An Interview With: Knight Kiplinger

Some of you Washington Real Estate Weekly readers have requested an occasional update on economic trends affecting both local and national real estate. I thought we’d give it a whirl this week, and I’d start by asking a friend whose publications are so renowned for offering this kind of data and insight. This interview was conducted yesterday, April 12.

Among the Kiplinger publications are Kiplinger’s Personal Finance magazine; the weekly Kiplinger Letter (a business forecasting publication); and KiplingerForecasts.com (a subscription Web service). Knight is, of course, a frequently quoted expert on all manner of economic analysis and predictions.

Bisnow on Business: Let’s do a summary of both national and regional trends in various areas, a snapshot as of today. Start with this: How are commercial rents and vacancies?
Commercial rents are firming up in many of the major markets around America. Vacancy rates for office buildings are probably at their lowest level in five years. Of course there’s a lot of variation there. Washington, DC, happens to have the lowest office vacancy rate in America for a major metropolitan area, at a shade under 7%. Nationally the office vacancy rate in major metro areas is expected to drop from about 15% down to 14%. So here’s Washington at half of the national rate for office space.

How about warehouses?
One kind of space that is in great demand all over America is warehouse and flex space. Because of booming trade, especially imports coming in, vacancy rates for industrial warehouse and flex space in coastal port cities is very, very tight right now--vacancy rates in the neighborhood of 2-3% in Los Angeles and Honolulu. We don’t have a lot of warehouse space in the Washington Metro area, but the demand for that is pretty strong too.

Retail?
That’s generally a national exception to this tightening market and rising rents. America has been over-stored for a number of years and big retail mergers are not helping the demand situation there very much. Sears and K-Mart, and May and Federated are moving their department store brands from store to store and consolidating in some areas. We’re going to be seeing some of that in the Washington Metro area as well. So retail space is generally pretty plentiful around America, although there are some exceptions.

Residential?
Start with rental residential, multi-family apartments. When the home sales market was sizzling for the last several years, vacancy rates in apartment buildings moved up pretty significantly. A lot of apartment complexes seemed to be emptied of their young adult tenants. Even single young adults who were leaving the rental market to buy their own house. Now with home sales slowing down, especially condos, we will probably see declining vacancy rates in apartment buildings and we’ll see rents firm up a little bit. Both nationally and locally. This year in 50 major markets nationwide we at Kiplinger expect average rents to increase about 4% as vacancy rates drop.

What’s your general picture of the Washington area economy and housing?
It’s really a phenomenon. Washington in population growth is the fastest growing top ten metro area in America in terms of population. And it’s due entirely to our favorite Uncle Sam. The surge in government spending on Homeland Security, on military procurement, government contracting of all sorts, has given Washington the fastest, strongest job creation and employment growth of any top ten metro area in America. And that means household formation. We have a fairly young metropolitan area in average population. So the fertility rate of our metro area is pretty strong. And this is supporting the demand for housing in the Washington area. It doesn’t mean that we are immune to cycles of overbuilding and excess capacity.

Such as condos?
I think that there are more new condo projects coming online now and in the pipeline for delivery over the next two years than even the strong population growth and job growth of Washington can absorb without a price adjustment, without a price correction. And there are pessimists who think two years from now whole projects are going to go on the block and we’re going to see fire sales of entire new condo buildings. Other people think that speculators will wait and pick up ten or twenty units in a building from a developer who has over-estimated the demand. As amazing a job creation machine as the Washington economy is, the condo construction has probably gotten ahead of the demand, and we’re going to see prices settle back. It seems to be happening already.

And what might determine whether that’s a soft or hard landing?
I think that lenders are becoming much more selective about the projects that they back. So the cautiousness and skepticism of lenders will be a break on the over-optimism of developers. So I think that it’s harder to be planning and launching a new condo project now. But the projects that were started two years ago and are in the pipeline now, which will have to be brought to market, can’t be postponed. I think they’re going to create an overhang of supply. I have a little bit of concern about the office market similarly. Of course we have submarkets within this big market. You’ve got the central business district in DC and the Maryland and Virginia suburbs. And those are all very distinctive submarkets. We’re not back to the speculative excesses of the late ‘80s and early ‘90s that caused the commercial real estate bloodbath of the early ‘90s. Nothing like that. But you see a little more speculative building now than you did before.

Do you follow the foreign money in this market?
A little bit. Global capital still considers Washington an attractively priced real estate market because they’re comparing it to London, and Paris, and Rome, and Hong Kong. So as breathtaking as downtown real estate prices have gotten recently, they still look moderate to global investors. And global investors often are more patient. They have a longer time horizon. Especially the European investors. But downtown real estate prices are pretty strong, even with the expectation of lower vacancies and stronger rents. Some of the prices being paid in downtown Washington today are truly stunning. Our company was recently on the sale side of a transaction and one of our co-owners in the building was Kuwaiti money. And they also thought the prices were pretty high. And we were all pleased to be selling. But for every seller there was a buyer who thinks it’s a good value. And some of these offers were from real estate interests that I consider savvy and foresighted. So I guess they’re happy with the transaction. We were happy too. But I do know a fair number of real estate investors, especially residential investors, who have been selling in the District to await better buying opportunities in a year or two.

Because they think there’ll be a correction?
That’s right. And these are investors who have been doing condo conversions for a couple of years. But they can’t find anything to buy. They can’t find anything that they think is well priced right now. So they’re going to keep liquid, keep their powder dry.

And do they think there’ll be something on the order of a 10% correction, or something more?
It varies. Some are thinking 10-15%. They don’t think that being out of the game right now and being liquid is going to risk them anything. They don’t think they’re going to miss big opportunities by holding more cash right now, and they think that they’ll be able to buy some distressed properties a year or two from now.

What is it about Washington that would cause it not to go up to some of the international prices or New York prices?
In some cities you have physical space constraints that support much higher prices, such as in some of the older, more densely packed countries of the world. Paris, London, Hong Kong, for example. But we have seen that attractive residential markets like south Florida and New York City have benefited from foreign money that doesn’t bat an eye at these prices. So there’s a convergence going on here. We’re moving closer to New York pricing. And we do have Uncle Sam supporting rents in Washington and residential prices in Washington by its very strong spending. Procurement spending and job growth. Washington is benefiting more from international money than we used to. It used to be pretty much a local market. But I know just within a few blocks of our office downtown there’s a fair amount of foreign money. Dutch money, British money. And they’ve done fine as long-term investors in this market and will continue to.

From your long experience and observation, how can you go wrong? Is it possible to go wrong in the long run buying Washington real estate?
No, not in the long run. Timing is everything. I know a great many investors who went through the ringer in the 1990s. They paid too high a prices for downtown land. And it was leveraged. But if they bought all cash and they could simply carry the taxes they’d be fine today. In the early ‘90s the slogan was, “Stay alive ‘til ’95!” Everybody said if you could make it through ’92 and ’93, if you could hold on to your properties, if you could keep the banks from taking them, it would be fine. But remember the FDIC and the RTC and the bank regulators were forcing the banks to call loans. Even performing loans. The collateral had declined below loan value. There were projects that were underwater. Even performing loans. Our company was involved in some deals in which we were completely current on the debt service. But the collateral had fallen below the loan value, and the loans were called. And if the loans had not been called, we would have still owned some of those properties today, we would have ridden it out, it would have been fine. So sometimes regulators can cause a panic that the market would otherwise endure. So you know, you’re not going to go wrong in the long run on well located Washington real estate.

And the impact of interest rates?
Interest rates are rising. So the debt carry is going up. It’s better not to be too highly leveraged at any time, especially when interest rates are rising. I’d say interest rates are going to tack another point or so on current levels. Over the next year the Fed will probably stop raising short rates after one or two more quarter points. But long rates are going to rise. This is a very unnatural situation, this flatness in the yield curve. Long rates are going to rise to the normal spread between long and short rates. And that’s going to squeeze some real estate investors and we’re probably going to see more turnover in properties.