We believe that some of the unique challenges for the market are exactly what makes Hawaii an attractive place to invest.
In particular, the difficulty of developing new commercial real estate and housing keeps a lid on new commercial real estate supply, thus giving an advantage to current landlords.
While tourism can present a level of unpredictability, the long term supply and demand dynamics present an attractive risk-adjusted return, especially relative to other mainland markets.
Since becoming a state in 1959, Hawaii has been portrayed as a sunny beach vacation spot with palm trees and a rich cultural history. As with most things, reality is much more complicated. While it does boast some of the most beautiful beaches in the world (with top notch surfing), the rich cultural ‘history’ is not all in the past. As the most recent state added to the union, native Hawaiians have the shortest history as part of the USA. Similarly, their culture was independent of American culture more recently than any other state, exacerbated even further by geographical distance. As such, investing in Hawaii presents some of the most unique opportunities and risks relative to the other 49 states.
We believe that some of the unique challenges for the market are exactly what makes Hawaii an attractive place to invest. In particular, the difficulty of developing new commercial real estate and housing keeps a lid on new commercial real estate supply, thus giving an advantage to current landlords. While the contribution of tourism to the local economy makes it slightly more difficult to predict short term demand growth, the relative stability to other ‘island destinations’, solid infrastructure, and temperate climate give us confidence in long term growth. The Chilton REIT Composite has an overweight position to Hawaii as of February 29, 2020.
Hawaii Economic Overview
With about 1.4 million residents as of 2018, Hawaii is the 39th most populous state. However, it has established itself as one of the top tourist destinations in the world, boasting almost 10.0 million visitors in 2018. These visitors spent $17.6 billion, which comprised about 18.5% of Hawaii’s gross domestic product (or GDP). This compares to the national average of 2.9%, and ranks Hawaii as the highest state for tourism spending as a percent of GDP. On the back of strong tourism, Hawaii’s GDP growth has outpaced the national average since 2000, which is especially remarkable considering that tourism’s worst years occurred following the September 2001 terrorist attacks and the 2008-2009 recession.
Local population growth has also outpaced the national average going back to 1960, owing most of it to in-migration. However, population growth turned negative in 2017 and has been negative for 2018 and 2019 as well. Job growth to support tourism has flourished, but it has not been enough to keep up with the national average. Hawaii’s median per capita personal income of over $53,000 on the surface is positive relative to the national median of $52,000, but it doesn’t tell the whole story. According to the Tax Foundation, $100 is actually only worth $84.39 in Hawaii as of 2017, which is the lowest in the country, below even New York ($86.36) and California ($87.11). As a result, as shown in Figure 1, when adjusting per capita median personal income for cost of living (using ‘regional cost disparities’), Hawaii’s income as adjusted is much lower than the US average. Similarly, Hawaii’s 2.9% unemployment rate as of 12/31/19 is below the national average of 3.6%, but the workforce participation in Hawaii is well below the national average at only 60.9% versus 63.4%.
In summary, the state of Hawaii has certainly benefited from becoming a popular tourist destination. However, the locals may not have benefited as much as they would’ve thought, contributing to a cultural insulation against visitors, particularly those looking to invest.
Notwithstanding the effects of tourism on the island, the insulated (and isolated) location of Hawaii generated a uniquely independent and proud culture that rivals many sovereign nations. Rightfully so after the experience that the Native Americans had with visitors looking to buy land and impart new customs, Hawaiians have been somewhat resistant to outside investment from the start. Infamously, the Delaware Indians sold Manhattan to Peter Minuit for $24 in 1626, which is equivalent to less than $2,000 today. In contrast, a study in 2018 estimated that the total value of Manhattan land was almost $2 trillion. Instead of outright sales to visitors, Hawaiians have shrewdly favored leasing the land for them to build hotels, condos, retail, and office properties. Thus, they are protecting themselves from losing out of the potential appreciation in the land, while also allowing investment to stimulate the economy (and hopefully make the land more valuable).
Despite the ground leases, the investment in housing has not been enough. Similar to California where regulations on development and rent control have created a mismatch in housing supply and demand, the lack of new housing has caused rents and home prices to explode well above the national average. According to one estimate, it can take 9 to 15 years to get entitlements approved. Approximately 95% of the state is reserved for agriculture and conservation, which further limits development, and increases the value of permitted land. As a result, the average Hawaii home transaction price was $780,000 as of September 30, 2019, which compares to the national average of $227,000. Similarly, the average rent for a 900 square foot (or sqft) apartment was $2,400 per month, which compares to the national average of $1,700, according to Zillow.
Furthermore, energy costs, gasoline prices, and even basics such as toilet paper are among the highest in the country. Gasoline prices are the second highest in the country, while electricity prices are almost triple the national average, and groceries are the highest. Some of this is due to the transportation costs to get goods to Hawaii, which must be brought via plane or ship. Due to a 100 year old law called the Jones Act, shipping goods between US ports is much more expensive than a ship from a foreign port to a US port. The Jones Act stipulates that all goods delivered from a domestic port to a domestic port must be carried on a ship that is built in America by Americans, at least 75% owned by Americans, and at least 75% of the crew must be American. While the purpose was to preserve the US shipbuilding industry (0.3% of global shipbuilding), it disproportionately punishes Hawaii (and Puerto Rico) which do not have the option of rail or truck. By some estimates, allowing foreign ships to deliver US goods from US ports could cut prices in half.
In addition, Hawaii has a state income tax with a top rate of 11%, which is second only to California with a top state tax rate of 12.3%. Adding more ‘SALT’ to the wound of high state taxes, the Tax Cut and Jobs Act of 2017 limited deductions of state taxes (property and income taxes) to only $10,000 which disproportionately hurt residents in Hawaii, among other states. These factors help to explain why population growth has turned negative. However, this is not all bad for commercial real estate.
Almost the entirety of the state’s office market is located on Oahu, and specifically Honolulu (including Waikiki). With about ten million sqft, Honolulu’s office market (downtown plus surrounding areas) compares to the downtowns (excluding surrounding area) of Nashville or Baltimore. Due to the high contribution of tourism, the office-using employment of Hawaii ranks quite low, with demand being driven mostly by local business and the government sector. As such, we expect demand growth to be muted. However, supply is tight, and the small denominator can make small absorption numbers have outsized effects on the market statistics. For example, the downtown Honolulu market absorbed 200,000 sqft in 2019, the largest year of positive absorption since 2006, though still only 2% of the total inventory. However, several office buildings are being converted to residential buildings, which reduced the supply. As a result, the office vacancy rate on Oahu declined from 13.7% in 2018 to 9.5% in 2019 according to CBRE. This should help office rent growth to continue to grow steadily in the face of low demand.
The REIT with the most Hawaii office exposure is Douglas Emmett (NYSE: DEI), which owns four buildings in Honolulu totaling 1.6 million sqft. As of December 31, 2019, these buildings were 94% leased with an averaged annualized rent of $34.96 per sqft, which compares to DEI portfolio averages of $44.80 per sqft. Annualized rent of $48.7 million at these Hawaii properties comprises about 7% of DEI’s office portfolio, or 6% of DEI’s total portfolio. The balance of DEI’s portfolio is located in West Los Angeles.
Hawaii-based REIT Alexander and Baldwin (NYSE: ALEX) also derives about 4% of its cash net operating income from office. As of December 31, 2019, the company owned 143,000 sqft spread between Oahu and Maui, which were 90.9% occupied generating annualized base rent of $32.93 per sqft.
DEI is the only publicly traded REIT with multifamily ownership in the state. Coincidentally, DEI is converting one of its office buildings to multifamily. 1132 Bishop Street is a 25 story, 490,000 sqft office tower that will be converted into 500 multifamily units. The conversion will be done in phases so that multifamily rent will replace office rent as office tenants vacate. The first units are expected to be delivered in late 2020. DEI owns three other multifamily properties in Honolulu, which were 98% leased at an average rent of $1,850 per month as of December 31, 2019. Annualized rent of $44.3 million comprises about 36% of DEI’s multifamily portfolio, or 4% of DEI’s total portfolio. When combining the Honolulu multifamily and office properties, DEI generates about 11% of its annual rent from the state.
Hawaii’s industrial market finished the year at only 2.0% vacancy, which is essentially full given a 1.5% ‘structural baseline vacancy’, according to Colliers, a global real estate research firm. According to CBRE, 2019 was the first full calendar year where all four quarters had positive net absorption since 2013, which drove steady rent growth. 2020 is expected to produce more of the same results, with Colliers projecting 2020 to have the highest net absorption in over a decade. ALEX owns a 1.2 million sqft industrial portfolio in Hawaii that was 95.3% occupied as of December 31, 2019. Net operating income of the industrial portfolio comprised approximately 16% of ALEX’s total portfolio as of the same date. An externally-advised REIT (which presents extreme conflicts of interest), Industrial Logistics Properties Trust (NYSE: ILPT), has the largest Hawaii industrial exposure with approximately 39% of its cash net operating income coming from the state.
Retail vacancy was 6.9% at the end of 2019 for all of Hawaii, which compared to 5.5% as of the same period in 2018 driven by slightly negative absorption of -145,000 sqft. Most of this occurred in the mall space, which was affected by the Sears bankruptcy in particular. 2020 may face similar bankruptcy headwinds due to announced closures of Pier One and the bankruptcy filing by Forever 21. Notably, Forever 21 is going to keep two stores open, and they are both at REIT-owned centers (Pearlridge, owned by Washington Prime Group (NYSE: WPG) and Ala Moana Center, owned by Brookfield Property Partners (NYSE: BPY)). American Assets Trust (NYSE: AAT) owns three properties in Hawaii, including a hotel and street retail property in Waikiki, and a grocery anchored center adjacent to a Premium Outlets (owned by Simon Property Group (NYSE: SPG)). AAT derives approximately 17% of its cash net operating income from Hawaii.
Ala Moana Center holds the crown as the most valuable US mall, estimated to be worth $6 billion. It comprises 2.4 million sqft and boasts 350 stores averaging sales of $1,500 per sqft. Brookfield Property Partners recently added a 300,000 sqft expansion, and plans to spend $153 million on a residential tower to be delivered in 2025. Publicly traded Howard Hughes Corp (NYSE: HHC, not a REIT) has capitalized on the “place” of Ala Moana, building five residential towers adjacent to the mall generating $2.2 billion in proceeds from condominium sales. HHC currently has plans for 11 more towers over the next eight years, as shown in Figure 2.
We believe it is important to delineate between the local and tourism-based retail markets in Hawaii. While Waikiki street retail and Ala Moana Center are driven by tourism spending which can be influenced by the strength of the US Dollar, grocery anchored centers are much more dependent upon the local economy. ALEX owns mostly grocery-anchored shopping centers that cater to locals. ALEX derives 77.3% of its cash net operating income as of December 31, 2019 from such centers spread between Oahu, Maui, and Kauai. The centers comprise 2.5 million sqft and were 93.3% leased with an average base rent of $33.12 per sqft as of December 31, 2019. This business should be much more resilient to the e-commerce threat than mainland shopping centers given the expensive and prolonged delivery times. For example, instead of Amazon Prime delivery times of one or two hours in many mainland cities, Hawaii Amazon Prime customers have delivery times of 3-7 days, which increases the reliance on brick-and-mortar shopping. In particular, grocery delivery is especially difficult on the island, which will keep the grocery brick-and-mortar stores as strong anchors for the foreseeable future.
In 2019, Hawaii’s lodging market logged Revenue per available room (or RevPAR) growth of 3.6%, which compared to the national average of 0.9% and the top 25 lodging markets at -0.2%. Two luxury developments were announced in 2019, which will carry the Rosewood and Auberge flags.
Host Hotels (NYSE: HST) owns the highest EBITDA-producing hotel among publicly traded REITs in the Hyatt Regency Maui, which produced $54.7 million in EBITDA in 2019 from 806 rooms. HST also owns the Andaz Maui and the Fairmont Kea Lani. Park Hotels (NYSE: PK), a spinoff from Hilton (NYSE: HLT) in 2017, owns the hotel with the largest number of rooms, the Hilton Hawaiian Village Waikiki Beach with 2,860 rooms. Rounding out exposure, RLJ Lodging (NYSE: RLJ) owns the Courtyard Waikiki Beach, and Sunstone Hotels (NYSE: SHO) owns the Wailea Beach Resort.