Large forces shape our world, but they’re perpetuated by lots of small instances happening quickly. No time in recent history has this been more apparent than 2020, and commercial real estate (CRE) is just as caught up in the whirlwind as every other industry.
Chris Thornberg is a founding partner at Beacon Economics and also the Director of the Center for Economic Forecasting and Development at the UC Riverside School of Business. Chris recently sat down with us to explain the macro trends that are being accelerated by the pandemic and how this recession differs from those of the past.
The conversation has been edited for length and clarity.
Tell us a little bit about yourself, Chris.
I’m not a CRE economist and I’ve never really billed myself as such. But you can’t be a macro economist without talking about real estate. That is by far and away the most cyclical part of the economy. As such it’s something you have to become.
I did my PhD, and started a career as a typical academic economist. I then got a job with a great economist department at Clemson University. As much as I enjoyed the other faculty members there, and I learned a lot, it wasn’t for me. My former dissertation advisor invited me back to UCLA to work with him at the UCLA Anderson Forecast, and that’s where I really cut my teeth on this intersection between what I would call academic rigor and public conversation.
I immediately found a niche and that niche was “the official clothing critic for the emperor” so to speak. Over the years, blowing up people’s conventional wisdoms can become an attractive hobby to the point where you might start making stuff up just for the sake of notoriety, but I’ve never had to do that. Eventually my relationship with UCLA became tenuous. Being a lecturer at a giant university is a fairly precarious position and there reached a point where I was done.
So, I left and started Beacon Economics in mid-2006. Made the recession call. Now I have 20+ people. We work largely in California, but we venture out of state quite often, doing national stuff, and we’re all over the map. We obviously do policy studies, impact studies, CRE studies, all sorts of different things. It’s fun. It’s exciting, and we learn something new every day, and I feel like we’re having a real impact. We’re known as straight shooters. You might not like what we’re saying, but you know we’re saying it out of honesty.
How do you see CRE in California differently than you do across the nation?
I don’t. I think it’s a mistake to think that state by state markets are vastly different. Obviously, place-by-place have different policy differences, but I’ve always pushed back on this idea of business climate. California has a lot of upsides. The basic drivers of CRE, which is functionally supply and demand, are just applicable here as everywhere. So, I don’t see a lot of difference there. Except for maybe the natural trends that are impacting real estate may be more intense in California because of some of the choices we’ve made from a policy perspective in this state.
What challenges do you see in the short-term for CRE?
Obviously, we have to remember we’re in a recession, and this is truly an unexpected recession. At the beginning of 2019, many economists said we were going to have a recession by the end of 2020, because the trade war was going to demolish manufacturing, inflation was on the rise and interest rates were going to spike. Let’s not forget that real estate was melting down too. To me, it was yet another head fake. Well here we are, and we are in the first virus led recession in the US. It came out of left field, and we’re still grappling with this and getting a handle on it.
For the most part, a lot of economists out there have come out and told us that this is going to be worse than the Great Recession, and again, no. The two worst recessions in U.S. economic history — Great Depression and Great Recession — were cycles that followed the collapse of massive financial bubbles. Financial bubbles lead to the worst type of recessions. They just do, because typically when the financial bubble is inflating, it causes parts of the economy to grow to levels that are unsustainable. In the US, you had a $15T in debt from 2001-2006 and that caused, of course, the housing market to go vastly beyond where it was. Lots of households picked up way more debt than they should have. Consumer spending was way beyond anything sustainable, and when I made that recession call, it wasn’t even a recession call based on the trends.
Candidly, by mid-2006, the wheels are already falling off the sub-prime train, and it was nasty because of the restructuring of the economy and the permanent shrinkage of retail, housing and construction. It’s as dramatic as what we’ve seen in the economy today with millions of people out of work, the big decline in the number of jobs — but there is nothing permanent in this. We didn’t lose anything. The jobs are right there, they’re just on the other side of the public health profession.
Now clearly damage is being done, but a lot of that damage is being done because businesses are closing, and people aren’t working. It’s more than being compensated for by government intervention. Indeed, from February to April, for every dollar of lost income the government gave back $2. So, on net, this is not a long run scenario the way the Great Recession was, and the quicker this virus goes away, the quicker this economy gets back up and running. I think trends suggest that it may not be quite as quick as I thought, but I nevertheless think that this virus is going to be largely under control. I think mandates will be largely lifted by the end of the year, and I expect the US economy to be very close to where it was at the start of the year by the end of the year. Now what that means is one of the most dramatically short and dramatically sharpest recessions we’ve ever seen.
Real estate is a long run asset. This is not a long run cycle. The pain in CRE and the pain in residential real estate we saw during the Great Recession was driven by the financial shenanigans that went on in the lead up to that downturn. Functionally speaking, these markets are about as solid as they’ve been in 30 years in part because of the restrictions put on lending after the Great Recession. So, as such, I don’t see a lot of shift. There’s a lot of negotiating going on right now. It’s a very interesting world. I don’t think you’re going to end up any place a lot different than where we’re at right now from a cap rate perspective or a vacancy perspective or anything else. Outside of a few exceptions, I think.
Probably the one place that isn’t true is retail. The one thing the recession is doing is hastening some of the long-term trends, and there’s a few of them out there. In the case of retail, obviously it’s the Internet. In fact, the U.S. has, on a per capita basis, somewhere around four to five times as much retail space as Europe or Asia. We don’t need this much retail, but a lot of local governments rely on it, so they’re just not willing to rezone. And a lot of retailers that were already on the doorstep of bankruptcy are going under. Remember that all them aren’t going bankrupt because of the recession. They’re going bankrupt because of the long-term trends.
Office space has been a really interesting watch for me over the last few years. One of the trends we’ve noticed has to do with where you’re seeing the best pace of rent increases. And the answer is that you’re not seeing them in markets with declining vacancy rates. It is not a supply driven office market.
So, markets that are seeing big increases in rent are seeing them because they’re building new product. But the new product isn’t filling a supply need, it’s replacing old supply. You look at a place like San Francisco, it’s such a great example. They’re building all sorts of new office buildings. They haven’t seen any decline in vacancy rates from the levels they saw right after the Great Recession. Why are they building? The unemployment rate prior to this in San Francisco was like 2.3% or 2.2%. It’s an incredibly tight labor market. Housing is in short supply. Every company is in a fight for the best employees, and the way to get a good employee is to have a nice office. So, they’re building new things that are 75-80% pre-leased before they even put a stick in the ground. All of these new companies move in and the old stuff gets emptied out. What does the government do with that old stock? And that’s tough, because cities want commercial.
Do you think the satellite office trend in the suburbs, that can absorb some of that space, will take off?
A lot of people are working from home and it’s becoming part of the management system and part of the workflow. We’re starting to realize that it isn’t the end of the world, nor is it the end of office space either. You still want to be in rooms. You’re still lacking innovation. I don’t think you’re as productive, and I think even workers are sick to death of sitting their house.
We need office space. But it’s going to hasten that process of reactive use. Yes, I do think you’re going to see employers looking for smaller footprints. Will they go to more satellite offices? Intriguing. I don’t know. It would be nice. I think it would be really interesting for companies that are bringing in lots of people. They haven’t done so. I think from an operations and managerial standpoint, it’s always seemed as a bit of a daunting challenge. It’s a possibility.
Another reason I’m not worried about CRE in this cycle. As far as cycles go, this has been a really moderate cycle for CRE. Usually, when you’re in the eighth, nineth, tenth year of a cycle, that’s when CRE is going a little crazy. There’s lot of people taking long risk. Never happened this time. Never had a huge spike in production. In fact, the market had cooled off. In 2019, you saw a slowdown in investments in new commercial structures. But we came into this recession with a market that was already reasonably subdued both from a financial and a construction standpoint. It wasn’t due for any kind of collapse, and that’s an important point as well.
Do you think that’s because the Great Recession has had a “gun-shy” effect?
I think so. I remember in 2007 when I was running around being Dr. Doom and talking about the end of the world, and I had a lot of commercial guys get up in my craw. I remember even two years, 2017-2018, I would go to these commercial things and I typically used to be the pessimistic economist. Things were fine. It’s been a really weird cycle.
So, the 2009 recession was caused by fundamental, systemic problems, but 2020 is from something biological that is difficult to control?
You know what this boils down to? There’s an old picture of the general sitting on his horse facing the butt-end, “The General Always Fights the Last War”. That’s exactly right. You think about where we were at during the Great Recession — the previous two recessions had been barely anything. We had that relatively mild early-90s recession and the tech bubble that popped and didn’t mean much — barely a recession. This time around, everyone is still looking for the Great Recession. No matter what happens, it’s the Great Recession. But you have to be a little more nuanced. You’ve got to be a little bit better study of history. You have to recognize that recessions just don’t look like the last one. Every recession is a little bit different in its own way, and you have to consider the factors that are creating that recession to have a sense of how bad it’s going to be.
We were pre-mania stage leading into the pandemic. What do you make of the dip buying and the mania-type environment we’re in now?
The savings rate went to some insane number — 33% — which is just crazy in April. So, you have a bunch of people who can’t shop, can’t go out, can’t go on vacation, you got tons of money, so is it a surprise that everyone is tossing money at every investment in sight? It doesn’t surprise me at all.
Now, what I think the clever investors in this cycle are seeing, and I think it’s reasonable to say, is that you have a world in which everybody is sitting on a bunch of cash, but things aren’t going to come back exactly the same. While I say most of what we’ve seen go away is going to come back, that doesn’t mean all. We’re not going to be completely whole by the end of the year. There are a lot of boutique hotels. Some people were taking some risks, but no one is going to walk away right now. There’s no point. You’ve got your PPP loan. Your people aren’t going anywhere. You wait it out. The smart money seems to be thinking this is actually a good study of history, because typically commercial is a big lagging part of the economy, smart money says that if you’re looking to pick up the deals, it’s Q4/Q1, not now. I presume there’s a lot of people out there pulling money together and waiting. Unlike the Great Recession where there was probably more supply of assets than there was demand, this time around I have a feeling there’s going to be more demand for assets than there is supply, and as such, I don’t see a big dip.
Is there anything you’d like to add?
Just something to throw in there, obviously, credit markets were disrupted, but the Fed has pretty much taken care of that. In the Great Recession, fiscal policy was too little, too late. This time around, it’s too much, too soon. I say it’s too much because it’s too much, and it’s too soon because they didn’t actually figure out better ways of doing it or wait to see where the problems actually arose.
Now, there are potentially serious downsides. In the U.S. in a typical year, total debt — federal, state/local, private, consumer — expands by $3-$4 trillion. This year, you have the federal government by itself picking up $3-$4 trillion dollars. A real question that everyone should be asking — What does this mean for credit markets towards the end of the year? Commercial real estate relies on debt. It’s going to be really interesting to see where this thing shakes out when the government is just hoovering up capital.
I know there’s a lot of money sitting on the sidelines. Is there that much money sitting on the sidelines? It’s going to be one of the questions here that we don’t really have an answer to, because we’ve never been in a situation where the government has borrowed this much in a single year. We’re borrowing more as percentage of GDP than we were during WWII. It’s nuts.