Market forecast

Better Days Ahead

Economic growth should propel commercial real estate recovery by year-end.

E conomists have many reasons to be optimistic this year. Interest rates remain low, keeping consumer spending patterns afloat, and business spending is escalating, posting an average annualized gain of 7.2 percent in the first quarter. In addition, strong productivity increases have boosted wages and corporate profits. Gross domestic product growth remains vigorous at 4.2 percent at the end of first quarter and likely will remain in the healthy 4 percent to 5 percent range for the remainder of the year.

However, the positive economic outlook cannot be sustained without jobs. The United States did not experience decidedly strong gains until March, when more than 300,000 jobs were added - the highest monthly gain since April 2000. The employment surge bodes well for the economy, but continued job gains of nearly 200,000 per month are necessary to support a continued recovery. Low-cost, high-population growth regions with steady employment gains, including Las Vegas, Phoenix, and Orlando, Fla., are rebounding. But urban markets such as Chicago, Boston, New York, and San Francisco, where job growth is stagnant, continue to struggle.

Job gains also are very good news for the commercial real estate industry. Employment growth yields office and warehouse space demand increases, higher retail sales, and stronger multifamily demand.

Office on the Brink of Recovery

Nationwide office market conditions have stabilized, and the prospects for a rebound this year are solid. A significant contributing factor is office-using employment, which rose in May 2003 for the first time since the economic downturn began and continues to escalate.

Office vacancies dropped slightly in the first quarter to 17.9 percent, down 0.1 percentage point from fourth-quarter 2003. However, despite recent job growth, the office market's recovery has yet to swing into high gear on the demand side. The bulk of recent leasing activity consists of intra-market relocations driven by cost and quality considerations as opposed to expansions. Net absorption totaled just 26.3 million square feet in 2003 and was a moderate 17 million sf in first-quarter 2004. A significant amount of shadow space will delay the demand rebound, which is not expected to peak until mid-2005.

Despite weak demand, developer and lender discipline helped the office market avoid hitting rock bottom. Modest construction has helped keep vacancies below 1991's high of 18.6 percent. Net construction completions in 2003 totaled 76 million sf, nearly 38 percent lower than 2002 levels. Completions in 2004 are expected to fall substantially to about 55 million sf.

Pricing power remains solidly in tenants' hands. Asking rents fell 5.3 percent year-over-year as of the first quarter; on the bright side, lease rates slid a modest 1 percent from year-end 2003, indicating that rents slowly are firming. As vacancies continue to fall and demand increases, rent growth should begin again in 2005.

Recovery signs have whetted the capital sources' appetites as well. Interest has increased lately for opportunistic acquisitions in markets where vacancies are high but the demand rebound is expected to be strong, such as Dallas-Fort Worth, Denver, and San Francisco.

Low Demand for Multifamily Continues

Multifamily vacancy remained at a lofty 7.3 percent in the first quarter, and weak job growth and a booming for-sale housing market will limit near-term demand. By year's end, vacancies are expected to decline only modestly to 7.1 percent.

Net absorption for apartments also remains soft. New demand totaled 109,000 units in 2003, not nearly enough to absorb the new construction coming on line across the country. Young renters have felt the greatest impact from the slow economy, as more than one-quarter of the unemployed are 25 to 34 years old. As a result, renters have been compelled to move in with roommates or home with their parents.

However, this is a short-term problem. Demand already is strengthening and is on pace to total more than 144,000 units this year, supported by a general economic recovery. Over the long term, the approximately 65 million echo boomers' entrance into the market will further drive demand, but this boost is several years away. The bulk of this generation will begin entering the prime apartment-renting age (20 to 34 years old) around 2007 and will grow by 1.2 percent annually between 2007 and 2012.

Supply has been slow to respond to weak fundamentals. The national apartment inventory grew by 1.2 percent last year, well above the pace experienced at the last cycle's nadir in 1993 when inventory growth slowed to near zero. Construction is expected to continue tapering this year, and inventories should increase by just 1 percent. Fast-growth, low-barrier-to-entry metropolitan areas including Palm Beach County, Fla., and Charlotte and Raleigh, N.C., should experience the highest construction as a percentage of inventory this year. (See chart, "2004 Apartment Construction.")

The supply overhang has stymied landlords' ability to raise rents. Average lease rates fell 1.7 percent in 2003 and are expected to remain relatively flat this year. Despite weak fundamentals, capital interest in multifamily properties remains hot. Approximately $28 billion of multifamily properties traded hands in 2003, outpacing all the other property types, according to Real Capital Analytics. However, capitalization rates have been falling steadily for more than two years as strong capital flows continue to bid up prices even as incomes decline. As a result, the possibility of unwarranted construction is a serious risk.

Retail Remains a Steady Performer

Resilient consumer demand supported the retail market's strong performance during the downturn. Record low mortgage rates sparked a home refinancing boom, which lined consumers' pockets with cash. Economic vacancies, which capture the percentage of space that is not viable given the current level of retail sales, declined 0.1 percentage point to 12.6 percent in the first quarter, returning to 1999 levels; by comparison, vacancies for the other property types are peaking at levels not experienced since the early 1990s. Demand should continue to improve as the economy recovers, allowing vacancies to fall to a healthy 11.4 percent by 2006.

While new construction has not slowed as rapidly as in the office sector, retail development activity has decreased from peak levels experienced in 2000 and 2001 as many national retailers drop their expansions or move into empty spaces. Net completions are slowing: Nearly 93 million sf is expected to deliver this year, down about 16 percent from average annual completions in 2002 and 2003.

National discount and variety retailers compose about 40 percent of total current retail construction, according to PPR/Dodge Pipeline. Chains including Wal-Mart and Target continue to expand the superstore format, and their rock-bottom prices are stealing market share from traditional grocers - particularly at the market's low end. Competition from Wal-Mart has taken a toll on Florida grocer Winn-Dixie, which recently announced that it will close 38 stores across the state.

While the discounters' encroachment into the grocery market is a relatively new phenomenon, traditional department stores have been battling their threat for years. Mall anchors in particular are struggling with slow or declining same-store sales, and, after much fumbling, middle-market players such as J.C. Penney and Sears are responding by adding shopping carts and central checkouts to compete more efficiently.

Supported by long lease terms and sturdy sales growth, retail was the only property type to experience a net lease rate gain last year, and rent growth should improve over the near term, averaging 2.8 percent in 2004. Strong sales activity has pushed cap rates down from lofty heights of more than 10 percent two years ago to about 8.5 percent as of the first quarter, but even now, risk-free investment spreads are near record levels, according to Real Capital Analytics.

Warehouse Market Sees Gains

Warehouse demand, which historically correlates highly with GDP growth, continues to increase with the economic recovery. Vacancy remained steady at 10.5 percent in first-quarter 2004, and net absorption is on pace to total 92.6 million sf this year, a 22 percent increase from last year.

Increased inventory levels have driven recent warehouse demand. The wholesale trade inventory-to-sales ratio fell to historical lows during the downturn as businesses became more risk averse and kept fewer products on the shelves. However, businesses are regaining the confidence necessary to increase inventories in preparation for future growth.

Last year, warehouse construction completions fell by 10 percent to 92.2 million sf; however, development activity has started to increase despite near-peak vacancies. Build-to-suit projects drive these surprisingly high new construction figures. Distribution logistics improvements and, to a lesser extent, discount and warehouse-format retailer growth have spurred the trend toward super-regional distribution centers. By establishing mega-distribution centers (more than 800,000 sf) near major ports such as Los Angeles and northern New Jersey, as well as in strategic locations including Atlanta, Chicago, California's Inland Empire, and Dallas-Fort Worth, retailers and consumer products manufacturers can serve the bulk of the U.S. population within a one-day drive. Massive build-to-suit distribution centers in these markets have driven supply and demand in recent years and will continue to account for an increasing share of warehouse activity in the near term. (See chart, "Inventory and Demand in Major Warehouse Markets.")

While demand is improving, a substantial supply remains, keeping a lid on rent growth. Rents dipped slightly in the first quarter and should continue to decline moderately by about 0.2 percent this year before gaining traction in 2005.

The warehouse sector's low historical volatility and cheaper tenant improvement and capital expenditure costs have driven investors' appetites over the last year. However, the number of industrial trades so far this year has dipped slightly. Through March, investment volume was down 7 percent from the same 2003 period, according to Real Capital Analytics.

What's in Store?

An improving national economy, office-using job creation, and disciplined construction suggest the office market is poised for a recovery. However, until job growth translates into healthy net absorption, that rebound will be slow to materialize.

The retail market is expected to be a steady performer over the next several years. While rising incomes and sturdy demographics will continue to feed retail demand, the downturn did not impact sales excessively; thus, pent-up consumer demand for retail goods is not likely to provide a significant upswing in the sector's performance.

U.S. employment conditions slowly have been improving, which portends favorably for the apartment market. However, the biggest risk to the burgeoning recovery is continued construction, as capital remains abundant. Developers may interpret declining vacancies as a green light to start building again.

The warehouse market is expected to hold up relatively well. Going forward, supply is expected to trend downward, based on lower levels of build-to-suit construction and moderate speculative supply. However, as in the apartment market, construction could come back quicker than forecast due to heavy investor interest in the sector.

Nancy Chesley

Nancy Chesley is a senior real estate economist with Property & Portfolio Research in Boston. Contact her at 617.426.4446 or


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