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