Good Times Roll On
Continued Economic Growth Means a Strong Year for Most Commercial Real Estate Markets.
In recent memory, no number has captured more public attention than "2000." Technically, the millennium will shift as the year 2001 is ushered in, but there is no holding back the popular appeal of the calendar rolling to a string of zeros. Sold-out hotels, restaurants, nightclubs, and other entertainment venues can testify that the economic impact of the millennium is now. Businesses and governments alike also are watching as the year 2000 begins, anxious to see where the much-hyped Y2K effects actually arise and with what impact.
But the numbers that really count for commercial real estate professionals define a solid, well-performing industry that will continue into the new year with strong supply-and-demand fundamentals. While some geographic areas show a little softening, for the most part, the good times continue to roll in all market sectors. Office, multifamily, and industrial are on a steady path, and retail remains robust in the face of the e-commerce challenge. Even mixed reviews for hospitality may offer opportunity for investors not opposed to higher risk.
Changing Times Ahead
Other numbers, such as those illustrating changes in demographics, world capital markets, and government policy options also will affect the commercial real estate industry in the next five years.
The 2000 census is a reminder that the destiny of the real estate industry is a function of embedded demographic patterns. The shift in age cohorts from 2000 to 2010 will show the most substantial growth in 55- to 64-year-olds. This faction is entering its next life-cycle stage, which some call the "active leisure years."
Spending patterns will be altered as the earning capacity of the baby boom generation focuses on its increasingly sophisticated consumption preferences. Many in this age cohort will explore alternative uses of their time after careers through the booms and busts of the past four decades. This should prompt additional need for entertainment and recreational venues, with other commercial facilities to support them.
At the beginning of the 1990s, a book about "edge cities" was a bestseller. It detailed strong growth in outlying suburbs far from established cities. However vigorous suburban growth depends largely upon the age cohorts in the child-rearing years, and the 1990s still were good years for suburban demand, as the ranks of 35- to 44-year-olds peaked. But the coming decade represents a trough in the entire range of young adults in the population.
Given these demographics, it is interesting that the renewed strength of center cities has surprised some futurists. The present situation is merely the staging point for a significant quickening of urban vitality in the United States.
The shortage of workers in the career-building ages from 25 to 44 will require businesses to rethink labor strategies crafted from 1970 to 1995 during the years of plentiful workers. The demand side for real estate will be even more tricky to discern, especially as preretirees and semiretirees create new approaches to meaningful part-time work. Worker retention will emerge as the key challenge for employers, and benefits will be a point of focus more so than wages.
The physical configurations of space will continue to be challenged, far beyond what the Americans with Disabilities Act has prompted. The issue is not just access, but how various forms of real estate will respond to new lifestyles and work styles. As a consequence, analysis of the supply side of the commercial real estate market equation will focus more closely on quality and function, in addition to sheer quantity measures.
As the year begins, most markets remain in good equilibrium. Construction is lively but not excessive. The supply-and-demand dynamics of the property markets do not suggest any immediate threat of a sudden, volatile disturbance of conditions in our industry.
While capital has been flowing freely into real estate — increasingly so as the second half of the 1990s progressed — investments largely have been made with great sensitivity to risk factors. The key discipline will be to project users’ space needs based upon achievable, affordable levels of demand in the coming years, rather than naively expecting the growth rates of the post-1993 expansion to continue indefinitely.
Risk and Opportunity.
Consideration of risk and opportunity will impel commercial real estate professionals to ponder the dynamics of change in the economy and in real estate markets. One way in which markets signal their concern about risk is in the price of money, expressed in interest rates or yield rates on a variety of investment instruments.
For decades now, it has been commonplace to think of rates as primarily being moved — both in the direction and magnitude of change — by shifts in inflation as indicated in the Consumer Price Index. However, the tight relationship between inflation and interest rates has been unraveling for the past six years.
The sharp increase in the Federal Reserve Board’s discount rate (and in short-term Treasuries) in 1994, the plunge in sensitive materials prices in 1997, and the managed decline in rates in 1998 and subsequent step upward in 1999 present clear evidence: Inflation no longer is the key to understanding interest-rate policy.
What then is driving changes in interest rates? A critical consequence of America’s international economic hegemony is that the Fed now is the central banker to the world. This pushes its decision matrix well beyond the CPI reports. Policy is becoming more and more concerned with global financial flows and economic policy will be the critical element of U.S. international relations in the years ahead.
At the same time, an immense shift has occurred in the federal budget. The huge deficits in the 1980s and early 1990s are now a surplus of $140 billion. Deficits need to be funded by borrowing, shrinking the volume of capital that is available for private investment. Offshore investors purchase large amounts of U.S. debt, creating outflows of interest payments from the economy. Surpluses, on the other hand, free additional capital for the U.S. private sector and create general downward pressure on interest rates.
Experienced policy observers believe that the government will find ways to compromise any surplus it has, and they caution against expecting sustained reduction of U.S. debt.
What choices could deplete the surplus? Essentially there are two options: reducing taxes or increasing spending. With tax cuts, a greater amount of wealth remains in the private markets. Even if no tax cut is forthcoming, a greater share of national income will stay in private hands, so the pressure to increase the tax bite is off for several years at least.
The other alternative is to boost public spending. This, too, stimulates the economy, including the real estate markets. In fact, spending on improvement programs for roads, airports and seaports, water projects, and other basic physical capital programs has direct implications for opening new locations for real estate and for increasing the demand for many commercial property sectors.
How these numbers play out in the next few years will determine the ride for commercial real estate for the first part of the 21st century. As 2000 begins, various commercial property types have predominantly positive outlooks.
Office Continues to Lead
Dense central business districts are the focus of the most intensive investment activity of any U.S. property type. After real estate investment trusts captured most investor attention from 1995 to 1998, institutional investment capital clearly has returned to the office sector. Pension funds, foreign investors, Wall Street-intermediated limited partnerships, and even life insurance companies are acquiring office buildings.
Average prices for office buildings are above $200 per square foot and frequently surpass $300 psf in top California markets like San Francisco. These prices reflect capitalization rates below 8.5 percent.
Other major cities participating in the investment trend include New York, Los Angeles, Chicago, Boston, and Washington, D.C. Often, the strength of a CBD carries over to nearby suburbs. For instance, the Hudson River waterfront near Manhattan, Schaumburg, Ill., outside Chicago, and northern Virginia and Bethesda, Md., are excellent examples of suburban areas sharing in their local cities’ prosperity.
However significant soft spots exist across the country. Suburban Atlanta and Dallas clearly face a period of rising vacancy rates and flat to moderately declining rents. Downtown Los Angeles still shows a vacancy rate above 20 percent and has had negative net absorption in some recent quarters. Likewise, CBDs in some older industrial cities such as Detroit and Pittsburgh have vacancy rates well into the teens.
By and large, new development patterns in the office sector are responding to real shortages of existing space. For instance, Seattle’s metropolitan area office vacancy rate is a scant 3.2 percent, while San Francisco’s is 3.6 percent. The long list of large markets with single-digit vacancies includes the Washington, D.C., metropolitan statistical area at 7.1 percent; the Boston metro area at 7.5 percent; Orlando, Fla., at 8.1 percent; midtown Manhattan at 8.6 percent; the Chicago area at 9 percent; and Orange County, Calif., at 9.3 percent. These figures justify a need for new office development in many locations.
Overall, development enthusiasm is running a bit ahead of total demand. Construction nationwide is likely to outstrip net absorption this year, pushing the national office vacancy rate higher. This year is a critical test of the recent discipline in development lending. While other property types have moderated the pace of supply additions, the upward curve of new starts continues in the office sector. This could compromise investor confidence if sustained beyond this year.
In the midst of a historically long and robust economic expansion, the highly competitive retail industry is generating mixed results. Some long-established companies and recent highfliers are entering, emerging from, or flirting with bankruptcy, casting a pall on spirits.
During the year ending in October 1999, the value of publicly traded stocks of retail REITs plummeted 24 percent, based upon such bankruptcy news and fears that e-commerce could threaten shopping centers.
Statistics show that the market has overreacted. Many chains are enjoying exceptional same-store sales growth and ambitious geographic expansion programs. For example, Target plans to open 850 new stores. The Gap plans to open 150 to 200 units under its own brand name, an additional 150 stores under the Old Navy name, and 40 new Banana Republic stores.
Certainly the economic fundamentals support more optimism than presently prevails among most shopping-center analysts and commentators. Real (inflation-adjusted) retail sales are estimated to have increased 7.3 percent in 1999, after gaining 6.5 percent in 1998. Real per capita disposable income has been rising about 2 percent per year since 1995. Retailers’ pretax profits in 1999 stand at $73 billion, triple what they were at the beginning of the 1990s, and twice as high as they were as recently as 1996.
The spectacular growth rate of Internet shopping — which can be expected to increase at a 50 percent annual rate for the coming five years — cannot be denied. Total cybersales will jump from $7 billion in 1998 to 10 times that amount early in the coming decade. But that is within the economic context of more than $6 trillion in 1999 personal-consumption expenditures, which are growing at approximately $350 billion per year.
Virtually all gloom-and-doom prognosticators subtract Internet sales from existing store sales volumes, leading to their forecasts of contracting demand. However, the pie is growing and Internet marketing actually may be stimulating consumer activity at malls. New retail formats always are rising, and the Internet is just the latest entrant into a large, competitive marketplace. Traditional formats have proved to be — and will continue to be — remarkably adaptive.
It is doubtful that the investment market soon will change its mind about shopping centers, so stable to slightly declining property prices are most likely in the coming year. Such a scenario provides an opportunity for buyers willing to break away from the herd, do their homework on specific markets and formats, and come to the table with real money. Competition will not be nearly as stiff as in other property types, so savvy investors should find some yield premiums in this sector.
Industrial Market Evolves
The outlook for warehouse and light-manufacturing properties is strong going into 2000. Vigorous consumer spending is keeping goods flow exceptionally positive, and vacancy and lease rates in the industrial sector have reflected the strong market.
Overbuilding has not proved to be a problem for this property type during the current cycle. In fact, industrial starts began slowing more than two years ago. Vacancy in the coming year may fall below the present 7.1 percent level.
Internet retailing is producing a positive effect on the industrial property market. Amazon.com and other e-commerce companies already are shifting from the "virtual company" model of only processing orders to physically controlling the goods-shipment process. An effect similar to Federal Express’ impact on Memphis should appear in a few Central time zone cities with good airports as Internet companies accelerate their shipping programs.
The investment trend toward huge bulk distribution facilities has appeared to run its course. The most popular investment vehicle now seems to be the industrial park — sometimes with flex characteristics — for purchasers seeking to gain a diversified tenant base with high credit but a variety of lease-expiration dates. Such properties still are commanding 9 percent cap rates, largely reflecting relatively flat income streams and currently rich levels of pricing.
With the general tendency toward unit-cost reduction in the goods production/distribution process, the ability to push rents substantially higher now is quite limited. Consequently, there is little robust value appreciation potential in this property category.
A number of markets will enter 2000 with excellent occupancies, according to recent Grubb & Ellis Co. figures. On the West Coast, Seattle boasts a minuscule vacancy rate of 3.4 percent, down almost three percentage points from a year ago. Los Angeles’ vacancy rate is just 4.8 percent, while Oakland, Calif., has a 5.1 percent vacancy rate.
Denver improved its industrial occupancy by nearly two percentage points in 1999, and its vacancy rate now stands at 5 percent. The northern and central New Jersey market, serving the huge East Coast population centers, has a 4.8 percent vacancy rate for its enormous 718 million sf of industrial inventory. And the Broward/Palm Beach County, Fla., market has a 5.8 percent availability rate.
Industrial markets with softer conditions exist elsewhere. Vigorous development has pushed vacancies into the double digits in cities such as San Diego (11.8 percent), Phoenix (13.6 percent), San Antonio (12.6 percent), Orlando (12.6 percent), and Tampa, Fla. (10.9 percent).
Multifamily Stays Steady
Multifamily properties remain solid performers. There is ample, continuing investment demand, especially from pension funds and limited partnerships of all sizes. The widespread appeal of the multifamily sector is its excellent supply-and-demand balance.
Average vacancy in the 60 markets reviewed by Landauer is 5.1 percent. When coupled with the historically lower volatility of apartment prices compared with other commercial real estate properties over the past 20 years, the risk/reward characteristics of multifamily complexes is very attractive.
Garden apartments — low-rise developments — in growing suburban communities account for most of the buying and selling activity rather than luxury urban properties, which are a much thinner market. Prices of $60,000 per unit are typical in many parts of the country, although top East Coast markets average above $75,000 per unit, and California units routinely average $100,000 or more. CBD luxury apartments in major Atlantic seaboard cities such as New York, Boston, and Washington, D.C., also come in above the six-figure threshold.
New construction has been very stable at the sustainable level of 325,000 to 350,000 units per year. A look at population growth levels explains the demand. About 270 million people live in this country, or about 105 million households, growing at a rate of about 1 percent per year. Given a small obsolescence factor, this means 1 to 1.2 million units of new housing demand per year.
Despite the hype of the multifamily industry, there is little evidence of a surge in "preference renters" coming from demographic change, especially if mortgage interest rates stay approximately where they have been in the late 1990s. Preference renters are people who can afford to be owners, but choose to rent. The outlook for apartments, therefore, is very much "steady as you go."
Despite almost universally tight occupancies, those markets with the greatest improvements in demand include several south Florida areas that were softer a year ago but are now about 95 percent occupied. These include Miami, Fort Lauderdale, and West Palm Beach.
Several California markets also have experienced increased occupancy. The Riverside/San Bernardino market, east of Los Angeles, saw its vacancy rate drop 2.3 percentage points over the year, to a scant 2.9 percent in 1999. Sacramento’s vacancy improved by 1.4 percent but still is at an above-average 6.3 percent. In the nation’s interior sections, St. Louis and Oklahoma City also registered significantly lower vacancies during the past year, at 3.8 percent and 5.8 percent respectively.
The news for the hospitality industry is both good and bad. Limited-service hotels face serious market competition, and investors have been shunning them for the past 30 months. Some industry members insist that such facilities remain profitable at lower levels of occupancy.
Full-service hotels in a half-dozen top markets such as New York, Boston, Washington, D.C., San Francisco, Las Vegas, and Orlando remain avidly sought after, though. Foreign purchasers and the major operators continue to look for trophy assets at the luxury and super-luxury end to showcase their chains.
The demand side of the hospitality market looks good. The travel industry is strong, as business travel remains robust and vacationers travel further and for somewhat longer periods. Airlines’ Saturday-night stay promotions have created significant additional weekend demand, compared to a decade ago. International travel to the United States will rise in 2000, as the global economy improves. Many markets also will benefit by an influx of international visitors just before and after the Salt Lake City Olympics in 2002.
However, the supply side remains troubling, even as construction recedes from its 1998 peak. The total number of hotel rooms will increase 8 percent by 2001, far in excess of increased demand. This is not a collapse of the hotel market, such as what happened in the early 1990s, but this property type remains in fragile condition.
Publicly traded hotel companies have seen their stock prices hammered. Starwood Hotels & Resorts Worldwide, for instance, was trading 46 percent below its 52-week high price as of the end of October 1999, an estimated 53 percent below its net asset value. Similarly, Host Marriott was 42 percent beneath its 52-week high, with a net asset value discount of 36.5 percent. At such prices, hotel assets may be the most underpriced real estate play available for 2000.
CCIM/Landauer Investment Trends Quarterly data suggest that buyer interest in well-situated hotel properties is increasing, with the chains themselves, foreign purchasers, and special-purpose ventures leading the investment parade.
This is a property category that, if not at its cyclical trough, is certainly near it. A contrarian approach would suggest that capital with an appetite for higher risk/higher return vehicles could look to hotels in 2000 as a market-timing move.
Continued Good Times
The numbers that count as 2000 begins paint a highly virtuous picture for the economy. It is unusual to be so optimistic so deep into a period of economic expansion. No one yet has found a way to repeal the business cycle or the real estate cycle. However, looking at the next year or two, there is no reason to predict either a general U.S. economic recession or a systemic downturn in real estate prices. The huge growth of the late 1990s may be behind the market, but if there is a plateau ahead, it is on a high plane indeed.