Where are we in the Cycle?

Legendary investor Howard Marks recently published this excellent memo about opinions. In the post he uses this year’s Presidential Election to underscore his point that, “The opinions of experts concerning the future are accorded great weight…but they’re still just opinions.” He says that the question “what inning are we in?” is one of the four questions he receives most often. Mike and I can relate to this; in fact, we were preparing for a presentation last week when this exact question came up. Marks writes, “Perhaps no one can say just what it is that will ring the bell on today’s positive trends, but people still want to know how advanced we are in the process, and thus when it will come to an end.” In commercial real estate, we see this too.

A significant reason Mike and I are great partners is that we think similarly; we have different skill sets, but similar guiding principles and one of them is to present facts and avoid exaggeration. We are careful to avoid doomsday predictions and “top calling” (i.e. the market will reverse by ____, insert imaginary date, and therefore you should do _____). The truth is that we don’t know when things will change. No one does. Thus, to answer the question of “where are we in the cycle” we walk clients/prospects through the current state of the market and offer educated opinion based on what we are seeing.

So where are we, after Q1 2017? Here are my biggest takeaways of where we stand:

New construction is on fire: In Q1, Spotify signed a lease for 378,000 sq. ft. which made 4 World Trade center 100% leased. 3 World Trade Center is off the ground and Silverstein (owner) along with the CBRE agency team are actively marketing the property. At Hudson Yards, I keep finding myself saying, “wow…unbelievable!” when reading the news. While nothing is finalized, in the past two months there have been reports that Cooley, Silverlake and Third Point are all headed to Hudson Yards. None of this activity, downtown or at Hudson Yards, is irrational. I wrote last year that good product is replacing good location. That trend has continued into this year with companies preferring newer buildings regardless of their location.

Supply: There is a lot of supply coming to Midtown as tenants move west and downtown. Importantly, a lot of this supply is in high end building. Additionally, many tenants that stay in Midtown either in a renewal or relocation are taking less space which further adds to the supply. Even if the firm is growing from a headcount perspective, they are “densifying” — i.e. increasing their rentable sq. ft. per employee count. The question remains, “can demand keep up with the upcoming supply increase?”

Demand: Trump’s president. If he’s successful with some of his deregulation efforts, this could be a boon for banks and other financial services companies. Historically, the “FIRE” industries (financial, insurance and real estate) have been the largest occupiers of office space in New York. However since previous highs in 2007, that segment has experienced a reduction in NYC employment by 13,000 jobs. If these industries start to hire again, it’s possible some of the supply created by companies heading to Hudson Yards and downtown is absorbed by growing FIRE tenants.

Demand continued, the rise of nontraditional industries: When I recently asked 50 friends what topics they would find interesting for me to write about, the most common response was WeWork / the shared space industry. It’s no surprise – 1) it’s cool (I built my website in a WeWork on Madison Avenue) and 2) that industry was extremely small not too long ago and now is massive. The largest co-working firm, WeWork, has leased a significant amount of space in Midtown including buildings like 300 Park Avenue, 575 Fifth Avenue and Tower 49. Healthcare is also booming. Last year, NYU Langone signed a 30 year lease on the entire property at 222 East 41st Street, and it’s rumored that NY Presbyterian is taking ~500,000 sq. ft. at 237 Park Avenue. While we are seeing increased demand from these nontraditional industries, they have yet to lease space in the ultra high-end market where there is significant supply coming back (i.e. 375 Park Avenue where Wells Fargo is leaving, 9 West 57th Street where KKR is leaving, etc.).

Face rents remain steady, but effective rents are dropping: Rents have been relatively flat for 2 years. At the end of 2015, average asking rents in Manhattan were $71.85 and YTD they are $73.64. However, rents are only part of the story. The other part is concessions – free rent and tenant improvement allowance (“TI”). While free rent on a 10 year deal in Midtown seems to have stabilized around 10-12 months, TI allowances continue to increase and are the highest they have ever been. CBRE recently published an excellent whitepaper titled, “What’s driving the increase in tenant improvement allowances in Manhattan.” I’m happy to share this with you, please e-mail me if you want a closer look. Overall though, this decrease in effective rents is potentially worrying.

I don’t know what inning we’re in or when the game will end. The truth is that no one does (read the entire Howard Marks article for more color or see this chart showing how it’s worked out for experts tying to predict the stock market.) While there is a lot of supply coming online in Midtown in high-end buildings, in my opinion it’s too early to affirmatively say there won’t be demand to meet that supply. People who claim the market will reverse by a certain date/time in the future should be questioned; what do they know? Financial services companies can start to grow again and if they do, “when the cycle will end” is anyone’s guess. However, the drop in effective rents is troubling and there is significant competition for landlords to lease space.

If interested in meeting for a market presentation, please send me an e-mail to coordinate. Thanks for reading my thoughts.