Market Momentum

The commercial real estate recovery continues to build momentum. A torrent of equity capital has been raised to purchase commercial properties and loans. Lenders continue to come back to the market, loans are being refinanced, purchased, and restructured, and the underlying fundamentals continue to improve.

While current market conditions are encouraging, concerns still abound about the mountain of loans coming due over the next few years, particularly those done at the top of the last cycle. The commercial mortgage–backed securities market also largely remains on the sidelines, although credit is gradually improving in that market as loans are restructured and sold.

In addition, interest rates should remain exceptionally low during the next few years. The heightened uncertainty in Europe has set off demand for liquidity, driving long–term Treasury yields well below the prevailing inflation rate. The Federal Reserve is largely thought to be on hold through the middle of 2014. Long–term expectations for interest rates are beginning to come down and there is growing expectation that economic growth, inflation, and interest rates will remain lower than at any time in the past 25 years — which makes real estate look much more attractive.

Property Sector Profiles

Multifamily. The underlying fundamentals for income–producing properties continue to improve, particularly in the apartment market. Demand for apartments remains exceptionally strong across most of the country. Nationwide, vacancy rates have fallen 1.3 percentage points over the past year to 4.9 percent, helping to push up rents 2.8 percent, according to Reis. Demand for apartments is being fueled by stronger employment growth, which is lifting household formations.

While conditions are improving across the country, rents are rising the fastest in areas that are benefiting from the explosive growth in mobile technology and social networking, as well as a few markets where major industrial development projects have significantly boosted job growth. When it comes to rent increases, major technology centers, including San Francisco, San Jose, Calif., Oakland, Calif., Seattle, and Austin, Texas, account for at least half of the 10 fastest–growing markets during the past year. Another top market is Chattanooga, Tenn., where a new Volkswagen assembly plant opened up during the past year, drawing a large number of skilled workers into a relatively tight apartment market. A similar dynamic is playing out in Charleston, S.C., where the opening of Boeing's new commercial airliner assembly plant has bolstered job growth and in–migration, helping to increase rents by 3.5 percent.

Industrial. The strength in industrial development is also helping to drive gains in the warehouse and distribution market. Manufacturing employment has been rising solidly for the past two years and is up 2.0 percent during the past year, with the strongest gains coming in durable goods. Manufacturers have added nearly 500,000 jobs since manufacturing employment bottomed in early 2010. Gains are largely concentrated in the Midwest and South but are evident in most regions of the country.

The industrial market tends to follow manufacturing trends, and vacancy rates have fallen sharply in areas where manufacturing has picked up the most, including Detroit, Milwaukee, and Chicago, as well as in key national distribution markets such as Dallas, Phoenix, Atlanta, and Indianapolis. Conditions have also improved in tertiary markets benefiting from strong industrial growth, including areas like Janesville, Wis., Chattanooga, Lubbock, Texas, and Rockford, Ill., as well as rapidly growing port cities like Savannah, Ga., and Charleston.

In addition, Seattle, Washington, D.C.'s northern Virginia suburbs, Boston, and the San Francisco Bay Area are also seeing solid gains, benefiting from the nearby tech booms. Florida's major markets have also improved, with Miami, Tampa, Orlando, and Jacksonville all posting solid gains in the past year.

Another trend benefiting the industrial market is the explosive growth in online retailing. Retailers continue to be some of the most active participants in the industrial market, building new facilities to handle both brick–and–mortar and online operations. Gains are most evident in the Sun Belt, where population growth is strongest. The mobile Internet industry is also helping growth in the data center market, which is gaining in virtually every major market. Mega data centers are clustering around major metropolitan areas, including New York, Washington, D.C., Los Angeles, Dallas, and Atlanta. Other significant data center clusters are popping up in tertiary markets in the Carolinas, Iowa, Nebraska, and Tennessee, where abundant inexpensive power is available and the availability of sustainable energy sources is growing rapidly.

Retail. While online retailing is booming, the retail market itself continues to struggle. Several big–box chains have reported disappointing earnings and are closing underperforming stores. The upside is very little new supply has come on line, and vacancy rates have edged slightly lower. The retail market is becoming increasingly bifurcated, with the strongest growth occurring at the high and low ends of the spectrum.

A bright spot is regional malls, which are performing surprisingly well. A new regional mall opened in downtown Salt Lake City during first quarter 2012, and a handful of additional malls are currently under development. Mall merchants have done a much better job of developing winning strategies to compete with online retailers.

Small variety–store merchants that deal primarily with lower–income customers are also doing well. Many are opening standalone stores that undercut the big discount chains. However, bookstores and electronics chains continue to struggle with growing online competition, which is leading to more store closings.

Office. Office markets are showing only modest improvement. Office employment has increased 2.2 percent during the past year, compared to average growth of close to 3.0 percent during the past cycle and well over 4.0 percent during second half of the 1990s. Moreover, firms continue to find ways to squeeze more workers into fewer square feet. Even with modest growth, net absorption has risen for five consecutive quarters, but growth is exceptionally modest by past standards. With little new construction, vacancy rates have edged lower, falling 0.4 percentage points over the past year to 17.2 percent, according to Reis.

While the overall market is seeing only modest gains, there are a few pockets of strength. Major technology centers, including the San Francisco Bay Area, Seattle, Austin, and Raleigh, N.C., all continue to see strong demand. Rents have grown the most in the San Francisco Bay Area and New York, which is also increasingly driven by the tech sector.

Despite the sluggish pace of recovery, office property sales have increased this year. Properties in key technology centers, areas with a great deal of exposure to healthcare, and a few major energy markets, such as Houston, continue to outperform most other major markets. New York appears to be successfully navigating the slowdown in the financial services industry and is seeing an influx of technology jobs. Washington, D.C., however, has seen demand for space and buyer interest wane as continued anxiety and uncertainty about the federal budget has sent chills through market. The suburbs of Washington, D.C., are faring better with the tech sector fueling gains in northern Virginia and healthcare driving gains in suburban Maryland and Baltimore.

Looking Ahead

With the rekindling European financial crisis and the U.S. presidential election coming into full swing, overall economic activity is likely to slow down during the second half of the year. Businesses will become even more cautious about expanding operations and hiring new workers, which means demand for commercial space is likely to drop. The capital markets may also suffer a few bouts of illiquidity if the woes in Europe take an ugly turn or another unsightly battle to raise the U.S. debt ceiling breaks out.

Despite these impending challenges, the most likely outcome continues to be modest economic gains across most of the U.S., with a few notable bright spots lighting the way, including the technology, manufacturing, agriculture, and energy industries. Better news from Europe and government agreement to tackle the massive fiscal issues facing the country would provide an upside surprise.

Mark Vitner is managing director and senior economist for Wells Fargo Securities in Charlotte, N.C. Contact him at mark.vitner@wellsfargo.com.