John Chang - Senior Vice President, National Director Marcus & Millichap Research Services

The Impact of War on Commercial Real Estate



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John Chang - Senior Vice President, National Director at Marcus & Millichap

John Chang serves as the National Director of Research and Advisory Services for Marcus & Millichap.

Mr. Chang joined Marcus & Millichap in April 1997 as a Research Manager in the Seattle office. After holding executive marketing and e-business positions with premier residential real estate firms in the Pacific Northwest, he rejoined Marcus & Millichap in November 2007 as the head of its Research Services division.

Mr. Chang leads a team of dedicated real estate research professionals who produce the firm’s vast array of market research publications. These detailed reports, analyses and presentations provide insights on all major commercial property types including: Hotels, Industrial, Manufactured Housing, Multifamily, Office, Medical Office, Retail Multi-Tenant, Retail Single-Tenant, Self-Storage and Seniors Housing.


What You're Going to Learn

  • How War Impacts Commercial Real Estate in the USA
  • Why You Should Expect Supply Chain Issues With the Ukraine War
  • How the War in Ukraine May Accelerate Our Housing Supply Shortage
  • How Sanctions on Russia Will Have Negative Effects on the Entire Financial System
  • How Six More Interest Rate Hikes in 2022 Will Affect Commercial Real Estate
  • How Real Estate Performs in a Market With Rising CAP Rates
  • What Happens if Russia Defaults on Sovereign Debt
  • What Is the Impact of Uncertainty on Commercial Real Estate
  • How Inflation is Affecting Commodities
  • Why Are People Quitting Jobs in Record Numbers Across the US


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Show Highlights



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The Ukraine War-Expect Supply Chain Issues

Adam Gower: Let's try and drill down a little bit, into specifics. Before even Ukraine started, they were, exactly as you've described, there were a few headwinds already. There was inflation, inevitability of rising interest rates, supply chain issues, etc., etc. There was  quite a few things - oil prices, energy costs, etc. Everything was on the way up. Let's talk about supply chain. So, specifically about Ukraine. What kind of direct impact, if any, can supply chain issues have as a direct result of the Ukraine war on commercial real estate? What are we talking about?

John Chang: Sure. So, the one that's most visible right now, is what's happened with oil prices. So, there's financial sanctions on Russia, which would limit their output of oil and their ability to sell oil. And then, on top of that, the US has declared that they're not going to buy any Russian oil anymore and that creates a shortfall in the amount of oil available. So, we have a fairly consistent use of oil in the United States and all over the globe. Russia's a top exporter of oil globally. They basically deliver about 12% of the global supply of oil. So, there is an effect, when you try to shut that down and you reduce the amount of oil available to the world, that puts upward pressure on prices. You have a shortage of supply. Demand is still relatively constant and then that rolls over into gasoline prices. So, you start to see that price of the pump move and that affects people in general. Not only is there oil, but chromium and rhodium are both rare earth elements that Russia supplies a significant portion of those. Those are heavily used in catalytic converters for automobiles. We again, already have a shortage of autos being manufactured. There's shortages of steel and aluminum. They're already affecting the auto manufacturing. This is going to compound that. So, we can see it happening across various aspects of the economy. Another major export out of both Ukraine and Russia are grains and food products. And that's going to roll into effects. It could tighten up the food supplies on a global level. Not all of that rolls into the United States. We produce a lot of food here in the US. That's not a major import for us, but it does tighten the chain across the world and as a result, that strains the supplies and raises costs for everybody.

The War in Ukraine May Accelerate Our Housing Supply Shortage

Adam Gower: So, just talking about the increase in energy costs, right? Fuel, specifically, just looking at oil, price of oil. So what this does, is it increases inevitably increases construction costs. So let's just take, just for argument's sake, we look at a multifamily building. So now, all of your projected costs of improvement, value-add or construction, whatever you're doing, those are going to go up. Some components of that is going to go up simply because of increased energy costs. At the same time, you know, there's this argument that rents and we've seen this. We could talk about this in more detail later. But there's this argument that rents are more flexible with multifamily. Yet, if you have increased costs of transportation and commuting and household costs, those are going up, at the same time as you've got costs of construction going up, you've also got downward pressure on affordability. So, do you think this is going to create stress even in those asset classes that everybody's so comfortable with, being recession resilient, like multifamily?

John Chang: Well, I think multifamily will continue to be recession resistant, but, the supply shortage. We already have a housing supply shortage in the United States, and it's pretty significant. You know, depending on who you ask, it's anywhere between 2 and 5 million housing units shortfall. And, as a result, we have record low vacancy rates in apartments. We have appreciation of housing prices that are unheard of right now. The days of inventory, or the months of inventory of houses for sale, is also at a record low. And so as a result, we have already a strained housing supply, and it's going to be exacerbated by this. As you said, there's going to be upward pressure on construction costs, if they can get them built. And, as a result, that's going to push up rents. That's going to force people to double up. They were planning to move out on their own. If you look at the demographics right now, the millennial generation is primed to create new households. That's part of what's creating the housing shortage. And there simply aren't enough housing units out there. We expect about 400,000 new apartments to be built in the United States. That is the most apartment units to be built in any single year since the 1980s, and yet it won't be enough. And now, with this new pressure, the ability to get to 400,000 units is going to be restrained. I don't think we're going to get to that projection going forward just because we have so many barriers in the way, and so many headwinds. So this is going to exacerbate the issue.

Sanctions on Russia Will Have Negative Effects on the Entire Financial System

Adam Gower: Do you remember during the last downturn? The big downturn, 2007, '08, '09.

John Chang: Yep.

Adam Gower: I was working for a bank, as I mentioned. The only asset class really, that was consistently outperformed everything else was multifamily. Even with affordability issues, right? As people went and lost their jobs and there were all kinds of downward pressure on economic stability, whatever, in that time. Multifamily always outperformed. Now, just sticking with Ukraine again? What about the impact of sanctions? This is a big question. It seems easy for us to think we've crushed the Russian economy. But what is the impact of that?

John Chang: It creates ripples throughout the financial system. It creates instability. There's risks of a Russian default on their debt, and that could cause more problems within the banking system and the financial systems. So, there is a knock-on effect, possibly, out there. Structurally speaking, for commercial real estate, the effect of the sanctions is kind of more long term. We'll see it a little bit at a time. I don't think we see a shock to the system per se. We already had the Federal Reserve taking a more hawkish position. But in fact, actually, the sanctions and what's going on in Ukraine actually caused, I believe, caused Chairman Powell and the Federal Reserve to actually take a slower action this time around. We only had a 25 basis point increase in the first rate increase. There was a possibility they would have gone more. But, I think because of the anxiety about what's happening in Ukraine, because of the sanctions, because of the uncertainty that that's creating, they took a more cautious approach.

How Real Estate Performs in a Market With Rising CAP Rates

Adam Gower: So, let me just pursue a bit of doom and gloom for you. So, everybody has been watching this overheated market. Cap rates, insane. Sub threes all over the country. It used to be just the west side of L.A.. Now, I mean, really everywhere, right? Seriously. And everywhere and almost every asset class, it's not just multifamily. It's just compressed everywhere. As you know, I'm over generalizing, but we all know that's the truth, basically. So, if at 150 basis points, I think you said 150 basis points or 100 basis points, you see this 46% decline in intent to buy. So the reason for that, if I read between the lines right, is because it's going to cost too much and cap rates are too low. It doesn't make sense. Therefore, does that not mean that cap rates will start to come up and if they do, what about all those people that have been buying under the assumption that our cap rates are going to be nicely stable at 3or 4%? What's the impact going to be on all the people that have bought with those assumptions, do you suppose?

John Chang: Okay. So, it is not necessarily true that cap rates will rise. If you look back over time, we've seen the spread between the 10-year Treasury and the average cap rates, compressed very tight. Back in '07 and '06, now granted, there was a lot of enthusiasm in the marketplace and cap rates were compressed pretty tight. But actually, the spread got very, very thin at that point as well. So, it is not a foregone conclusion that cap rates, in general, will rise. Now, the place where we're most likely to see it, is the places where you have a 2.5 cap, a three cap. Right? The other place you're going to see it is on assets where you have less ability to move rents. Things like net lease investments that are tied into a 15-year lease. Right? They're going to soften up a little bit because that's a coupon clipper. And just like bond yields would be coming up, you're going to see that in those bond like types of commercial real estate. Now, for the investor who went in and bought a great apartment asset in a great market with lots of growth, they bought it at a 2.5 cap. They're not going to have a problem.

John Chang: Right? Even though cap rates are going up, that's influencing their exit strategy downstream. Right? You never realize that new cap rate until you actually sell it. And so their yields are going to be as they planned. Assuming, okay, we're going to raise rents over the course of the next several years and our cap rate will rise. We may have bought an apartment building in Austin where you have great employment drivers, you're going to have great in-migration. The demand for housing exceeds the supply and you're going to raise your rents and you're going to grow that revenue. So, I already bought it at 2.5 cap. Rising cap rates don't really mean a lot to the performance of that asset until I sell it later. Now, hopefully if you bought that at a 2.5 cap and you can sell it later, hopefully you're going to sell it at a similarly low cap rate. But if you have to exit, right, if you get to the end of a fund and per the rules of your fund, you have to sell that asset. And then cap rates are now, for that market, maybe a 3.5 or a 4.5.  Yeah. You're losing out on that deal.

Adam Gower: Yeah. I mean - you're going from 2.5 to 4.5.

John Chang: Yeah. But in the meantime, you saw.

Adam Gower: That's a 50% drop in value, John.

John Chang: But in the meantime, your rents have gone up. You know, in that kind of a market. You may be seeing rent growth of double digit rent growth every year along the way, in which case, if you're achieving that, you're going to offset that.

Adam Gower: Right.

John Chang: Not what you want. Right?

Adam Gower: Big ifs. Right.

John Chang: As an investor, when you wrote that check and you bought it, you didn't say, gosh, you know what, I hope you know, cap rates go up 200 basis points between now and when I sell it.

John Chang: Thinking, hey, I want to sell it later at a comparable cap rate. But, the underwriting was based on rent growth and revenue income growth. And then again, particularly these syndicators of funds where they have a strict end of life on these funds and a timeline that they have to hit with the sale of that asset. Then, those guys are going to, you know, they're shaking the dice a little bit.

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What Happens if Russia Defaults on Sovereign Debt

Adam Gower: Let's go back to Russia for a moment. And Russian sovereign debt default. So what actually does that mean?

John Chang: I don't know. Honestly. This is, I mean, it's one thing for Greece to go in default, right, in a regular time, or in a financial crisis mode and then the banks and the financial institutions sit down and they work it out. It's an entirely different situation for a global power to default. Especially one that's already demonstrated that it doesn't really care what the rest of the world thinks. Right? So, theoretically, there should be financial repercussions. There should be banking repercussions. There's the - whoever loaned them the money, whether it's Deutsche Bank or somebody else, is going to want to recover those funds. Right? And they're going to put pressure on them to do it. But, it's really hard to do with a country like Russia. This isn't a small country in the EU where they're playing by certain rules. Right? The rules in the EU are very specific about how this is going to be handled. The rules for Russia are completely different and they get a say in what those rules will be. So, I can't say exactly how this is going to play out. I can say it's not going to be good. It's not good for anybody but we haven't seen something like this before.

What Is the Impact of Uncertainty on Commercial Real Estate

Adam Gower: Somebody as knowledgeable and as well read as you are about the economy and about the impacts of these kinds of things. If your answer is, I don't know, then what we know then, is that there is considerable uncertainty. And in that wonderful short video that you put up on LinkedIn that I recommend everybody go and watch, it's on your profile on LinkedIn, you talk about the impact of uncertainty on commercial real estate. So talk to me a little about, you know, this morass of stuff going on. People, even like you don't know, what's the impact. Nobody really knows. What is the impact of uncertainty on commercial real estate?

John Chang: Well, uncertainty - when people have uncertainty, they have a tendency to move to somewhere safe. Right? And for some investors, that means bonds. Right? And for other investors, that means real estate. So, again, uncertainty can drive capital into the perceived safer assets. I was speaking at a medical office conference, a couple of months ago and I was talking to our brokers and saying, okay, what are people looking for right now? And they said, well, they want 12-year or 15-year leases with high quality tenants and they're buying them at a 7 cap. Right? Or a 6 cap. And I said, well, why are they buying these? And they said, they want that safety. There's instability out there. They want to have durability of income. They want to know what to expect. And, in the case of medical office, specifically, they're also banking on population growth of the elder population as baby boomers age and the demand for medical office space will rise over time. So, they're going to see appreciation on that side of the asset. So, that is one strategy I'm seeing people play out. But in general, uncertainty causes people to move to safer ground and real estate can be a big piece of that. I know a lot of the investors that I talked to are trying to put more money into real estate because they're not sure where things are going to go over the next couple of years.

How is Inflation Affecting Commodities

Adam Gower: Inflation. So I'd actually stopped asking you about inflation because you touched it so well. I'm now going to ask you something that I know that economists love to talk about and do, and that's to predict the future. I know that that's what you love to do all the time. So, how severe do you think inflation can get? I actually was asked recently about hyperinflation, and I'm not sure the person asking me actually knew what that meant. But you do. Hyperinflation being hundreds or thousands of percent a day. Something crazy. What do you think - like, what are the scenarios, realistic scenarios, you think will play out with inflation? Oh, you fell over when I asked that. What happened?

John Chang: Yeah, right. Sorry. So, hyperinflation is pretty much off the table. I don't expect that at all. Right. That where you could actually see prices move during the day, right. Where you see things happening on a day-to-day basis. But, we could see elevated inflation right now depending on which measuring stick you're using. It's somewhere between 5 and 8%, 7.5, 8%. Depending on if you're using CPI or core CPI or PCE or core PC. There's a whole bunch of different options. But, what I can't say is, all of them are higher than they're supposed to be. Now, will they keep going up? If you look at a graph showing what's happening with inflation, that graph doesn't look like it's leveling off. It looks like it's still going up. Right. So, you know, I look at it and go, okay, if you were measuring this on trajectory alone, it's going up. Now, looking underneath the surface, the key drivers of inflation right now, you look at the cost of goods used in manufacturing, the producer price index. That's rising. That's accelerating. Right. The underlying materials, the raw materials, one, we have all of these sanctions going on with Russia that could cause further reductions of availability of raw materials. Right. There's also issues with the pandemic going on in China right now, which is reducing the availability of raw materials. We have some tariffs still in place that are slowing down availability of materials out of other countries. You know, we have lumber prices that are still quite high. They're double what they were before the pandemic.

John Chang: The price of steel is three and half times what it was before the pandemic. The price of aluminum is double what it was. Those things have all been going up lately. They haven't been going down. We just produced our national investment reports - our forecast for 2022 and I spent my morning this morning down at the printing company because the printing company, they're a huge printing company, ran out of paper. They can't get paper right now. So, you see all of these shortages. Those shortages translate into inflation. In addition, you look at the cost of housing. That's rising pretty aggressively. You look at the price of wages, right? Wage inflation is 5.5%. Normally it's 2.5. So, it's double what it would normally be. So we see all of these drivers, not just the headline number, not CPI, not core CPI or PC. What you have are underlying drivers of inflation that are still very high and in many cases rising, which implies that this is going to be around a while, which implies it could keep going up over the next few months. And I think this is why the Federal Reserve, at their meeting on the 15th of March, came out and said, Hey, this is a little worse than we thought. We're going to hit this a little harder than we we originally talked about. And so that's why the Fed is going to try to grapple with this beast. It's going to be a big challenge for them.

Why Are People Quitting Jobs in Record Numbers Across the US

Adam Gower: One of the trends that I've been noticing and others have been noticing as well, is record job quitting trends in the United States. What do you think? What can we learn from that interesting dynamic.

John Chang: Okay. So, there's a lot packed in there, right? So, we went into the pandemic, we had this huge layoff, right? We laid off, or we lost about - almost 23 million jobs. That was huge. Over the next few months, we recovered, we bounced back. We got a lot of those jobs back. But we were still in a pandemic. And during that pandemic, we saw a lot of the baby boomers who were working into their 60s, who were, had always considered retiring but never had decided, you know what, now's the time. I'm done. I'm going to retire. So we saw that. We saw a lot of people decide, okay, I'm not going to work. I'm not going to go back to work. I'm going to take care of my kids or somebody else. I'm going to care for somebody else. That is another big chunk of population. Those all exited the workforce. We saw a lot of people move. We saw a lot of people migrate from high cost center markets like in New York or the Bay Area and relocate to other cities across the country where they took a high, very expensive market salary with them to some place with a very low cost of living.

John Chang: And then they looked at their significant other and said, Hey, by the way, you don't need to work. Our cost of living just got cut in half, but I'm still making great money. And so, we saw a lot of people exit the the employment market from that. Now, that drives a labor shortage, right? We're basically at a 5 million person shortfall. If you look at the number of job openings versus the number of people actively looking for work, the unemployment rate is about 5 million more jobs than there are people looking for work. That's a shortage. That's driving up wage pressure, but it's creating a very aggressive recruiting climate and a lot of opportunity. So, you know, historically, normally, when you have job dissatisfaction, you suck it up and carry on. Right? You know, you just keep moving forward and you're like, okay, I'll get past this. I'll keep moving and I'll solve this and it'll be fine in the future and you suck it up. Now, today, because there's so many jobs available, so much demand, so many opportunities. I'm not going to suck it up. I'm going to take it. I'm goingg to quit. I'm going to go out.

John Chang: I'll find another job. It's fine. There's so many to choose from. There's recruiters calling every day. It's okay. So the quits rate has gone up a lot because there's this huge labor shortage and there's a lot of jobs being created because we have good economic growth. We can't forget, as we talk about all these risks: inflation and rising interest rates and all these barriers to growth. We cannot forget that economic growth, last year was quite strong and that the forecast, even with all these headwinds, are still pretty good, depending on who you ask at any given time. It's somewhere around, somewhere 2 to 4% expectations of economic growth this year. So, there are opportunities and that job dissatisfaction is people aren't going to put up with it. They're going to move on. They're going to go find something else. They may even change into a different city, wherever they want to go live. A lot of movement into the southern states and to the quality of life. We see migration into Texas and Florida and so on, and that will continue. So, I guess the keyword there is take care of your employees. They're golden right now. There's really nothing more important right now than the quality of the people who you have working for you.

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