2001 Outlook: The View From the Top
Expectations Remain High for Most Commercial Property Markets.
In the current, comfortable economic climate, it may be helpful to step out of line to consider the outlook for 2001 and beyond. Despite claims of a “new economy,” some of the most basic rules haven't changed at all; supply and demand still govern the dynamics of the marketplace.
As evidence accumulates that productivity increases are genuine and sustainable and that the perceived inflationary influences are not likely to trigger a long-lasting upward spiral, monetary policy should bring real interest rates down from their present high level. The Federal budgetary surplus, the likelihood that the dollar will move downward in the coming years to correct the trade imbalance, and the coming shift of 401(k) plans from stock equities to corporate bonds are all harbingers of a strong fixed-income market and lower interest rates.
The economic — and commercial real estate — outlook, therefore, is optimistic. It does not discount some serious risks that exist in the economy, particularly the shakeout in the dot-com sector, and excesses that are found across the economic landscape.
Nevertheless, the clouds of a recession are not yet on the horizon. This year looks like a continuation of what has become the longest expansion in American economic history.
Moving into 2001, commercial real estate professionals are getting used to some impressive numbers from the office market. The average office building price rose about 20 percent in 2000, to about $150 per square foot on a national basis, according to the CCIM/Landauer Investment Trends Quarterly .
It is not hard to find the engine driving the investors: national office market statistics are in superb condition. Tight occupancy and rising incomes mean that the fundamentals for this property type are sound. The national office vacancy rate is at a 25-year low of 8.6 percent, as of the end of third-quarter 2000, according to Grubb & Ellis market data. Rents are rising at double-digit annualized rates, with a year-over-year change of 12.7 percent for class A space and 14.8 percent for class B properties.
The influence of the bicoastal economy readily can be discerned in the individual Market Quality Ratings for offices.
MQRs forecast supply/demand characteristics to compare various markets. In an MQR 1 market, demand exceeds supply over the five-year forecast period. An MQR 7 represents the other extreme — oversupply conditions are expected to dominate the market. MQR 1 through MQR 4 are considered to be favorable in terms of their fundamentals.
The 20 states bordering either the Atlantic or Pacific account for about 51 percent of the U.S. employment base, but have generated 58 percent of recent employment growth. It is no coincidence, then, that market quality is noticeably greener near the oceans. Twenty-nine office markets achieved MQRs of 2 or 3. Of these, 21 markets either were on the Pacific coast or Atlantic coast.
San Francisco and Oakland, Calif., repeated as the top-scoring office markets, earning MQR 2 ratings. San Francisco vacancy is down to 1.4 percent and class A asking rents average $80.20 psf, according to third-quarter 2000 Grubb & Ellis statistics. Across the Bay, Oakland's central business district is 4 percent vacant, while its suburbs have only 2.9 percent availability. Class A rents in Oakland are $43.18 psf.
New York also gets an MQR 2 rating. Midtown vacancy is 4.3 percent and Lower Manhattan is not far behind at 5.2 percent; rents in these submarkets are $70.02 psf and $48.31 psf respectively. Building activity has resumed, especially in the revitalized Times Square district, in which Arthur Andersen recently joined Condé Nast and Bertelsmann on the roster of anchor tenants for new towers. The 350,000 jobs that New York recently has gained have helped Manhattan absorb more than 40 million square feet on a net basis.
In northern California, San Jose and Sacramento earn MQR 3 scores. San Jose is a vibrant center in its own right, not a satellite of the San Francisco market. San Jose has vacancies beneath 2 percent and heady class A rents, averaging $78.36 psf.
Technology is boosting many coastal markets, although few of the MQR 3 cities solely depend on high tech. Washington, D.C., for instance, has substantial concentrations of information technology companies in its Virginia suburbs and key biotech firms in nearby Maryland. Enough growth around the nation's capital should prompt 130,000 new office jobs for this region in the next five years, which will keep the vacancy level, now about 5 percent, very low. No wonder offices in the district itself, Alexandria, Va., and Bethesda, Md., are selling for $250 psf or more.
Boston, similarly, has a well-established technology cadre around the Massachusetts Institute of Technology and along Route 128. Boston has seen its office vacancy rate fall to 1.4 percent in the CBD and 4.1 percent in the suburbs. There is not a great spread between class A ($42.50 psf) and class B ($38.50 psf) rents in this marketplace, a sign that tenant choices are constrained.
The same song can be sung on the West Coast. Seattle managed a net gain of 23,000 jobs in 2000, and about 5,000 of these likely went straight into the office market. Overall office occupancy is about 97 percent, and precious little inventory is left to accommodate the 33,000 additional office jobs projected in the near future.
Down the coast in Portland, Ore., the lassitude stemming from the recent Asian crisis has ended and a number of local industries have resumed vigorous growth. Portland's compact, attractive, and livable downtown posts a 5.9 percent vacancy rate at a relatively affordable $22.90 psf class A rent. That rent is likely to rise in Portland's slow-growth development climate.
Today's consumer has no lack of spending power. Thus, if retail property struggles to generate high sales psf, it is because the industry builds stores at such a breakneck pace.
The trend of improving retail market quality should continue. Real retail sales for 2001 through 2005 are expected to expand at 2.8 percent to 4.4 percent annually, which would mean an additional $363 billion in retail sales by the end of the projection period, more than enough to see increases in sales psf in most U.S. metropolitan statistical areas.
Fully two-thirds of the retail markets reviewed this year have investment-grade rankings of MQR 4 or better, and 18 are MQR 2 or MQR 3, indicating strong prospects. Only four out of 60 markets rated MQR 6 or MQR 7, suggesting sluggishness in just a few local markets until 2005.
The recently opened Mall of Georgia will be joined by the Mall at Stonecrest and the Mills Corp.'s 1.5 million-sf Discover Mills project, both of which broke ground in the Atlanta area in 2000. Local data suggests about a 9 percent vacancy rate in retail facilities around the MSA, and base rents are likely to be flat at this level. But retail spending in Atlanta is growing at about a 14 percent annual rate, fueled by both population increase and rising incomes. This produces an MQR 3 rating for the Atlanta area, which is the same rating as a year ago.
Mall development also is part of the picture in Seattle, a much tighter market with a 1.5 percent retail vacancy rate. This is one of the few metro areas that is not considered overbuilt. Annual retail sales growth runs about 11.5 percent, and has prompted developments such as the 810,000-sf Northgate North project. The economy here is diversified, technologically advanced, and well positioned for international business. The result is a MQR 2 retail rating.
Supply and demand in the Austin, Texas, retail market also is strong and also earns an MQR 2. Except for a spike in 1995, when the 1.1 million-sf Lakeline Mall was built, there has been little expansion of the general shopping center inventory here. Some grocery and drugstore building is occurring, but even the Wal-Mart and Target chains find it hard to get approved sites for development.
In Houston (MQR 3), Wal-Mart will open 200,000-sf-plus supercenters in the suburbs of Katy and Woodlands. Albertson's has broken ground on three developments, and H-E-B is also building several grocery stores. Urban Shopping Centers, meanwhile, expects to start a 700,000-sf expansion of the Houston Galleria, a clear sign that optimism has returned in force to the Houston market.
The ratio of new starts to total retail inventory in Minneapolis-St. Paul, Minn., has been running just at the national average since the mid-1990s, and this development discipline has meant above-average gains in sales psf. About $10 billion in additional retail store sales has been registered in the Twin Cities since 1995. Finding appropriate development sites is becoming increasingly difficult, and so further improvements in cash generation at existing shopping facilities is anticipated, leading to an MQR 3.
At all steps in the chain of production, industrial real estate has been challenged to evolve rapidly, and it does so with astonishing success. Absorption of industrial properties is strong. Rents are moving upward. And investors have been pricing acquisitions with the expectation that industrial real estate assets will offer attractive returns throughout the early 2000s.
The economic revival in Houston not only has seen the energy business jump-started, but has accelerated its population increase again. Industrial vacancy at mid-2000 was 7.1 percent, according to third-quarter 2000 Grubb & Ellis figures, but rents are a very competitive $3.84 psf for standard warehouses.
Oakland, with a 3.4 percent vacancy rate, is one the nation's tightest industrial markets. However, with rents now at $6 psf, Oakland is one of the most expensive West Coast markets, which is likely to constrain its competitiveness. Add to this the potential ripples of the dot-com shakeout and some watchfulness over this strong market seems to be in order. Nevertheless, based upon past performance and existing momentum, Oakland earns an MQR 2 rating, joining Houston and Denver.
The Mile-High City improved one rating level from a year ago. In 1999, Denver absorbed slightly more than 3.5 million sf of industrial space. For just the first six months of 2000, it generated 3.2 million sf of net new tenancy, driving rents to an all-time high of $4.61 psf. Denver's 142 million-sf inventory amounts to 71 sf per capita, close to the U.S. average, and its 5.7 percent vacancy rate is below the 6.5 percent national average, Grubb & Ellis reports.
Among the MSAs more typically noted for their demographic growth, Dallas, Fort Worth, and Phoenix all post vacancies in the mid-6 percent range. The Dallas/Fort Worth Metroplex serves as a regional distribution hub, and therefore has a high inventory/population ratio of about 95 sf per capita. Alliance Airport, on the Fort Worth side of the Metroplex, is booming, and FedEx is able to ship out of this location to destinations as far away as the Philippines. Alliance also has a major intermodal facility for truck/rail freight operated by Burlington Northern Santa Fe.
Phoenix saw its industrial market tighten nicely in 2000, and rents are moving upward from their $3.90 psf level at midyear. Phoenix rates an MQR 3, as do the Dallas and Fort Worth MSAs.
Several markets illustrate exceptional occupancy performance. Their vitality is so robust that either new construction or slow growth likely will ensue in the first half of this decade. These locations include Northeast markets such as northern and central New Jersey (3.5 percent vacancy), Long Island, N.Y., (4.9 percent), and Boston (5.8 percent). Vacancies are systematically higher in the Midwest and Southeast regions, often generating industrial MQRs of 4 or 5.
The multifamily property sector is riding an extended winning streak, and its blueprint for model market quality looks as good for 2001 as it did in the 1990s. Apartments consequently are in heavy demand among investors of all types.
One clear sign of the consensus in multifamily investment is the rally in real estate investment trust stocks specializing in this sector. As of the end of third-quarter 2000, multifamily REITs found their share prices virtually in line with analysts' estimates of net asset value, in contrast to the discounts persisting in office, retail, and lodging stocks.
Market quality for apartments is at its highest level for any year since MQRs began in 1992. Vacancies in San Francisco and San Jose are around 1 percent and monthly rents have soared above $2,000 per unit. Land is scarce from one end of the peninsula to the other, and rental apartments cannot compete with commercial development in highest-and-best-use calculations.
Austin is the third MQR 1 apartment market and, with the exception of the land shortage issue, shares many of the characteristics of San Jose and San Francisco. Austin has grown from about 536,000 people in 1980 to approximately 1.2 million today, and although thousands of apartment units are developed annually, Austin can barely keep abreast of demand. Rents are up 5.4 percent year-over-year, nicely outpacing inflation, and yet remain affordable in a market where median home prices have risen 15.2 percent in the past year.
Along the Atlantic seaboard, MQR 2 metro areas include Boston, northern New Jersey, and Washington, D.C. All these areas have tight vacancy rates below 2 percent in their stock of market-rate rental housing coveted by investors. Densities are high, and the local economies are booming. High per-capita incomes have boosted rents in these markets by 10 percent to 12 percent, according to surveys by M/PF Research of Dallas.
Markets up and down the West Coast also are positive. MQR 2 markets include Seattle, Portland, Oakland, Orange County, Calif., and San Diego. Average prices per unit have exceeded $90,000 for the entire Pacific region, compared with the CCIM/Landauer $67,000 national mean.
In top locations such as Southern California and the Bay Area, investment prices are well above $100,000 per unit, and deals at cap rates below 8 percent are common. How long can it be until a correction occurs? Right now, there is no apparent sign of a trigger for market decline.
U.S. rental housing markets, then, should be a mainstay for the commercial real estate industry in the early 2000s.
The booming economy has encouraged mobility, and hotel occupancy percentages advanced slightly in 2000 despite a 3.2 percent increase in the number of rooms available.
Industry analysts estimated that 2000 would bring earnings of $24.4 billion, up 8 percent from a year ago, and forecasted a 2001 gain of 8.6 percent. However, evidence of anxiety lingers around the hospitality sector. Publicly-held lodging companies still trade at a 25 percent discount to their estimated net asset value, the worst of all sectors by this measure of REIT/real estate operating company performance. Investors thus continue to express their skepticism despite the 15.4 percent total return produced by hotel companies in the 12 months ending September 2000, as calculated by Realty Stock Review .
However, almost two-thirds of hospitality markets nationwide are under such intense competitive pressure that they rate MQR 5 or lower. Hotels are a prime example of market bifurcation. Geographic areas doing well in business travel, domestic vacations, and international tourism are prospering. Those that lack one or more of these demand generators struggle.
The influence of the bicoastal economy will be especially strong in shaping hotel market quality for the coming years. The major 24-hour cities, especially, look to be top performers. Major resort destinations also should do well, as households with high discretionary incomes ride the wave of economic success. Areas of comparative weakness look to be cities with a concentration of limited-service facilities, especially in middle America.
Returning to the top of the list for 2001 is Las Vegas, the largest hotel market in the country as well as the most dynamic. It scores an MQR 1, the best possible rating. Even with a 15,000-room increase in supply since 1999, Las Vegas has managed to keep its occupancy close to 80 percent and has posted year-over-year revenue per available room growth of 14 percent according to an October 2000 special report in Smith Travel Research's Lodging Outlook.
Also rated MQR 1 is New York. The average daily rate in New York is the highest in the nation at $190, up more than 7 percent from a year ago. Full-service hotels in Midtown are fetching more than $300,000 per room when they become available for sale. New York is a major international tourism destination, capturing 22.5 percent of all overseas visitors to the United States. In addition, domestic travel to the area exceeds 30 million visitors per year.
Washington, D.C., also earns an MQR 1, with business travel thriving while both domestic and international tourism flows are strong. Projections indicate that occupancies, now running at 75 percent, will remain above 70 percent through 2005 even if the area adds 8,400 rooms to its 68,950-room inventory in the interim.
The other MQR 1 markets are the East Bay standouts, San Francisco and San Jose, with occupancies above 80 percent leading to double-digit growth in room rates and RevPAR in 2000. The key question for these markets is where new facilities can be put to meet expected demand.
Hoteliers have ambitious expansion plans, but they will be challenged to get their locations right. Financial discipline may be the very best tonic for the hospitality market. In perspective, the potential weaknesses are nowhere near as threatening as the glut that arose in the 1980s. Thus, through 2005, hotels may become more, rather than less, attractive as real estate investments.