Oil's Impact on Commercial Real Estate

Perhaps more so than any other industry, oil and its pricing volatility impacts all elements of the U.S. economy, both positively and negatively. Looking at it from a macroeconomic level, higher oil prices are good for some industries, and yet bad for others—and the same goes for lower prices. So overall, how does oil and energy affect the commercial real estate economy? Well, almost in the exact same way, if you break it down.

According to recent statistics from the U.S. Energy Information Administration., U.S. oil production will grow to 9.31 million barrels daily by 2016, so the industry is still healthy production-wise. But for the past few years, prices have remained low and are expected to remain steady or even decline for the foreseeable future. Where this has the greatest impact for commercial real estate is in the retail sector. It’s a simple equation: Reduced gas prices cause a boost in discretionary income and the end result is additional spending for the country. Money that would be typically earmarked towards filling car and home gas tanks now remains in the wallets of U.S. consumers and retailers are the clear beneficiaries.

It’s not a coincidence that the retail sector has shown a marked improvement as oil prices have plummeted. The 2014 holiday retail sales were strong and 2015 is expected to be much the same. By extension, another byproduct winner in this ripple effect are operators of industrial properties, particularly as online retail demand triggers the movement of purchased items through their facilities.

But while retailers and shopping center and industrial building owners celebrate continued affordable gas prices, commercial real estate within markets like Houston, where oil production is the “bread and butter” business, the news is not so welcome. In fact, the entire state of Texas, our country’s number one oil drilling state, has really been squeezed by the price decline.

The Lone Star State is always subject to the underlying forces of the energy sector. When oil fundamentals are strong and prices are up, Texas is a national economic leader. But when the opposite occurs, stunted financial growth is the unfortunate result. This decline has seeped into most of the regional commercial real estate segments such as the Texas office and retail sectors. In addition, a slowdown in local construction has been steadily occurring. Fortunately, Texans have learned from previous oil crunches to diversify the businesses to avoid being completely beholden to the energy industry—so while there has been some job loss, it has been mitigated to some degree.

But Texas and other localized markets specializing in energy aside, the current state of the oil industry and its lower than normal prices and the uplift in consumer spending has generally been considered a good thing for commercial real estate. While the long-term future of oil prices remains a mystery, retailers will still be able to ride this wave for the time being.

London's Gatehouse structures CMBS-like Islamic securitization

London-based Gatehouse Bank has structured a 100 million euro Islamic loan facility backed by direct legal ownership of property, a novel type of securitization which in some ways resembles commercial mortgage-backed securities (CMBS).

Conventional CMBS were hit hard by the U.S. sub-prime mortgage crisis seven years ago and were seen by some bankers as a source of the crisis as mortgages became non-performing.

The Islamic version developed by Gatehouse, one of Britain's six full-fledged Islamic banks, may be less unstable because, although it is based on income from commercial property, it includes actual ownership of the underlying property.

Gatehouse structured and arranged the five-year deal to fund its acquisition of property in the Paris region.

Securitization in Islamic finance is still in its infancy. Regulators in Malaysia introduced guidelines on asset-backed securities (ABS) in 2001, revised in 2004, which also cover sharia-compliant ABS.

In 2013, Munich-based FWU Group issued a $20 million Islamic bond backed by insurance policies, the first tranche of a $100 million programme arranged by EIIB-Rasmala, a venture between London-based European Islamic Investment Bank and Dubai's Rasmala Group.

Gatehouse Bank issued a 6.9 million pound ($10.4 million) covered Islamic bond backed by a property in Basingstoke in 2012.

2015 CMBS Outlook

The economy, coupled with low interest rates, contributed to continued growth in the commercial real estate and securitization markets. Property fundamentals for most CRE segments improved, fueling the appetite for CMBS investment. As demand increased, credit standards continued to ease as competition among loan originators progressed through the year. Credit metrics continued to weaken as leverage climbed to new post crisis highs and debt service trended downward despite lower interest rates and the prevalent use of interest-only loan structures.

Despite the slowdown at the start of the year, the economy posted meaningful growth through the remainder of the year, ending the Q3 at 3.9%. In addition to the economic expansion, employment figures scored solid gains throughout the year, as approximately 241,000 jobs were added in each of the last 11 months, lowering the unemployment rate to 5.8% from 7.0% a year earlier. The increase in payrolls is no longer contained in the technology and energy sectors but has broadened over the past year to include health care and leisure & hospitality, which contributed to economic growth in many regions of the country. This bodes well for commercial real estate (CRE) fundamentals across the U.S.

As the economy continues to expand, KBRA believes that real estate fundamentals will remain stable across all of the property type segments, many of which will experience flat to modest growth. However, the multifamily and lodging sectors are standouts, having experienced marked gains over the past few years. The performance of these two sectors in many markets is at or above that experienced during the height of the last real estate cycle. About Kroll Bond Rating Agency KBRA is registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization (NRSRO). In addition, KBRA is recognized by the National Association of Insurance Commissioners (NAIC) as a Credit Rating Provider (CRP).

Is Houston the Next Gateway City?

Institutional investor demand for Houston commercial real estate, coupled with job growth, a less expensive cost of housing and movement of oil and energy industries into the city is leading local players to predict that the most populousmetropolis in Texas could become the next gateway market. "Houston has always been a strong market for institutional investment, but it is now viewed as a gateway city," Kevin Roberts, the southwest president at Transwestern, said. "Today, it is considered one of the top tier investment markets in the U.S."

Las yea, the city was ranked fourth in the U.S. for foreign investment and fifth globally, according to the Association of Foreign Investors in Real Estate. "This was a huge improvement since not all that long ago, Houston was not a primary investment market for foreign capital, because most foreign investors were going toward gateway markets such as Los Angeles, San Francisco, New York, Washington, D.C., and Boston," Tom Fish, executive managing director at JLL, said. "[The city has] recently been perceived as a gateway market in the eyes of foreign investors, and [it] now has a healthy amount of foreign bidders."

Consolidation of the oil and energy industries into Houston has created internationally competitive jobs that draw foreign capital to the region, Kevin Roberts, the southwest president at Transwestern, said. He explained that Houston is predicted to be the number one supplier of oil and gas in teh United States in 2015.

Because of this, there has been a rapid increase in foreign investment from Mexico as well as an in-migration trend, according to Jan Sparks, managing director of structured finance at Transwestern. "There is significant influx of wealthy Mexican nationals into Houston, predominantly in Mexico City and Monterrey. Houston offers a stabilized, safer environment for them to raise their families and conduct their business. Commuting to numerous cities in Mexico from Houston is easy and inexpensive. They can get in and out of Mexico in the same day if they desire," she said.

The city has seen in-migration from the Northeastern, Midwestern and Western parts of the U.S., Roberts said, as people seek to take advantage of low-tax business opportunities. "Our governor has been very aggressive in trying to attract people to those businesses," Fish said. "The one thing that is interesting about the oil business is that it's not just people in hard hats drilling. It also produces an enormous amount of technology jobs, and a lot of people are coming in from places like California to fill those positions."

 

Job growth in Houston, which is seeing 80,000-100,000 new jobs created each year, is close to double the national average, Fish said. This means the office sector has seen a lot of demand, Sparks said, as it has been an efficient way to place large amounts of equity for the past two years. Houston now has more office space under construction than any city in the country, according to Fish, a vast majority of which is already leased.

 

Multifamily is also one of the leading product types in Houston this year, Roberts said, with more than 17,000 multifamily units delivered in 2014 and nearly 15,000 of those units abosorbed. "Many members of Generation Y are coming in and renting these urban, multifamily units," Roberts said. "Sixty percent of Generation Y renters think that they'll move within the next five years, so they're willing to pay up for apartment units because they are renters by choice."

 

With all of the new construction, Fish said that he believes there is enough discipline in the market to limit it to the best products that are able to get capitalized. "We have had a terrific four years of double-digit rent growth, and as long as we continue to experience the job growth that we are now, I think we'll be able to absorb the units that we have coming in," he said. "Even though construction prices are going up because of the heightened labor market, I think the future of Houston looks pretty healthy. There's always a little bit of caution about what will happen in the oil industry, but I'm very optimistic."

 

Although the market in Houston has been favored among investors for a couple of years, according to Roberts, he doesn't believe Houston has seen its peak yet. "Many use baseball analogy that we're in teh middle innings of an extra innings baseball game," Roberts said. "Fundamentals in Houston and the economy's supply and demand equilibrium are very much in check, and I do believe that this current cycle will have a very nice run. I don't think we're close to the end. I think we have several years in the future to enjoy this momentum and continue to build on it."