What does 2021 have in store for commercial real estate? With enough data and the right way of making sense of it, you can actually create a crystal ball to see where you can get the most bang for your buck in the years to come. Joining Chris Larsen in this episode, Dr. Glenn Mueller shares his knowledge of real estate cycles and how we can use them to better predict how the real estate market will perform. He discusses which sectors will perform best in the future, how interest rates relate to cap rates, and whether or not offices are going away. You can hear all this and get more information at du.edu/burns-school. You can also get his new book “Educated REIT Investing” at https://www.amazon.com/Educated-REIT-Investing-Intelligent-Investor/dp/1119708699https://www.amazon.com/Educated-REIT-Investing-Intelligent-Investor/dp/1119708699.

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What Does 2021 Have In Store For Commercial Real Estate? With Dr. Glenn Mueller

Learn How To Predict The Future Of Real Estate

We have Glenn Mueller, PhD. He has 44 years of real estate industry experience including 37 years of research. He’s internationally known for his market cycle research and that’s why he’s on the show. After I heard him at a conference in Keystone Resort in 2020, prior to COVID even starting, I knew we had to share what Dr. Mueller has to say with our audience. Dr. Mueller is a Professor at the University of Denver’s FL Burns School of Real Estate and Construction Management as well as the Real Estate Investment Strategist at Black Creek Group. He’s an Advisory Board Member at The Arden Group, former Chairman of the Board for European Investors REIT Fund, and a twenty-year visiting Professor at Harvard.

You’re not going to want to miss this episode because Dr. Mueller shares how you can take data and use it to create a crystal ball to determine what are the best areas of real estate to invest in, where we are in the market cycle, and how you can get the best returns for yourself and your portfolio. He’s also going to share where we are in this market cycle. He’s going to talk about industrial and apartment buildings, whether we have too many apartment buildings or not enough, and then the question in a lot in people’s minds, are office spaces going away? Should we have more office space? Should we have left off less office space? What should we do with the office space that we have now if anything at all? I urge you to check out our YouTube channel and that’s going to allow you to see the presentation with Dr. Mueller’s slides. You can also download them from the University of Denver website. Join us for this data-packed special episode as Dr. Mueller joins us going into 2021 to tell us where we are in today’s market cycles.

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Dr. Mueller, welcome to the show.

I am glad to be here.

We first met out at the Best Ever Conference in 2020 before the whole pandemic started. I will tell you, over the course of two days, I was most impressed with your presentation. I love market cycles. I talk about that in my book and my experience of watching my parents lose their jobs. I would love to get your take on what you think of 2020 as a whole, and how the pandemic has affected the current cycles before we talk about what the future holds for us.

I’m a professor at the University of Denver and I’ve been doing this for a long time. I started looking at the market way back in 1990 when I was with Prudential Real Estate Investors. The things that drive a real estate cycle are the economy and supply. I want to show that as we go. Population growth, people use space and that drives demands for real estate GDP growth. It determines how much space they’re going to use. We’re looking at a pre-COVID forecast here where you can see that it used to run about 2% and as expected.

It was passed to continue on that same glide path for many years going forward. That was a great trajectory but we’ve been through economic ups cycle and COVID shut that down. Although what we’ve had as you may have heard the term a K-shaped recovery. A V-shaped recovery is down and bounce right back up. A U-shaped recovery is bounced to the bottom, sit there for a while before recovering. K is a combination. We have COVID essential businesses that get to stay open and keep working and not essential, which have been closed down like retail restaurants and those types of things.

We did have a V-shaped recovery with GDP dropping 2% in the second quarter and then bouncing back 34% in the third quarter. If you go down to 32%, you got to come up 37% to get back to its place. We have all these people in businesses that have not come back yet. That’s the bottom flat line. Take a V on top of a flat line and you have a case on the cost side. The most important thing is employment growth. In employment growth, we’ve lost millions of jobs that may never come back and smaller dozen restaurants closed. Those people have to be redeployed into the workforce someplace else. The COVID drop there was probably going to be more of a U-shaped recovery. If we’re lucky, the vaccines do take over and help us get back to where we’re going.

On the cost side, we always look at inflation. Inflation bounced around a lot since the recession bottomed out with a negative number back in 2010. It has averaged about 2%, so expect that to be probably a little more than that. I’ve got COVID haves and have nots in there. If you look at the construction industry, lumber prices were up 16% for a while. Now, they’ve backed off to about 20% building supplies and labor have been hard to come by. Demand there is strong but restaurant and retail workers, a lot of them lost their jobs and many may never come back. Income-producing real estate, I use that term versus commercial because I include apartments in there.

You’ve got the five major property types office, retail, multifamily, hotel and those are doing well. The ten-year treasury is how we benchmark mortgage in the commercial real estate world. You can’t get a 30-year mortgage on an office building. Ten-year treasury is a graph through 2019 with an expectation of interest rates increasing but as you should all know, the current rate on the ten-year treasury is around 8/10 of 1%. That’s sub 1%. That’s probably going to continue for a while going forward because people are trying to put their money in real estate places. That means that we have the lowest rates on home mortgages and commercial properties that we have ever seen since we started collecting that data. That’s one bright spot on what we’re seeing going on there.

With respect to interest rates, we’ve seen historically low-interest rates typically when you mentioned apartments, which our audience is accustomed to. The cap rates, a lot of times, are trading with an abandoned that tenure. Is that accurate?

No. We always look at the spread over the ten-year treasury on cap rates and it is at a reasonable rate. You’re talking that’s if you’re the best departments in the country class and in the big metro areas, they’re probably in the 3.5% cap rate range. In certain markets, they are probably in the 4% to 5% range in third-tier markets. Class B or C might be in the 6% to 7% range now. Is that what you’re finding?

You’re spot on there.

If everybody’s looking for a yield or looking for income, that’s a good income. The new question is and the new data that’s being collected is the rents, are you collecting that? A new statistic that’s arisen in 2020 is what percentage of rents are you collecting? Fortunately, in the apartment world, that number has been high. It’s been in the low to mid-90% range because people are now stuck at home in their apartments and the government relief money and unemployment money allows them to pay their rent so they can stay in their apartment. When that ends, if we don’t get another stimulus package going here, we see that in the restaurant or in the retail industry. That number dropped when COVID, when all these things got shut down to 30%, it’s risen back to about 50% to 55% now but it’s low. It has become a new statistic to watch.

Here we have in the US economic cycles physical cycle and a financial cycle, but we’re looking at occupancies, rents, and property types as three key things to look at. Demand and supply drive occupancies, occupancies drive rent growth. Occupancies plus rent, give you the income that you’re going to get off your property. That’s local in nature. My cycle graph shows you that we go through, historically, cycles in real estate that have been around seventeen years. Our recovery expansion, hyper supply, recession phase. It’s nothing more than a vacancy graph turned upside down. At the bottom points, 1, 2 and 3 down, negative rent growth, finishing out the recovery at 4 or 5 and 6 rent growth but below the rate of inflation, above 0.6, which is the long-term average.

Rents rise rapidly towards 0.8, which is green, which is the go signal for cost feasible rents. They cost $400 a square building a new office building. Investors are looking for a 10% rate of return. Ten percent of $400 is $40 a square foot. That’s got to be the rent in the marketplace to the cost-justify building. We can’t turn the widget machine on and produce that overnight. It takes a while for supply to catch up with demand. When they’re both growing at the same rate, you probably remember back to Econ 101 class that that’s demand and supply equilibrium in the marketplace. We would love it to sit there for a long time. It typically doesn’t. Either supply starts to rise above demand as we build a little too much or demand drops off because of recession as we’re going through now.

Occupancy starts to fall off, rent growth slows down. We go back through the long-term average and get low and negative rental growth. The study that I did many years ago shows the negative rates at the bottom, at the long-term average, this study from 1968 to 1997, 4.6% rent growth was about the rate of inflation. In the expansion phase and the green box, you see strong rent growth with the highest rent growth of 0.10. We peak out at 0.11, rent growth slows back to inflation at 0.14, low and negative to the bottom. What I do is I look at all the major property types and where they are in their cycle, but the more important thing is knowing where your market is while the national average for office, maybe at 0.7 on the graph. What you see is cities are spread all over the map.

The reason for that is every city has a different economic driver or what we call economic base industry. I make a quick example here of two cities in Texas. We got Houston, the only market in a recession. Why? Houston’s main economic driver is the oil. With low gas prices that we’ve had for many years, they’re not growing. They’re not adding people. They are not exploring for more oil. As they lay people off, there’s less demand for office space. Contrast that with Austin, Texas. Austin is one of the tech markets. A lot of companies moving there because they can get employees, but Austin is over the top in the hyper supply phase. Not because demand is slowing down but because they’ve always supplied it because of 3 or 4 years of strong tech growth. Demand for office rents rose and developers are putting up new spec office space. They’re putting up a little too much. There’s a difference in what’s happening.

This is my favorite graph that you showed when I saw this presentation here before. This is about every 17 to 18 years. Touch on that. Why are we looking at that 17 to 18-year point typically? How far back in history has this gone?

The data that I have goes back to the mid-1970s. We can see that cycle going along. Nareit got an excellent slide that I’ve got in here showing the seventeen-year cycles and how they go along. That was the reason for the 17 points that you see on this graph. Some are a little longer or a little shorter but on the average. If it was a normal cycle, you’d see the cities marching through these one at a time. What we’d love to see are cities just hanging out at peak occupancy equilibrium all the time. We put up what we need, life is good, rents grow at a rate that’s higher than inflation. That would be awesome.

One of my favorite books is The Secret Life of Real Estate and Banking. I read that several years ago. They talked about data going all the way back into the 1850s. They talked about an eighteen-year cycle. If you look at adding that extra 120 or so years, it seems to continually line up generation after generation.

It’s a demand and supply cycle that we work with here. Every property type is different though too. Here’s the demand for industrial coming from online sales, and manufacturing has picked back up in the United States. You see a lot of markets at that peak equilibrium, number eleven. A number of markets now are at hyper supply because there’s been so much demand, we’re putting up a little bit too much space. The other thing is if we take industrial and look at it closely, bulk warehouse is going crazy. Amazon leased 25% of all warehouse space in the United States in 2019. They hit 1.2 million employees. They’re hiring 1,000 people a week. It’s been unbelievable. In some markets, we’re putting them a little bit too much space.

In other cases, when you look at the R&D flex space, it might be a guy who was running a little auto repair shop. He’s got a little office upfront that you walk into but a big garage door in the back to pull the cars in. You see a lot of small businesses that sell specialty items that distribute them through that system. One great example of that is the airports. The Denver Airport employed 40,000 people. When everything shut down, all the restaurants are closed, all the retails are closed, the warehouses that were daily supplying goods to that airport suddenly are needed at the moment. We’re seeing clients in a specific COVID have not sector that’s going on.

If we go on to apartments demand is great. The Millennial generation is coming of age getting their first job, renting an apartment and things are looking good. A lot of markets at the peak but a lot of markets are over the top because it’s the one property type that’s easy to build and oversupply. One new thing that’s been happening is since COVID kicked in, and this goes with a lot of my grad students. They were living downtown paying premium rent, having a teeny little 400-square-foot apartment but in a building that had a commercial kitchen, big gym, swimming pool, all kinds of game rooms and bowling alley, every amenity you can think of. When Covid started, it all shut down and they’re stuck in this 400 square feet. They used to go out to dinner every night, now they can’t. Many of them, when their leases came up, they moved out to the suburb at three times the space for the same rent or rented a house. The single-family home rentals have gone off the charts. We’ve seen a move from downtowns to the suburbs. The question is when COVID is over, do they move back downtown? We don’t know how that will work out.

You may be bringing this up here shortly Dr. Mueller but this is one thing we’ve seen. We focused on garden style, suburban, secondary markets for the past seven years. They’ve been outperforming versus the urban. The other difference we’ve seen is collections. We’ve seen the higher quality of collections almost unchanged since spring. Whereas some of our affordable housing communities are collecting on the lower end of what you were saying, the low to mid-90s. We’re seeing around 90% there.

I would say it’s a difficult time for the people that are living week to week, paycheck to paycheck. The question is how do we bring those people who typically don’t have good educations or skillsets? Restaurant workers, retail workers, etc. How do we get them back into the productive act? That’s the real challenge that COVID has thrown out to us. That’s hard to go by, so that’s the haves or the COVID have-nots.

On this chart, supply growth is used to be up in the 3% to 4% range bottom in the early ‘90s, around 0.5% pop back up by 1,000 a little over 2%. Now, in most of the property types in 2010, we’re running around 0.5% and come back up except for apartments because it is easy to build. You can fill a brand new apartment. I’ve taken away from older apartments too just by driving back. You may not make as much money, but we have this demand growth from Millennials that continues. Some of them did go home for a month or two because of COVID, but they quickly decided to move out and move back. Here’s the data going back to 1980. Peak in office, back in the ‘80s, bottom in the early ‘90s, a peak in 2000, bottom in 2003, when the tech bubble burst another peak in 2006 and 2007, bottom during the great recession ‘09, ‘10, but nice moderate level that was 2018 and 2019. We expected that to continue. Surveys say that 85% of people say they’d rather be back in an office than working at home.

You have to distance in the office. We were cramming them down to be 3 feet apart. If we have to do 6 feet like our office in Black Creek that I work in, people were sitting 3 feet apart. One team goes in one week. One team goes in the next week so that they’re sitting 6 feet apart. We did stop. Our lease was coming up here at the end of the year. We’re going to move into a brand new space and put that on hold. We did a two-year extension on our existing lease until we figure out what’s happening. Big companies are now talking to architects about how do we design the new post COVID office? What does it look like? How does it work? People are social animals. They rather be speaking in front of the audience with you here, as we did at the Best Ever in Keystone than doing this online because it’s lonely. Everybody can talk about what benefits they got not being at home, but then what are the losses that we’ve had from that standpoint?

This has been a huge question with the office group we work with. Our office is going away. I can’t imagine them going away entirely. I’m super excited to see what you’ve got here for us.

The answer is no, they’re not. I expect we’ll see somewhat of a decline in demand over the next couple of years. You see all the office markets in the hyper supply or the recession phase, forecast out here in 2021. If we look at industrial, the highest occupancy levels since 1980 for industrial, expect that to slow down a little bit. The office occupancy drop-off a little bit as we oversupply a little bit, but notice that if rent grows over time, and this is both pluses and minuses added together, rents are up 40% since we started having this data in 1995. You can see the correlation between the occupancy level and the rent growth is 79%.

If you tell me what’s going on with occupancies, I can tell you what’s going to happen with the rent growth. A lot of markets are in the hyper supply phase, mainly because of overbuilding, not because of a lack of demand. The demand there is strong. If you can get an industrial property, you’re most likely going to do well. Apartments, we had a peak back in 2014, overbuilt a budget, slowed that down. We had another peak in 2019 and this is the pre-COVID forecast. Over supply is coming on and we’re seeing many of those buildings taking a pause because most of them were downtown. We’ve seen that shift. Suburban apartments are doing better on occupancy level-wise than downtown. Suburban rent growth were able to pick up because you had this people in downtown paying a lot more rent saying, “This is a decent deal.”

You’re able to push rent slightly in the suburbs where you’re offering more space. It is an interesting time there. Once we settle in after the end of the year, we’ll work with some of these. Most of the markets are in the hyper supply phase with some markets still peaking. We’re also seeing people moving from major markets. San Francisco is one of the biggest ones, all these tech people who were tough to get to downtown. The two-hour commute for some of these people and they worked on the bus for hours to get to work. They’re going, “Why do I want to live and pay this huge rent in this teeny little apartment in San Francisco when the company says, ‘Go work from any place?’”

They’re moving to nice places. Here I am in Colorado and it is growing like crazy outside now. We’ve been redub a Zoom town because all the people that have come up here from Denver, all of a sudden at night, I look out and 50% are more lights on than I used to see at this time of year. People are going to other places. Whether they stay or not is one of the questions or whether they might go to urban areas. Once this is over, it will be interesting to see.

There’s a real dichotomy. The theme for now has been the K-shaped recovery. You have this dichotomy with apartments. It seems like urban has been stagnant. You’ve had an oversupply, whereas suburban rent growth has persisted. How have you seen supply in 2020? In my book I talk about how we need four million units to come online. I feel like with lumber prices with the pause in building, how do you think that pause is going to affect the supply in the next couple of years?

There hasn’t been a pause. What’s getting done is a lot of the construction labor was sucked over to the single-family home marketplace where people are now at home. They want things done. I finished rehab in Minnesota on a lake near my grandkids. Good contractors were either nine months to a year out to come and do something for you or quadrupling their price. Now, it’s going to cost X for many. Construction demand is off the charts and gets things built are doing well with it. We’ll see where that goes. The demand is there and as long as those Millennials can get a job, they’re going to be using apartments because the average age of a first-time home buyer in the United States is still 36 years old.

The demographics got it.

Retail, it’s a COVID have versus a COVID have not, COVID essential businesses, Lowe’s, Home Depot, Walmart, grocery stores are off the charts. They are expanding and doing all kinds of stuff. Amazon is opening their whole new grocery concepts and stuff like that, 200 stores in 2020 with zero contact. You have to scan with your phone and walk out kind of thing. It’s a crazy time but a lot of demand decline. We’re going to have to figure it out. As a matter of fact, it’s a great place to think about investment as adaptive reuse. What do I do with this empty retail space? Can I turn it into apartments? Can I turn it into office space? Do I turn it into a closed-in a warehouse? There are lots of concepts there. That’s the capital side of real estate. How much time do we have left? Can we talk through some financial flow stuff here?

Absolutely. We can extend this because this is a special episode. A little thought there, coming off that, talking about converting retail. One of the areas you don’t talk about is senior housing but I feel like as the Boomers start to get older, we’re going to have a real demand for that versus the decline of the malls. I’ve seen that there are companies going out and acquiring malls and converting them to senior housing. That’s easy because that’s where those seniors walk around inside anyway. You can live there.

That’s the kind of adaptive, reuse and creative. That is needed in the marketplace now. That stuff is good. That’s where keeping your pulse on trend changes and where demand is a real key to success. The financial cycle is capital flows affect prices. If everybody wants to put money into some kind of investment, prices are going to go. We’ve had a slow down in the economy. We’re in new highs in the stock market every day because the world is awash in so much cash. It’s got to go someplace. Bond prices are unbelievably high and yields are unbelievably low. Where do I go? Did I yield on the S&P 500 in all of 1.4%?

The dividend yield on a ten-year treasury is now 0.8% and junk bonds are down close to 2%. Real estate by comparison ends up looking like a real winner. In the capital cycle, the black line follows the blue line but little or no capital flowing in at the bottom grows quickly as rent growth turns positive peaks out in hyper supply and drops off. Two types of capital flowing. One is two existing properties. You buy a property for me for a higher price and that’s more capital flowing into real estate. The other one on the bottom there, capital flows to new construction. It starts at that cost feasible rent level at 0.8% and we start building new buildings. They may not get finished until close to the bottom on the other side. If we look at income-producing real estate in the United States at $18 trillion compared to stocks and bonds, it’s 22% of the investible universe.

All the big institutional investors, pension funds, endowments, wealthy families, etc., they are all allocating to real estate because they look at it as a good yield investment. The ten-year treasury is 2% back in 1953. Now, we’re at below 1% and this forecast is wrong. I think we’re going to stick by 1% for a while. If you buy a bond and interest rates go up, you lose principal. Between 53 and 73, when it hit its long-term average of 5%, 7%, the total return was only 1.9% and between ‘53 and ‘81, the return was only 3.9% when the average yield is 5.7%. When interest rates are going down, the total return is higher because your bond value goes up even though the average rate was 5.7%. It is looking bad there.

The downside risk is real estate only had five years of negative returns versus over 24 months. Capital flow and this is the commercial real estate. You’ve all probably seen in the papers and stuff like that. The Case–Shiller Home Index that talks about housing in the United States and where it’s going. We have the same thing for commercial real estate. It’s called Moody’s/Real CPPI put out by Real Capital Analytics. You may want to go to their website, RCAnalytics.com. They started collecting data on every commercial transaction over $2.5 million. You can see capital flow transactions of $20 billion in the first quarter of 2001, $160 billion for 2007, during the great recession, only $15 billion in 2009 and back up to over $160 billion starting as early as 2015, and continuing on now, and then the price index there as well.

If we break that down by property type, you can see here that apartments are 183% or 83% higher than they were at their peak in 2007. It came down and they bounced right back up. Retail still hasn’t fully recovered. Industrial is 34% higher than it was. The downtown office is 39% higher. The office is only 4% higher. By property type is different and then by the market will be too. Cap rates in 2000 used to be in the 9% range. Now, they’re running and this is average high quality versus low, strong cities. We’ve got apartments with an average of A, B and C qualities under 5.5%. The others are in the 6% range in the hotel. This is pre-COVID at 8.5% or 9%. They’re way off the charts there now. How much extra income am I getting over the risk-free rate of a ten-year treasury? It used to be 3.5% back in 2001. It was only 150 basis points in 2007. Now, it’s up there at 3.5% to 7% so real estate looks attractive relative to the other incomes that I can get in. That’s why we’re seeing capital flowing into real estate now.

To me, that’s the money slide there. That’s going to give you the best apples to apples comparison.

When we look at it, what’s happened is in my decades in this business, real estate was local. Local buyers, local sellers, and local banks doing the financing back in the ‘70s and the ‘80s. The institutional investors funding endowments came in, national buyers, national sellers, national financing development. In the ‘90s, the publicly traded companies, REITs took off. We had real estate and access to the public capital markets through the REIT stock idea, and on the debt side through commercial bridge back securities. Since the year 2000, it’s gone global. Since I mentioned publicly-traded REITs for that matter, non-traded REITs, I finished a new textbook called Educated REIT Investing and you can get that on Amazon.com. It’s only $28.

What’s happened is this shows capital flowing across the world in 2019. What you see here is the United States investors put $11.8 billion into Germany, which was a 27% increase over the previous year. German productivity is strong, good market, etc. Number four, Germany going into the United States, $5.2 billion down 1% from the previous year. Money’s flowing around the world. My best example was in 2019, the most expensive building selling in the United States was an office building in New York City. It went for a 3.5% cap rate. That same class building in London would have gone 2% cap rate. In Hong Kong or Singapore would have gone for a 1% cap rate. An Asian investor in US goes, “That’s 75% off the price. I would be paying here. I’m going to get a lot more income.”

That international capital coming to the United States is helping to keep our prices up. The international people are pushing the US pension funds and endowments into second-tier markets. When they move in, the family offices and the smaller investors like you or me, we moved down to the third-tier markets to gain that extra yield that we’re looking for. I’m bullish on the fact that real estate should hold up and do well. Demand for it by investors is strong and capital is flowing in. All these real estate cycles can be long or short. We’re in a down cycle now that looks like it may have bottomed at the end of the second quarter.

In 2002, we started to bounce back up. We got a V and then we got a flat K so you got to be careful about the COVID have and the COVID have-nots as far as the tenants in the buildings. You’ve got to watch for that. Supply is low and how long to recover. A lot of people are saying employment will be fully recovered until 2024. It is a slow recovery for us, slower than in past times. Debt financing is hardly at all live now too, which means cash is king. The more capital you got cash, the better opportunity you’re going to have to be able to buy stuff from that standpoint. Keep residential homeownership separated from commercial real estate. Residential home prices have also gone berserk because of low-interest rates.

In my book, I talk about the differences between that income-producing and most of our audience are accustomed to that but it’s amazing. You were talking about your rehab. My wife’s a residential architect and she’s doubled her prices. She’s booked out 2 to 3 times as long as she’s ever been. Regarding the presidential election, I don’t know if we have an answer yet. Who is going to be our next president? There are still some question marks out there but let’s say Joe Biden is our next president. Any ideas on how his policies may affect the commercial real estate market?

I think it’s also down to the two Georgia elections. If we have split politics here, that means that a lot of the higher tax policies don’t get pushed through. There are a lot of people that need it badly though. I think that have come, in case. A lot of people talk to me about, “Why don’t you worry about being so much more for the US government. They got $1.6 trillion in cash in the treasury now.” My answer is, “No, back in 1980, when interest rates were 15%, it took 18% of the federal budget to pay interest on the bonds they had outstanding.” Now, it’s only 8% of the federal budget. In other words, you can afford to borrow more when interest rates are low.