The REconomy Podcast™ | First American

The REconomy Podcast™: The Dynamics Re-Shaping Commercial Real Estate - The Business of Space

Written by FirstAm Editor | Jul 13, 2023 1:30:00 PM

In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Senior Commercial Real Estate Economist Xander Snyder discuss the commercial real estate market, explaining the dynamics that are fundamentally re-shaping the ‘business of space.’

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Listen to the REconomy Podcast™ Episode 68:

“Recent coverage of commercial real estate focuses on things like lending activity, lack of liquidity, or depressed transaction volumes. And these are all important issues. But many, and not all, but many of the underlying drivers of trends in the commercial real estate market today stem from changes in how we as a society are choosing to use, demand, and provision space.” – Xander Snyder, senior commercial real estate economist at First American

Transcript:

Xander Snyder - Hello and welcome to episode 68 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Xander Snyder, senior commercial real estate economist at First American. And here with me is Mark Fleming, chief economist at First American. Hi, Mark.

Mark Fleming - Hey Xander, very much looking forward to another commercially focused discussion with you. And for listeners who tune in regularly, you'll notice Odeta won't be joining us on today's episode. She is currently on a much-deserved holiday. So Xander take it away.

Xander Snyder - Here we go. So Mark, I don't know if you remember, but the last few times I came on the show, we talked about some office trends, and they were kind of gloomy episodes. 

Mark Fleming - Yes. How could I forget? The return of strategic default. Ooof. Dare we say we are living up to the nickname for economists as dismal scientists.

Xander Snyder - Dismal, indeed. But, today, I want to talk about something completely different. No gloom, no gloom. No, no dark stories. No, nothing like that. No gloom, no doom. I want to take a step back, way back, to get some perspective of what the commercial real estate industry is on a more fundamental level, maybe even a philosophical level.

Mark Fleming - Ohhh, waxing philosophical on commercial real estate. Well, you've definitely piqued my interest. Are you going to be 'Thoreau-ing' our listeners any curveballs today? Get it? Get it.

Xander Snyder - 'Thoreau-ing?' That's pretty good. I think 'So-crates' would be proud.

Mark Fleming - I see you came prepared with an excellent 80s reference today. For listeners who don't know, 'So-crates,' is how Keanu Reeves' character refers to Socrates in the absolutely classic 1989 film, Bill and Ted's Excellent Adventure.

Xander Snyder - Yes, excellent movie. So, the reason I want to take this high-level perspective is because commercial real estate has been in the news quite a bit lately. And sometimes the coverage of commercial real estate can get kind of technical and use a lot of jargon.

Mark Fleming - Yes, all those fancy terms, like balloon payments, commercial mortgage-backed securities, debt coverage ratios, negative leverage. They sure do make their way into commercial real estate news regularly.

Xander Snyder - Yeah, and sometimes it's easy to get lost in the weeds of all that technical language. So, at a more basic level, I think commercial real estate can be thought of as the business of space.

Mark Fleming - Ooh, the business of space. That sounds a little fancier than commercial property market, doesn't it? But now, of course, by space, you don't mean outer space, you mean the physical space that's used by people and companies for living, working, selling products, or storage.

Xander Snyder - Exactly. The commercial real estate market arises as a result of how we use, demand, supply and maintain physical space for different purposes. And I think it's an interesting philosophical point -- see, I told you, we'd get to philosophy -- to consider right now, since a lot of this recent coverage of commercial real estate focuses on things like lending activity, lack of liquidity, or depressed transaction volumes. And these are all important issues. But many, and not all, but many of the underlying drivers of trends in the commercial real estate market today stem from changes in how we as a society are choosing to use, demand, and provision space.

Mark Fleming - And a lot of times you'll hear economists say things like, in the long run, or in the short run or medium run. This sort of seems like one of those cases, right? There are long-term trends, like changes in technology that we can observe and comment on, while simultaneously there are these shorter term trends, or even shocks recently to the system, that are constantly interacting with those long-term trends.

Xander Snyder - Yes, and I think breaking out different timeframes is really a very useful tool. For example, liquidity crunches, which we're in the middle of right now. They don't go on forever, but you can't uninvent the steam engine. So, in the medium term, maybe you can reasonably expect lending to pick back up at some point followed by deal volume, but you can't uninvent Zoom. It's here. The rise and rapid adoption of remote work technology has fundamentally changed how we use and, therefore, demand both office and residential space.

Mark Fleming - It sure has. Look at us recording our podcast episode thousands of miles away from each other. But, it is worth mentioning technology impacting how society designs and uses space isn't a new phenomenon. Technology has been changing how we use space throughout human history. Look at the Industrial Revolution. Before the Industrial Revolution, there weren't any factories because factories didn't exist yet. So much more space was agricultural before the Industrial Revolution. When the steam engine, that steam engine that you cannot uninvent, rolled out, rolled around. Get it? Rolled around. You need big physical spaces to use it in and power all of the machinery, hence the factory, and the industrial commercial real estate asset. As people then transition from the farm to the factory, more people move to cities and urban density grew necessitating more retail space and multifamily dwellings.

Xander Snyder - Exactly. And another more recent example, the Information Age has brought about the need for massive data warehouses to store all this information and the computing power to analyze it. As a result, you now have this fairly niche sub-asset class of data center space that's dedicated to storing and running massive amounts of computers and servers. Clearly, they didn't need data centers in 1900.

Mark Fleming - Back then, and as recently as the 1980s even -- I can't resist -- the only data centers you had were libraries. Who remembers how to use a card catalog?

Xander Snyder - I had to learn at one point, but I don't think I remember. I do, however, remember distinctly learning how to use the Dewey Decimal system.

Mark Fleming - Right, the Dewey Decimal System.

Xander Snyder - You certainly couldn't work remotely in the 1980s either.

Mark Fleming - That's absolutely true. Fast forward to today, remote work hasn't just changed the way we use and demand office space, but also how we use and demand residential space. Since residential space is now regularly used as workspace, it has become what economists like to call a substitute good. This substitution of residential space for office space wasn't even possible before technology enabled it.

Xander Snyder - And, while remote work technology is probably the most obvious example of technological innovation impacting space usage today, it's not the only one. Before the pandemic, the rise of eCommerce was already changing how people shopped. Before you could go to Amazon and buy anything your heart desired and have it delivered the same day, you used to have to physically leave your house to buy goods.

Mark Fleming - Imagine that. Horrifying, horrifying, indeed. And, for context, eCommerce sales did spike during the pandemic increasing from about 12% of total retail sales in the first quarter of 2020 to 16.5% at its pandemic peak. Right now, eCommerce sales account for approximately 15% of all retail sales. Think about all the innovation that's come about in terms of online payments or distribution and logistics required using commercial real estate space to deliver products to homes quickly when purchases are made. Yeah, even after all of that, the vast majority of retail sales still happens in brick and mortar stores.

Xander Snyder - Yes, and even this relatively small 15% has really upended how we shop and therefore use retail space. Competition from eCommerce is driving further innovation from physical retail stores, as these brick and mortars are being forced to differentiate the shopping experience that they offer from the one that's available online. Some have even built apps that are meant to be used as a sort of in store shopping aid, allowing customers to find products more quickly, or be offered discounts based on where they are in the store.

Mark Fleming - I'm channeling that movie Minority Report right now. But what's interesting about this eCommerce example is there that there are knock-on effects. eCommerce hasn't just changed the way we use retail space. It's also changed the way we use industrial space, the need to be able to quickly deliver goods, either directly to consumers or quickly to retailers, has driven incredible demand to lease and own industrial properties.

Xander Snyder - And I think, among all the commercial asset classes right now, industrial is arguably the most resilient. And this is due to the ongoing demand to use industrial space either for storage or distribution. And this has resulted from the technological innovation over the last two decades. Sure, the industrial market is softening. But, if you look at the demand drivers for industrial space today versus 15 years ago, it's no comparison. There are simply more uses for industrial space today than in the recent past.

Mark Fleming - And one interesting side effect of thinking about commercial real estate as the business of space, as we've been doing, is that it all comes across as pretty dynamic. And, by contrast, I think when a lot of people look or think about big commercial buildings, they think about these static, immovable objects that sit there on the ground, used and consumed over time.

Xander Snyder - Yeah, it's an interesting juxtaposition, this dynamic versus static. Let me take that comparison and ask you a follow-up question on that, Mark. Do you think that there are uses for space that are less dynamic, maybe less subject to technological innovation, and therefore more or less likely to remain the same over time.

Mark Fleming - That's interesting, I think, well, for now, at least, we still need a place to live, to eat, and to sleep. In that sense, it seems like our need for residential space should be more consistent over time. So it stands to reason that there will continue to be demand for residential space, regardless of future technological innovation, especially now that it's often also the substitute for workspace as well. Unless, of course, we're talking about the far, far, far distant future. And we've all become brains living in a jar, and we don't take up much space anymore. I suppose we'd have to all be stored somewhere, though. But this is an economics podcast, not a science fiction one. There will be no 'Weird Science' in REconomy.

Xander Snyder - Mark, I do believe that's two 80s references in one episode.

Mark Fleming - That is, indeed. And then that's a podcast episode, well done. See our REconomy playlist on your favorite streaming platform for music. We'll throw some songs on up there from Weird Science.

Xander Snyder - Shameless, and 'Weird Science,' for those who don't know, is another classic 80s sci-fi flick. So, maybe for this reason, you could argue that commercial real estate is a little bit more prone to changes in use space than residential real space, at least in the really long run, for that underlying demand to actually need to eat and sleep somewhere, you think?

Mark Fleming - Possibly. So, Xander, now we spent some time waxing philosophically about different perspectives of the commercial real estate market, which before today, I didn't know was even possible.

Xander Snyder - Yes, Plato would be either proud or bored.

Mark Fleming - Why? Why even take the time to talk about why commercial real estate can be thought of like this, as the business of space.

Xander Snyder - I think this long-term perspective can provide little insight into what's other a fairly turbulent market right now. And, now I'm not saying that you can eliminate uncertainty, that's not possible, but you can ask how the use of space and, therefore, the demand for space is changing and why it's changing and what the drivers are for that change. Chances are those drivers are still going to be around whenever this liquidity crunch ends and deal volume picks back up, which will happen. We just don't know when exactly.

Mark Fleming - Xander thanks for hopping on the show today to give us your weirdly scientific -- too much, maybe? Too much? -- perspective on the business of space.

Xander Snyder - Great chatting with you, Mark. Thank you for joining us on this episode of The REconomy podcast. If you have an economics-related question that you'd like us to feature on a future episode, you can email us at economics@firstam.com. We really do love to hear from our listeners. And, as always, if you can't wait for the next episode, follow us on Twitter, either @MFlemingEcon for Mark, or @XanderSnyderX for me.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.