Market forecast

Getting Better All the Time

A growing economy and continued capital influx are music to the ears of commercial real estate pros.

A t midyear, the U.S. economy is humming along. Although high prices at the pump may suppress consumer spending, such worries are offset by new job growth and healthy corporate earnings. In several commercial real estate sectors, higher energy and construction costs are keeping the lid on new supply and driving up sales prices -- but not driving away investors still enamored of bricks and mortar. Will the tune change in the next six months? Experts around the country predict the industry's high and low notes through year-end.

OFFICE SINGS

by Patricia A. Nooney, CCIM
Managing Director

CB Richard Ellis, St. Louis
The U.S. office market has experienced dramatic improvement since 2005. Leasing activity has been hottest in Washington, D.C., and New York, where rents hover around $44 to $46 per square foot, and Los Angeles, where rents are nearly $30 psf. Office investments continue to be desirable, especially among individuals and small ownership groups, equity/opportunity funds, and life/pension fund advisers. First-quarter 2006 capitalization rates for class A office product were around 6.8 percent and around 7.1 percent for class B. The balance between investor demand and the offering supply is shifting, which alleviates some of the downward pressure on cap rates. Additionally, pricing for both central business district and suburban properties has been increasing substantially since 2005, which signals that improving rents and occupancies are be coming the primary price drivers.

In terms of volume, Manhattan remains the most consistently active investment market, with Northern and Southern California close behind. Investors that are priced out of coastal markets continue to turn further inland, causing a disproportional amount of capital to flow into secondary and tertiary markets. Office investment sales increased 34 percent nationally in 2005, with 25 markets posting sales volume of $1 billion or more. While the pace of sales is starting to slow, it is unlikely the trend will drop off substantially this year.

Compared with other product types, office supply is growing at a lesser rate, as demand in most major markets simply does not bear significant development. Exceptions to that trend include the Sun Belt markets, which continue to gain popularity among corporations and investors as viable headquarter locations and investment vehicles. As large blocks of contiguous space in major markets become scarce, these locations are well positioned for continued absorption and overall growth. Additionally, as construction, labor, and energy costs climb, the pace of new office development remains controlled.

The best office forecast available is one of steadiness and consistency. Provided the national economy keeps inflationary pressures at bay and continues its steady growth, employment-fueled space demand should continue. The toughest outlook? A sudden housing market crash could fuel a retail crash and ultimately, a banking crisis. While this is unlikely on a national scale, markets such as California, where the housing market is due for correction, could see relative manifestations of this trend.

RETAIL HUMS

by Stephen E. Williamson, CCIM
Director of Retail Services
Transwestern Commercial Services, Dallas

Retail was the darling of 2005's investment community; the average shopping center traded in the 6 percent to 8 percent cap rate range, with certain investment-grade retail and single-tenant assets even trading as low as 5 percent. Although it may seem like they have dropped, particularly since interest rates have risen slightly, this year's retail cap rates have remained relatively unchanged from 2005. One of the reasons is that capital markets' liquidity has remained strong due to pension funds' reallocations into real estate. As long as this steady flow of capital is available - and it appears it will be for at least another 18 to 24 months - retail investment demand should remain strong, prompting stiff competition for well-located class A retail properties.

Based on current construction reports, new retail space for 2006 will top out around 57 million sf nationwide, about a 25 percent decrease from last year's 75 million sf, helping to ensure the retail sector will not overheat through overbuilding. Big boxes including Target, Wal-Mart, PetsMart, Home Depot, Linens 'N Things, Best Buy, Bed Bath & Beyond, and Ross Dress for Less continue to be the biggest drivers of new retail development this year. Lease rates on new construction have increased nationwide, mainly due to higher prices for steel and concrete. In the last 12 months, construction costs have increased 30 percent to 35 percent. On average, retail lease rates are increasing nationwide by 3 percent to 6 percent this year, while vacancy rates should average from 5 percent to 10 percent, depending on the specific submarket.

The remainder of this year should continue to be very favorable for the retail sector. Though cap rates may move upward slightly, investment sales will remain strong and there will be a premium on delivering new product to the market as demand outweighs supply. Development will continue to occur at its present pace with big-box and other national tenants leading the way in the power and lifestyle categories. Lease rates and occupancy rates will show modest growth, while tenant interest in established retail areas will remain strong. Retail leasing, development, and investment sales should remain healthy through year-end and into 2007.

Rendering caption: Big-box retailers Target, Linens 'N Things, Sam's Club, and Ross Dress For Less are among more than 60 tenants committed to the 1.3 million sf Tempe Marketplace, Arizona's largest retail development since 2001.
Rendering credit: Ross & Allyn Public Relations

INDUSTRIAL SWINGS

by Patricia A. Nooney, CCIM
Managing Director
CB Richard Ellis
, St. Louis
Overall U.S. industrial market availability was 9.9 percent during 1Q06, an almost imperceptible increase over the 2005 year-end figure of 9.7 percent. However, a comparison of 1Q06 to 1Q05, when the national availability average was 10.7 percent, indicates steady, if slow, absorption of national industrial product.

Markets that lead the nation in highest availability include Austin, Texas (19.7 percent), Boston (19.0 percent), Atlanta (18.0 percent), Jacksonville, Fla., and Columbus, Ohio (tied at 15.3 percent), and Baltimore (13.4 percent). Atlanta's presence on this list is largely due to a local construction boom, combined with the shifting user base in this industrial hotbed.

Markets citing the lowest availability rates in the nation are Tampa, Fla. (4.3 percent), Las Vegas (5.0 percent), Long Island, N.Y. (5.6 percent), Palm Beach, Fla. (6.7 percent), and Portland, Ore. (6.8 percent). Many of these markets either benefit from being commercial ports or are areas where demand outpaces supply. While not major distribution hubs historically, their available development opportunities have made these markets increasingly popular places to do business.

New industrial properties are expected to total 130 million sf this year, or 2.5 percent of existing inventory - a small increase by historical standards, according to CBRE Capital Markets. As long as concrete, steel, and labor costs continue to climb, a construction spike remains unlikely. Of notable exception are California's Inland Empire and Long Beach markets, where the demand for industrial warehouse space near these busy ports remains at a fever pitch.

Investors, particularly life and pension fund advisers, real estate investment trusts, and some small syndicates and individuals, are returning to industrial property as a viable investment opportunity. Last year's record industrial investment sales volume of $35 billion is a trend that is likely to continue.

Currently the most active markets are Dallas, Seattle, and San Jose, Calif., originally hit hard by the tech recession. As investors are priced out of primary and secondary markets, tertiary markets are becoming increasingly appealing. Cap rates, which have reached their cyclical low, are expected to remain near current levels. Prices, however, have room for improvement. As market fundamentals across the country strengthen and construction and/or replacement costs con-tinue to rise, price appreciation should occur through year-end.

Rendering caption: One build-to-suit and two speculative industrial properties are being developed in Van Nuys, Calif., by Voit Development Co. and Selleck Development Group adjacent to The Plant, a 1.2 million-sf industrial, retail, and entertainment center located on a former General Motors assembly plant site.
Rendering credit: Brower, Miller & Cole

HOSPITALITY PERFORMS

by Arthur Adler
Managing Director and Chief Executive Officer-Americas
Jones Lang LaSalle Hotels, New York

The lodging industry experienced an unprecedented level of hotel sales activity with more than $21 billion total volume in 2005, outpacing 2004 volume by 63 percent, according to Jones Lang LaSalle Hotels. This strong transaction activity is expected to continue into 2007. The U.S. has been at the forefront of the global "seller's market" trend, but buyers are not missing out. Investors are taking advantage of low interest rates to buy into a sector with rapidly improving operational fundamentals, including double-digit revenue per available room and average daily rate growth in major urban and resort locations. This equilibrium of sellers enjoying strong capital gains while buyers see sustained upside will continue to raise transaction activity volume.

In addition, many hotel REITs are trading at or near 52-week highs and CMBS issuances for hotels increased by 151 percent above the level reached in 2004. As a result there is more available capital chasing less available product, which has an upward impact on pricing and continues to put pressure on yields. The average cap rate on 60 transactions for which data was recorded remained historically low at 6.0 percent.

Internationally, RevPAR is on the rise for top cities in North and Latin America. The most promising markets line the U.S. East and West Coasts, as well as Mexico and the Caribbean. Most of the top 25 U.S. markets exhibited strong fundamentals, characterized by steady growth in demand and limited supply increases. New York, Washington, D.C., and Hawaii represent markets with low risk and strong income growth, which when coupled with market liquidity and prohibitively high construction costs, translates into higher risk-adjusted yields for investors.

Dallas and Montreal exemplify markets with higher risk and lower returns. Low barriers to entry and a resulting supply/demand imbalance has exerted pressure on yields and lowered potential returns, thereby increasing the required internal rate of return to invest in these markets.

This year's transaction volume is likely to reach $20 billion or higher, supported by highly accessible debt and equity capital markets. The limiting factor, however, will be the availability of quality hotel investment product. High construction costs and residential conversions are keeping supply low. Subsequently, increasing demand will put upward pressure on both rates and occupancy. The expectation of further improving fundamentals and an increasing depth of capital will stimulate a similar level of transaction volume into 2007.

MULTIFAMILY PLAYS ON

by David Baird
National Multifamily Director
Sperry Van Ness, Las Vegas

The national apartment market is likely to add some power this year in the form of increased occupancies and rental growth. A combination of a healthy job market, moderate development, and decreasing inventories due to condo conversions has strengthened most multifamily markets.

On a national basis, occupancy exceeded 95 percent at the end of 2005, the first time since 2001, according to MP/F Yieldstar's 2006 U.S. Apartment Markets Outlook. Rental rates increased 4.1 percent, a welcome improvement compared to the rent declines experienced in 2002 and 2003.

Given the positive momentum, apartment occupancy should continue to improve this year, eventually reaching 97 percent in 2007. Rental rate growth also should remain strong, possibly reaching as high as 5 percent nationally.

Miami, the tightest U.S. apartment market last year with an occupancy rate of 99 percent, may be surpassed by Fort Lauderdale, Fla. With an anticipated employment growth rate of 5.1 percent and fewer than 400 rental apartments under construction, Fort Lauderdale's market is expected to tighten further, pushing revenue growth to 4 percent annually.

Domestic and international investors continue to be drawn to the coastal markets in Southern California, Florida, New York, and Washington, D.C., despite their high prices and low cap rates, while relative return-driven investors are seeking opportunities in middle America. Large REITs such as Archstone-Smith and Equity Residential are going toe-to-toe with foreign capital for quality assets and often winning the deals. For example, Archstone-Smith recently emerged as the buyer for two high-rise apartment communities in the New York City area, paying $166 million for 462 units.

In Denver, Houston, Phoenix, and Raleigh, N.C., apartment fundamentals have stabilized and rents are rising. Phoenix is benefiting from strong population and job growth and condo conversion activity, which is reducing inventory. Increasing land prices further ensure improved occupancy and higher rents. Denver's occupancy rate is now in excess of 95 percent, while Raleigh's robust 3 percent job growth and lack of new construction - only about 500 units this year - improves its outlook.

Rendering caption: The Plaza by Opus West Corp. is the first Orange County, Calif., residential tower to feature a rooftop pool. Upon completion in 2Q08, the project will add 105 apartments to the market.
Rendering credit: Sperry Van Ness

Dallas-Fort Worth and Atlanta continue to struggle. Although Dallas managed to record its second-highest level of absorption last year, rental rate growth is lacking. Continued demand this year should translate into modest revenue growth. Atlanta's development pipeline is still reasonably full with 9,000 units scheduled to come online this year. Moreover, big employers General Motors and Delta Airlines may face economic troubles that could affect local job growth. And, despite rising interest rates, single-family home sales have not slowed enough to positively impact the rental market.

Las Vegas and Charleston, S.C., stand out for tremendous occupancy and rental rate growth, as well as red-hot investor interest. Condo conversions and a lack of available land are driving rents in these markets as much as 10 percent annually and pricing for quality assets has doubled in many instances.

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