Economist Says CRE's A-B-C Asset Categorization Is Ineffective

Commercial real estate economist Dr. Joshua Harris offered unique perspectives about how CRE assesses itself, including the A, B, and C asset model system as well as how to categorize primary, secondary, and tertiary markets while addressing the CREW Network conference last week in Atlanta.

He also spoke to the general state of today’s economy.

“We live in a world of ‘black swans’ now,” he said. “Who could have ever forecast what we’ve been through in the past few years?”

Harris noted that many predicted in the past year that the recession looked imminent, “but so far that has been a miss.”

However, while the 10-year treasury rates seem elevated, sitting in the mid 4% range, “that’s kind of like normal. And painful. The slowdown we have now in real estate lending is because the cost of capital is higher. The risk-return ratio today favors waiting.”

“Cap rates are higher now due to interest rates; this has become the long-term new normal. Sellers don’t want to sell, even though there is plenty of capital out there.”

The health of the US economy is up for debate, Harris said. The Atlanta Fed forecasts the US GDP at a seemingly solid 4.9% for Q3.

“That seems pretty good, but it’s the inversion of the 10-year and 2-year treasuries that is a leading recession indicator,” he said. “It’s what makes us feel like this current recovery isn’t very strong. Real estate likes to borrow short term and invest long term. And that’s hard to do right now.

“All and all, nothing that is going on today is going to matter, long-term. Even the Fed last week said, ‘We don’t know what’s going to happen’ with the economy.”

No More ABCs

Harris called the Class A-B-C system antiquated, and mostly ineffective.

He suggested a L-C-I classification: luxury, commodity, and infrastructure.

Luxury assets are highly desired building that fills emotional needs and wants and is in the “best” locations or parts of town. They can command the highest rents – and the tenants know it. Their occupancy rates remain high even during economic downturns and there is often a waiting list to lease there.

Commodity assets fill basic needs, and their living spaces are acceptable but not aspirational. Rents fluctuate with market cycles and there are risks of low occupancy during periods of oversupply. They are situated in “nothing special” locations.

Infrastructure assets are required and necessary for their city and society to function. Rents are usually stable and are subject to supply-demand conditions. Occupancy is usually high except during a major recession. Their locations are nearly irrelevant unless they are hyper-critical for functionality.

Assessing Markets Through Live, Work, Play

Furthermore, Harris said he prefers not to divide markets into primary, secondary, and tertiary. Instead, they can be classified based on the live-work-play dynamic.

“Live” is based on the affordability of the housing relative to the location. Other key characteristics include the quality of schools, climate, and their reputation for aura, safety, and crime. “If you don’t feel safe there, that’s what matters – not crime stats,” he said.

Also, consider transit and ease of mobility for their residents. Amenities are appropriate and there are advantageous shopping and cultural options. Markets that score well in the “live” category aren’t always ideal when it comes to “work.”

“Work” is measured by the strength and diversity of its economic base and whether there is relative ease in obtaining and retaining employment. The location should have access to office and industrial workplaces and access to capital and human and knowledge infrastructure. “Play” markets include free and affordable leisure activities and support a work-life balance culture. There will be amusement, arts, and tourist activities, as well as natural amenities such as rivers, lakes, parks, and oceans. The area should be able to attract tourists by having a good hotel supply.

“If people don’t want to visit there, then you probably don’t want to live and work there,” he said. “We saw a lot of visitors to Nashville and Charleston, S.C., in the recent past and now a lot of people are moving there.”

Businesses Judging Regulatory, Network, and Linkages

As for choosing areas to do business, Harris uses R-N-L categories to grade for companies to consider if they want to relocate there: regulatory, network, and linkages.

Regulatory is measured by how “business-friendly” the market is and its level of taxes and fees. Markets with governments or public officials who recognize and remove regulatory burdens, especially in relation to zoning, are best. Proclivities to inclusiveness and stability in the laws and courts is also a plus.

Network scores well when there’s connectivity among the locals, especially a strong degree of business connectivity. The population here has high levels of education and diversity, and higher education is prevalent.

Linkages mean transportation in and out of the market is an asset, such as through planes and trains. “Can you easily get from Point A to Point B?” he said. There should be domestic and international connections and an ability to grow and serve to meet population growth.