is Houston. Real estate practitioners with
long memories will recall vacancy rates above 30% in Houston during the oil-bust years in
the late 1980s. Easy credit, plenty of open land, and an absence of zoning restrictions all
contributed to overbuilding even as demand waned. But, over the last 20 years, office
construction in Houston has moderated with an average addition to stock of approximately
1% per year versus the national pace of roughly 1.3%. Could it be that Houston has become
supply disciplined? A closer look at the annual data reveals that Houston’s average annual
supply growth over the last twenty years may be a statistical anomaly because virtually no
new office supply was delivered in the market for the first five years of the analysis, 1994 to
1998. Yet, even after accounting for this dearth of development activity, Houston would
continue to be categorized as a low PES office market.
2
Awaiting the Cranes: Supply Discipline & Office Market Performance
Discipline Pays
Conventional wisdom suggests that investing in supply-disciplined property markets pays.
But, does it? To answer this question, we examined the relationships between low,
moderate, and high PES market portfolios and total return. Using NCREIF data from 1994 to
2013, average annual total return performance for each office market was compared to
overall office sector performance and total return spreads were calculated for each market.
Positive spreads indicated portfolio outperformance; negative spreads underperformance.
Portfolio spreads were then calculated for each of the PES groups by taking the simple
average of each group’s individual market spreads. Figure 2 displays the average annual
total return spreads for the low, moderate, and high PES market portfolios.
Office Market Price Elasticity of Supply & Total Return Spreads (1994 to 2013)
Average Annual Total Return Spreads (bps)
Figure 2
150
96
100
50
0
-50
-11
13%
-100
-103
4%
-150
Low PES
Moderate PES
High PES
Sources: CBRE-EA, as of 4Q13; NCREIF, as of 4Q13; TIAA-CREF
It is not possible to invest in an index. Performance for indices does not reflect investment fees
or transactions costs.
The results reveal a pecking order across the varying degrees of supply discipline. As
expected, the low PES, or “supply-disciplined”, market portfolio had the best performance;
its average annual total return spread was nearly 100 basis points. The high PES, or
supply-undisciplined, market portfolio had the worst performance, underperforming by an
average of roughly 100 basis points. The moderate PES market portfolio underperformed,
but the average result was near zero, suggesting performance comparable to that of the
broad office sector. The results indicate that, on average, supply-disciplined markets have
historically outperformed; markets that lack supply discipline have underperformed.
Tell Me More…
But, this categorization alone is not a basis for making investment judgments because not
all markets within a particular PES group offer equivalent attractiveness. For example, with
its historically limited supply and modest rent growth, Hartford, CT would be considered a
low PES market.5 But, despite its low PES value, Hartford lacks broad appeal for real estate
investors. Its supply discipline is not enough to compensate for its shortcomings which
constrain the demand for office space.
3
Awaiting the Cranes: Supply Discipline & Office Market Performance
Differences across markets are illustrated in Figure 3. For the low PES portfolio, all of the
total return spreads were positive, indicating market outperformance, but portfolio
performance was primarily driven by New York and San Francisco. For the high PES portfolio,
market performance was consistently bad with the exception of the high growth markets,
Austin and Seattle. For the moderate PES group, markets were equally split between
outperformers and underperformers. In all, there were 6 markets that can be viewed as
significant chronic underperformers: Philadelphia, Chicago, Sacramento, St. Louis, Atlanta,
and Minneapolis. All of these markets underperformed the broad office sector, on average,
by more than 150 basis points per year over the last 20 years.
Individual Office Market Average Annual Total Return Spreads (1994 to 2013)
Figure 3
300
255
Low PES
200
Moderate PES
159
131
128
103
100
31
51
24
49
9
0
-9
13%
-100
High PES
190
-88
-200
-174
-188 -192 -194
-230
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Sources: CBRE-EA, as of 4Q13; NCREIF, as of 4Q13; TIAA-CREF
With chronic underperformers in both the moderate and high PES groups, there is obviously
more to the market supply discipline story that needs explaining. To explore this view, Figure
4 plots the components of the PES calculation, average annual change in stock and average
annual change in rent, for individual office markets. Each market is identified along with its
average annual total return spread in basis points over the last twenty calendar years. The
scatter plot also displays the lines that correspond to the breakpoints for the groups. The
purple line shows all points where PES values equal 1; the blue line shows all points where
PES values equal the US value, roughly 0.5.
4
Awaiting the Cranes: Supply Discipline & Office Market Performance
Average Annual Percentage Change in Stock & Rent (1994 to 2013)
Sources: CBRE-EA, as of 4Q13; NCREIF, as of 4Q13; TIAA-CREF
The complexity of the chart requires very careful examination which is rewarded with a clear
conclusion. Supply discipline is not only about the relative response of supply to changes in
rent as in the PES measure, it is also about the absolute response of supply to absolute
changes in rent. The metro markets enclosed in the oval are the 6 chronic underperforming
office markets; they include both moderate and high PES markets. In these markets, supply
responded to rent changes that were too weak to produce outperformance in total return.
In contrast, both Seattle and Austin are high PES markets where supply has been very
responsive to rent changes, but those rent changes have been strong enough to propel
outperformance.
These observations suggest that investors need to consider both supply discipline and the
absolute magnitude of expected rent changes in their market selection processes. The
latter encompasses all the factors that influence local economic vitality and demand
for space.
5
Awaiting the Cranes: Supply Discipline & Office Market Performance
Conclusion: Supply Discipline and Investment Decisions
We find that supply-disciplined office markets as a group have indeed produced stronger
investment returns versus the group of markets lacking supply discipline. This finding alone
justifies using supply discipline, as shown in the PES metric described in this report, as a
criteria for identifying attractive markets for investment. But, when individual metro area
market performance was examined, the story proved to be more complicated. The best
performing metro areas not only had disciplined supply relative to rent growth as shown by
their low PES scores, but also had stronger rent growth than other markets in an absolute
sense. On the other end of the spectrum, metro areas with weak absolute rent growth
produced much less attractive investment performance even when supply elasticity
was moderate.
These results validate the process that we use for selecting target markets. In that process,
we focus on metro areas that have historically demonstrated supply discipline combined
with strong demand for space. Supply discipline alone is not enough.