July 5th, 2012 Home
Cohen Asset Management Letter to Investors
We are pleased to provide the following report for the year ending December 31, 2010.
We are living through revolutionary times. Spurred on by Facebook and Twitter posts, citizens of Egypt pushed out their long-term leadership. The combination of a young, unstable demographic (70% of the population under 30), these new communication tools and inflationary pressures in food and energy prices has made for a volatile start to 2011. With other regimes in the Middle East facing similar pressures, there is a growing sense of unease in the global capital markets especially with regards to potential impacts on energy prices.
While not completed in response to the economic risks presented by turmoil in the Middle-East, the merger of AMB and ProLogis is also revolutionary. The scale of this transaction will lead to the development of a publicly traded REIT entity with an estimated value of $14 billion of industrial real estate assets. The world has never seen such a concentration of industrial real estate assets and this transaction was in part possible due to a revolution in the thinking of institutional investors who have come to accept the industrial property sector as a stable source of income.
Growing concerns about turmoil in the Middle-East and energy markets aside, but for jobs, signs in the economy suggest that we are now at the end of the period of economic uncertainty or limbo that we experienced since the official end of the recession. It is a limbo in the sense that 2010 was a period in between. There was the outright recession where jobs and production were being cut and economists were noting that a full-fledged recovery with both expanding production and a strong pace of job growth was on the way. Production has definitely recovered, GDP is growing nicely but job growth is still anemic with only 1.1 million jobs created in 2010, well below the pace of growth in the labor force. The U.S. economy will be in a true recovery once this pace of job growth steadily and reliably begins to increase at a pace of 150,000 to 200,000 new jobs per month.
Moving forward, it is anticipated that international trade will help to drive this recovery in job growth as well as driving industrial demand in the U.S. industrial markets. Our research providers expect that this period of limbo should transition to a full-fledged recovery towards the end of 2011 into the beginning of 2012 with the U.S. dollar in particular playing a key role.
The greenback’s long-term weakness against our major trading partners, coupled with recent increases in productivity, should continue to make U.S.-manufactured products competitive within the global landscape, thus pushing exports, creating jobs and, in turn, expanding industrial demand. The ongoing economic recovery of our major trading partners, on the other hand, will provide an additional lift. According to CBRE-Econometric Advisors (“CBRE_EA”), East Asian countries, in particular, are expected to expand at more than 4% in 2011.
The remarkable manufacturing recovery has been one of the brightest spots for the domestic economy over the past year. Although the job market remains weak, employment within the manufacturing sector continues to increase. During the recession industrial production fell by 18% and manufacturer’s capacity utilization fell from around 80% to about 65%, however, since the recovery began, both have seen impressive recoveries. Industrial production is up 11% from its pre-recession low, while current manufacturing capacity utilization at the end of the year was over 73%. Still, more improvement is needed before we return to healthier pre-recession levels as manufacturing job growth will not increase at the same pace as seen in 2010 unless capacity utilization increases to the high 70% range.
All of this notwithstanding, recent European sovereign debt issues in Greece and Ireland (with Spain and Portugal not totally out of the woods yet) placed downward pressure on the Euro during 2010. This pressure created a short-term impetus to our Euro-zone imports and limited U.S. exports. As consumption in the U.S. continues to focus on foreign manufactured products trade will continue to play an important role in the industrial real estate market’s short-term outlook.
Despite the period of economic limbo experienced in 2010, the industrial real estate markets were clearly on the path to recovery in the second half of the year. Demand for industrial space was negative through the first half of 2010 but net absorption turned positive in the second half in many of our Target Markets. With industrial real estate construction just about non-existent in many markets in the U.S., this trend has generated declining availability rates throughout the nation, standing at 14.3% at the end of 2010. Availability peaked at 14.6% in mid-year 2010 and, for purposes of comparison; the previous high-water mark was 11.9% in 2004 as a result of the recession that followed the Internet boom.
With the nation’s manufacturing industries firmly in a recovery mode, representative companies have begun to use up spare capacity. With the record low capacity utilization during the depths of the recession, a large amount of industrial real estate shadow space was created within the manufacturing industry, and this shadow space needed to be worked off before firms would start to demand space again; which we began to see during the 4th quarter of 2010.
As we have previously mentioned, construction remained very low to non-existent during 2010 which is helping to drive the nascent recovery in market fundamentals. The stock of industrial space grew only 0.1% in 2010. By contrast, in the boom period from 2004 to 2008, the stock of space was growing 1.5% per year.
Half of the major markets in the U.S. saw no construction at all in the final quarter of 2010, including markets such as Los Angeles and Dallas. At this point and time during the recovery, these low construction figures are a beneficial feature of the industrial real estate asset class as this sector is characterized by a fairly quick delivery framework that, in good years, can deliver all the space needed in a robust and growing economy. However, as we have seen, in a period of economic slack, construction can pull back quickly which can help market fundamentals stabilize such as rental rates and availability of space; which we have started to experience.
However, despite improving fundamentals, particularly during the second half of 2010, only a few markets reported rental growth for the year. Most tenants took advantage of current market conditions to lease-up high quality, modern space at favorable rental rates. Newer space in most of our Target Markets reported positive absorption every quarter during 2010 while older non-functional properties showed considerable weakness. The worst performing markets during the year were the usual suspects led by overbuilt markets such as Las Vegas and economically depressed markets like Detroit and St. Louis, markets we are not invested in.
Today, pricing power in lease negotiations is definitely moving in favor of the landlord with fewer concessions such as free rent being offered to tenants and tenant reps having a more difficult time achieving a very favorable outcome for their clients. The leases we are structuring are distinct in that they have a high component of credit with an embedded growth opportunity which should allow for an increase in Net Operating Income in coming years. Looking forward, in our Target Markets, we expect rents to begin growing consistently on a quarterly basis by early 2012. Despite the resumption of rent growth, elevated availability rates will keep rental growth in the market from accelerating swiftly as a large volume of transactions will be needed to reduce the stock of empty industrial space, which established a record high in the wake of the recession. Based on the research providers that we engage we do not expect industrial rents to reach the pre-recession peaks until 2015 however, there will be a great degree of variation among markets. Keep in mind there are factors that will most likely change this forecast although we do expect rental growth to recover first in a number of high-tech markets such as San Francisco and San Jose, as both domestic and global demand for technological goods remains buoyant. Among the laggards in rent recovery will be markets at the epicenter of the housing crisis, such as Las Vegas, Phoenix, and Detroit.
Capital Market Situation
As we have previously mentioned, the merger of AMB and ProLogis is expected to generate a new industrial real estate entity with an approximate value of $14 billion. At such a level, this new entity will be worth more than the entire value of all industrial properties traded during the 2009 recessionary trough.
The investment market picked up dramatically in 2010 with total transactions nearly doubling from 2009 levels to $16.2 billion. As transaction activity was returning throughout 2010, the trend in asset values moved in step. As one of the measures we look at, sale prices for industrial real estate assets across the U.S. averaged roughly $55 per square foot in the 4th quarter of 2009. In 2010, this figured climbed 11.2% to just over $61 per square foot. Cap rate compression helped drive this price increase with a fall from an average of 8.7% to 8.3% between the 4th quarters of 2009 and 2010.
Looking at this increase in prices and change in cap rates, clearly part of the change in capital markets activity was a function of the type of assets investors were buying in 2010.
Trading in high quality core assets in core locations was the order of the day in 2010, and as we begin 2011, with more secure income streams in place for those assets that did trade. Consider for instance the average sale price of $55 per square foot in the 4th quarter of 2009. A cap rate of 8.6 percent on this price implies a monthly net income of 39 cents per square foot for the average industrial asset sold. With a cap rate shift down to 8.3 percent, this 39 cents of net income would only generate a value of $57 per square foot. So $2 of the price increase in 2010 came from investor interest in the sector overall. The remaining $4 in pricing came from the fact that higher quality buildings traded with net income in place averaging 42 cents per square foot in 2010. But the actual cap rates for well leased high quality assets in core locations is expected to trade closer to a 5 cap by the end of 2011. We were involved in an acquisition in Baltimore last year which traded in the low 6 cap range and are involved in a transaction which is expected to close in the second quarter in the mid 5 cap range here in Southern California this year at a substantially
As the industrial market and the overall economy move on from a state of limbo, we must be careful how we define recovery. Yes, net absorption for the most part has finally turned positive and availability has declined for the first time in over three years. However, the markets had been decimated with the slack in the utilization of space and, overall rental recovery will take more time. Though the recovery will benefit from the current record-low construction levels, a tremendous amount of industrial real estate space remains empty. Given such current imbalances, it is worth revisiting the recoveries from the previous downturns. Following the 1990-91 recessions, sustained positive rent growth did not occur until the market had experienced five consecutive quarters of declining availability. After the 2001 recession, rent growth did not resume until after three quarters of declining availability rates. In sum, a recovery in demand is one thing, but the return of meaningful rent growth is something that will take additional time. As the economic recovery gains further traction and hiring expands across major markets demand for space will continue to increase, thus pushing availability rates further down toward long-term averages, which should result in long term sustainable rent growth in our Target Markets.
Bradley S. Cohen
Cohen Asset Management, Inc.