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Awaiting Cranes Office

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June 2014

TIAA-CREF Asset Management

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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NewHouston
York
LosSan
Angeles
Francisco
Oakland
Boston
Denver
Washington
DallasChicago
San
Orange
D.C.
Diego
Philadelphia
County
Austin
Minneapolis
Seattle
St.Sacramento
LouisAtlanta

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0.0%

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

-283

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New
SanYork
Francisco
Oakland
Los Angeles
Houston
Orange
Boston
Washington
County
San Diego
Denver
D.C.Dallas
Philadelphia
Chicago
Seattle
Austin
Sacramento
St. Louis
Atlanta
Minneapolis

n

Ne
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Yo
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-300

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)

Average Annual Change in Rent

Figure 4
5.0%
4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0.0%
0.0%

US PES≈0.5
Hou; +9

Low PES

SF; +159

DEN; -9

DC; +103

OAK; +31

NY; +255
LA; +24

BOS; +131

DAL; -88
OC; +128

PES=1.0

Moderate PES

AUS; +49

SD; +51
SEA; +190

High PES

PHI; -174
CHI; -230

SAC; -188
ATL; -194

STL; -192
MIN; -283

0.5%

0.5%

1.0%

1.5%
1.0%

2.0%

2.5%
1.5%

3.0%
2.0%

3.5%

2.5%

3.0%

3.5%

Average Annual Change in Stock

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.

 ee David Lynn, Ph.D., CRE, Bohdy Hedgcock, and Jeff Organisciak, “Supply Constrained Markets”, Real
S
Estate Issues, Volume 35, Number 2, 2010. This paper identifies the price elasticity of supply (PES) as a
useful, albeit not perfect, proxy for market supply constraints.
2
See David Lynn, Ph.D., CRE, Bohdy Hedgcock, and Jeff Organisciak, “Supply Constrained Markets”, Real
Estate Issues, Volume 35, Number 2, 2010. In calculating PES, this paper uses cumulative supply and rent
changes from 2004 to 2008.
3
Recognizing the linkages between CBD and suburban locations within a market, office markets are examined
in a broad context. Efforts to focus on market segments have the potential to create data mapping issues, as
well as suffer from limited observations. Furthermore, the CBD versus suburban distinction is not always clear
or relevant in some markets.
4
A degree of latitude was allowed in assigning individual markets to PES groups. As a result, the breakpoints
can be considered “fuzzy” thresholds.
5
The Hartford, CT office market was not included in the analysis due to its lack of a full twenty calendar-year
history in NCREIF. Using twenty-year CBRE-EA data, it had limited average annual supply growth (0.22%) and
modest average annual rent growth (1.36%), resulting in a PES value of 0.16.
Real estate securities are subject to various risks, including fluctuations in property values, higher expenses or
lower income than expected, and potential environmental problems and liability.
The material is for informational purposes only and should not be regarded as a recommendation or an offer to
buy or sell any product or service to which this information may relate. Certain products and services may not
be available to all entities or persons.
Past performance does not guarantee future results.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF
group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management,
LLC, TIAA-CREF Alternatives Advisors, LLC, and Teachers Insurance and Annuity Association of America®
(TIAA®). TIAA-CREF Alternatives Advisors, LLC is a registered investment advisor and wholly owned subsidiary of
Teachers Insurance and Annuity Association of America (TIAA).
© 2014 Teachers Insurance and Annuity Association of America-College Retirement Equities Fund
(TIAA-CREF), 730 Third Avenue, New York, NY 10017
1

C17484 
141002984

(06/14)

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