Over a decade into the expansion, commercial real estate fundamentals remain on solid footing, although ascendant property prices present a clear downside risk.
The U.S. economy passed an important milestone earlier this summer. July marked the 120th month since the recession ended, making the current expansion the longest on record. Ten years in, the economy remains in decent shape, as solid employment growth continues to bolster household income and sustain consumer spending. While household fianances are solid, economic growth is clearly moderating, reflecting the trade war, slower growth abroad and a persistent cloud of policy uncertainty weighing on business investment and manufacturing.
Commercial real estate fundamentals have largely mirrored this trend, with demand softening a bit and new development cooling across most property types. Even with the downshift, property prices remain at or near all-time highs, which is drawing increasing attention from policymakers worried that commercial real estate may be a potential source of contagion that would amplify a slowing in the economy and potentially deepen any subsequent recession. The Fed has cut interest rate 50 bps since July, and we expect an additional 50 bps of cuts, likely in Q4 and Q1-2020. These cuts will likely lift property valuations even further. Over the past 10 years the Commercial Property Price Index has risen more than 87%, and it rose 6.7% over the year through August. Ascendant property prices are understandable given rents are rising across the board and demand remains generally solid. The contrast between the rise in property prices and downshift in economic growth is nevertheless concerning.
The apartment market serves as a clear example. For much of the expansion, multifamily construction has remained strong and apartment property prices have trended higher, as developers have taken advantage of the seismic shift away from homeownership towards renting. Since 2007, the apartment property price index has risen faster than any other major property type and is 76% above its prior peak. Lofty valuations are arguably justified, given a modern-era low in apartment vacancies. New construction has also been skewed toward higher end urban/lifestyle projects, while suburban apartment development and workforce housing have generally lagged.
Undergirding the demand for apartments has been a strong job market, but hiring has lost momentum in recent months, reflecting growing caution in trade-related industries such as manufacturing and logistics. The slowdown has not been quite as apparent in the creative and knowledge-based industries, such as finance, tech and professional services, which we in part attribute to a still fairly robust pipeline of venture capital. These industries tend to cluster in the large gateway and secondary markets where there is an ample supply of highly educated labor, whose apartment markets have outperformed as a result.
The Bay Area, Boston and Austin have been clear benefactors, with apartment rents continuing to climb alongside a seemingly endless stream of venture capital funding, which supports many of the fastest growing industries in these markets. While employment has held up relatively well, some high profile Initial Public Offerings have run into trouble, which might be a harbinger of tougher times in the venture capital and private funding markets. As venture capital becomes dearer, tech firms are likely to become more cautious, which would slow hiring and leasing.
The office market is similarly vulnerable, particularly co-working office space, which has benefited from these same trends. Observers have already begun to express concern, most notably Boston Federal Reserve president Eric Rosengren, who recently noted that the rise of co-working space is "creating a new type of potential financial stability risk in commercial real estate." The wellpublicized trials and tribulations surrounding a potential public offering for WeWork, the largest co-working company in the United States, has reignited the debate surrounding the long-term durability of the flexible office space model. The risks are pretty straightforward, although we believe they are somewhat overblown. Co-working firms, which typically take on long-term leases with property owners and re-lease the space on a short term basis, would likely be especially vulnerable to falling occupancy and declining rents that typically occur during a downturn. As tenants fail to renew the short-term leases, the loss of lease payments would also likely lead to a higher incidence of loan defaults.
We doubt the growing share of co-working leases presents an outsized risk for commercial real estate or the financial system more broadly. While flexible office space represents roughly one-third of all new office leases over the past 18 months and total square footage has more than doubled since 2015, occupied co-working space is estimated to be just under 2% of overall inventory. Coworking companies have their largest footprints in San Francisco, Manhattan and Los Angeles, but are expanding rapidly in up-and-coming secondary markets such as Austin, Denver, and Raleigh- Durham. But even in the largest and fastest growing flex markets, which tend to have a heavy presence of creative and knowledge-based industries such as tech, media, R&D and professional services, the ratio of co-working space to total inventory remains relatively low. Moreover, not all the firms leasing co-working space are small and thinly capitalized businesses. Many are divisions of large companies or satellite R&D facilities that are looking to quickly ramp up. Co-working space makes this fairly easy. Furthermore, it does not appear that U.S. banks are overly exposed to commercial mortgages, and thus the fallout from a potential downswing would likely be contained to the office market. Today, commercial mortgages amount to nearly 11% of the total financial assets of the U.S. banking system, which is not out of line in a historical context.
Even though there is less exposure than widely thought, the next recession may not be particularly kind to the co-working space model. During the prior two recessions, employment in "office-using" sectors fell relatively further than overall employment, reflecting the deep cutbacks in the tech sector following the long 1990s expansion and massive job losses in financial services following the housing bust (Figure 6). Co-working tenants predominantly include categories of workers which tend to feel the negative impacts of a recession early, such as startups, freelancers and entrepreneurs. A downturn would also halt the vast amount of venture capital flowing into startups, which would evaporate the primary wellspring of funding on which they depend.
Still, even if the flex office model bends during the next recession, it likely will not break. While WeWork and Regus rank as two of the largest co-working companies, there are over 200 other small and mid-sized operators such as Impact Hub, Convene and Knotel. Co-working space provides just-in-time office space, which enables both new and established firms to gain efficiencies by acquiring work stations and meeting rooms on an as-needed basis. Additionally, the average space per chair in a flex office is estimated to be 60 sq. ft., considerably smaller than the 194 sq. ft. in the traditional office layout. A more open and collaborative working environment with streamlined technological and business services only adds to the potential productivity gains.
By offering a suite of amenities such as beverage service and access to gyms, restaurants and retail, flex offices also provide creative ways to attract and retain younger workers, a segment growing in importance as more Baby Boomers exit the labor force. Moreover, even large organizations such as Microsoft, KPMG and IBM are beginning to see the benefits of the flex office model, which allows firms to gradually expand into new markets without making long-term commitments. This may serve to limit the downside risks of a downturn. Mitsubishi UFJ Financial Group recently leased enough WeWork space for 300 fintech employees in Charlotte, which allows it to immediately focus on hiring and more quickly ramp up its operations.
The efficiencies achieved through co-working may have tempered the real estate cycle. As with apartments, much of the growth in the office market has taken place in the Central Business District or next largest employment center in a handful of rapidly growing metropolitan areas. There have been relatively few spec office towers developed during this cycle, although co-working space is providing much of the flexibility that spec space did in the past. Overall office vacancy rates remain relatively low, particularly relative to the latter period of past business cycles.
Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. Customers should be aware that market orders for these new public companies are executed at the current market price, not the initial offering price. Market orders are executed fully and promptly, without regard to price and in a fast market this may result in an execution significantly different from the current price quoted for that security. Using a limit order can limit your risk of receiving an unexpected execution price. Large Orders in Fast Markets Large orders are often filled in smaller blocks. An order for 10,000 shares will sometimes be executed in two blocks of 5,000 shares each. In a fast market, when you place an order for 10,000 shares and the real-time market quote indicates there are 15,000 shares at 5, you would expect your order to execute at 5. In a fast market, with a backlog of orders, a real-time quote may not reflect the state of the market at the time your order is received by the market maker or specialist. Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. Although this article may provide information relating to approaches to investing or types of securities and investments you might buy or sell, Wells Fargo and its affiliates are not providing investment recommendations, advice, or endorsements. Data have been obtained from what are considered to be reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Wells Fargo makes no warranties and bears no liability for your use of this information. The information made available to you is not intended, and should not be construed as legal, tax, or investment advice, or a legal opinion.
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