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Commercial real estate industry seeks job recovery to promote market growth.

In late 2004 the national economy continued to strengthen, having endured a few bumps along the way. After a summer slump, the economy lumbered into the third quarter, albeit more slowly than expected. The third-quarter 3.2 percent gross domestic product growth was not bad, but certainly was slower than 2003's pace. Although several factors continued to suppress growth, overall the economy retained its relatively healthy glow.

Business spending remained strong. Corporate profits grew 19 percent year-over-year as of the third quarter, boosted by accelerated depreciation tax benefits of equipment investments. In fact, technology spending totaled $22 billion in the second quarter, compared with $16 billion per quarter in the late 1990s.

Fortunately, businesses stepped up as consumer spending, which supported the economy through the downturn, slowed from a sprint to a saunter. Retail sales growth dropped to 4 percent during the May to August 2004 period, although as of August 2004, year-over-year growth was still strong at 8 percent.

The slowdown was not surprising as the benefits of the tax cut and refinancing boom ended. High gas and oil prices further cost consumers, and very weak wage growth continued to curb spending.

Inflation also worried investors and for good reason. Core inflation remained tame, but adding in the volatile food and energy component pushed it much higher. Additionally, double-digit price increases for materials such as steel, concrete, and other metals inflated construction costs. However, the real estate industry ultimately may benefit from such cost increases. First, increased building material costs and rising capacity utilization rates mean higher replacement costs; second, inflation attracts more capital to real estate. Both factors support rising real estate values.

Looking for Jobs

The labor market remained a prime concern, as lackluster job growth persisted in 2004's third quarter. Close to 309,000 jobs were added from July to September 2004, less than half the number added in the second quarter. Businesses remained cautious in hiring due to rising energy prices and the lack of strong economic growth.

Job growth recovery is playing out differently in various national markets. On a positive note, of the 54 U.S. markets Property and Portfolio Research tracks, the majority are experiencing positive year-over-year gains. For instance, secondary southern and western metropolitan areas, such as Jacksonville, Fla., Las Vegas, and Phoenix, are growing, while larger eastern metros such as Washington, D.C., New York, and northern New Jersey have added the most jobs on an absolute basis. Still some markets, such as Detroit, Hartford, Conn., San Jose, Calif., and Boston, lag significantly behind with continued job losses. While most cities are getting back on track, the U.S. economy needs sustained job growth to drive the recovery and support commercial real estate demand.

Office Rebounds

Although it is taking small steps, the national office market recovery is underway. Vacancies edged down slightly to 17.7 percent in third-quarter 2004 from 17.8 percent in the second quarter. Although vacancies remain close to their cyclical peak of 18 percent in fourth-quarter 2003, market fundamentals clearly are improving.

Leasing activity has picked up as in-market relocations driven by cost and quality decisions have yielded to outright expansions in both inter- and intra-market leasing deals. Indeed, following a mild rebound in 2003 when net absorption totaled 26.3 million square feet (including one quarter of negative demand), the net absorption of 51.8 million sf through 2004's first three quarters eclipsed the previous year's mark. New product deliveries have declined steadily during the past three years to 45.8 million sf in the first three quarters of 2004 — a 22 percent decline from completions in the same period during 2003 and a 59 percent drop from peak levels in the first three quarters of 2000. But despite improving fundamentals, tenants are in the driver's seat, and rents have dropped by an annual average of 6 percent during the past four years.

Investors continue to prefer relatively low-risk, well-leased office buildings, as 87 percent of all 2004 office transactions through the third quarter involved properties that were at least 75 percent occupied, according to Real Capital Analytics. This preference for low-risk assets with minimal upside essentially is unchanged from 2003, despite ample evidence of the recovery.

Although still in its infancy, the recovery clearly has spread across most regions of the country. In fact, of 54 major office markets, only six had increased vacancy rates during 2004's third quarter. However, various markets have yet to see the worst of times, including large markets such as Boston and northern New Jersey, and smaller markets such as Columbus, Ohio, and California's Inland Empire.

The Southeast and Southwest were the toast of the town in 2003, shooting out of the gate with strong office-using growth that drove increasing absorption and declining vacancies. Strong population growth and low business costs are common themes for these regional strongholds; these attributes also attract expanding businesses during lean times. As a result, metros such as Tampa, Fla., Palm Beach County, Fla., Las Vegas, and Phoenix added office-using jobs at a furious pace while much of the remainder of the country languished. However, by August 2004, most of the country began hiring office workers again — remarkably, even San Francisco slowly is adding jobs. Only a few hard-hit high-tech centers, including Boston, California's East Bay, and San Jose, as well as a handful of Rust Belt metros such as Indianapolis and Pittsburgh, continue to lose jobs.

Nationally, office fundamentals will improve even more favorably early this year. As a stronger national economy is expected to produce office-using employment growth of approximately 3 percent, net absorption should tally close to 100 million sf in 2005. Coupled with the continued slowdown in new product deliveries (just under 56 million sf over the year), national office market vacancies will begin to substantially decline, falling to 16.6 percent by year-end. Stronger fundamentals will drive rents higher to positive annual growth for the first time since 2000.

Multifamily Improves

Third-quarter 2004 ushered in the first drop in U.S. apartment vacancies since the middle of 2000, as the national multifamily vacancy rate fell to 7.3 percent. A 10-basis-point quarterly decline in vacancy across the 54 tracked markets represents a turning point for the battered U.S. multifamily market. Indeed, during the past several years, the multifamily market endured a confluence of events that pushed vacancies up 2.4 percentage points. However, the same factors — unemployment, excess supply, rising homeownership, and demographic trends — that led to a significant downturn in multifamily occupancies now are setting the stage for a recovery that will be modest at first and gain traction as the decade progresses.

First, returning job growth particularly favors the multifamily market. As the U.S. unemployment rate rose between 2001 and 2003, multifamily demand dropped considerably. Stronger job growth in 2004 — 1.5 million new jobs were created through September — helped boost multifamily net absorption. Accordingly, metros such as Las Vegas, Phoenix, and Orlando, Fla., with above-average job growth are beginning to see vacancies tighten.

New multifamily supply also is abating somewhat. Despite lessening demand, developers continued building, lured by the siren song of cheap construction financing and strong investor interest in multifamily properties. This cycle's robust supply sharply contrasts with the previous cycle, when new construction virtually shut down after a drop in demand. While the construction pipeline remains full, the good news is that 2004 deliveries declined approximately 7.5 percent, or 140,000 units, versus those in 2003. The drop in new supply throughout 2005 will be even more noticeable, as completions are expected to fall approximately 23 percent to about 107,000 units. Metros such as Charlotte and Raleigh, N.C., and Palm Beach County experienced the heaviest rate of 2004 new construction (as a percentage of inventory), at 3.5 percent, 3 percent, and 2.9 percent respectively, compared with the average of 1.1 percent across 54 cities tracked.

The continuous rise in homeownership has been another persistent market problem, facilitated by historically low mortgage rates. The red-hot residential market siphoned off many potential renters, and rising demand for single-family homes as well as soaring prices have produced spillover condominium demand. In turn, many would-be apartment developers have redirected resources toward the for-sale multifamily market and the number of “rondos,” or apartment units purchased for condominium conversion, has grown steadily. Condominium/townhouse completions are expected to make up 43 percent of total multifamily completions this year.

Clearly, affordability now is a growing hurdle to homeownership in portions of the United States. Rising mortgage rates ultimately will exacerbate this problem, raising the desirability and, in some cases, the necessity of renting.

Finally, the leading edge of the large echo boom generation is beginning to reach its prime apartment-renting age — 20- to 34-years old — and will increasingly displace the much smaller generation X. All in all, multifamily market fundamentals are improving, and vacancies across 54 markets tracked are expected to fall to 6.7 percent by the end of the year. However, all bets are off if job growth grinds to a halt and multifamily construction picks up.

Retail Runs Out of Gas

In most cases, an improving economy means strengthening retail sales, but this is unlikely to hold true this year. While stalwart consumer spending propped up the retail market during the downturn, the forces that propelled this spending are dissipating, and retail's health will depend on job creation and wage growth. This is not to imply that the retail market is declining; rather, the hyper-growth in retail sales over the past year is unlikely to be matched in the near term.

The tech implosion, the 2001 terrorist attacks, and the economic downturn dampened spending, and the economic vacancy rate — the percentage of retail space not viable given the retail spending level — climbed from a historical low of 9.9 percent in 2000 to a cyclical high of 12.9 percent in 2003. However, tax rebates, low interest rates, and the wealth effects caused by sharply appreciating home values converged to send consumer spending back up, and retail sales grew by an impressive 11 percent from 2003 to third-quarter 2004. This boost pulled the economic vacancy rate down to 11.8 percent in the third quarter, 2.7 percentage points below the historical average.

Although growth in retail sales will moderate, economic vacancies will continue to decline this year. Analysts predict a more sustainable retail sales growth rate of 4 percent to 5 percent per year during the next five years, which, with slowing construction levels, will keep vacancies trending lower. Completions for 2004 are on pace to total more than 108 million sf, a 21 percent decline from the 1999 to 2001 pace. This year, just 89 million sf will be completed, an additional 17 percent moderation.

Several markets that have seen substantial building in the last couple of years will experience a sharp slowdown in construction. These include Minneapolis, Memphis, Tenn., Raleigh, and California's Inland Empire. Retail construction in all four markets is expected to decline by 40 percent or more this year.

While the outlook favors retail, a number of risks could dampen the forecast. Rising interest rates are perhaps the biggest concern; they could squeeze spending more than expected. The housing market also is worrisome. Locally rapid home price appreciation steered many home buyers to adjustable rate mortgages to leverage into homeownership. As rates rise, higher mortgage payments could pinch homeowners and disposable incomes, possibly provoking increased personal bankruptcies. This risk especially is disconcerting in California, where 50 percent of new home loans in 2003 were ARMs. This number climbed to 68 percent in the second quarter of 2004, according to

Long-term risk centers on national demographic trends. Population growth is strongest in the South and West, which should spark strong retail sales growth, while Northeast and Midwest growth is markedly slower, and retailers may struggle to increase sales in these regions. Also, the baby boom generation, a huge retail sales driver during the past decade, almost has passed through its prime spending years. The much smaller generation X replacing it will not match boomers' purchasing power. As a result, retailers already are tapping the echo boom generation for sales growth.

Warehouse Remains Steady

The national warehouse market remained in good shape through 2004's third quarter. Vacancy rates fell from cyclical high levels of 10.5 percent in 2003 to 10.3 percent in third-quarter 2004. Renewed business confidence and increased business spending, along with continued, albeit slow, consumer spending, have driven stronger leasing activity and therefore net absorption. Combined with declining new construction and low inventory levels in warehouses, these factors should push vacancies to 9 percent by the end of the year.

Warehouse net absorption — 76 million sf through third-quarter 2004 — was 50 percent higher than the same period in 2003. The future looks bright this year, as the inventory-to-sales ratio suggests further pent-up demand for space. Wholesale trade sales growth has outpaced wholesale trade inventory growth and an increasingly large gap has opened up since early 2002. In just over two years, monthly wholesale trade sales have increased by 20 percent, while wholesale inventories have risen just 10 percent, suggesting that demand should be growing faster than it has. Net absorption is forecast to total 124.6 million sf this year.

Recent activity indicates that standard-size users are returning to the rental market, leasing the 100,000-sf to 200,000-sf boxes left by large tenants that aggressively pursued build-to-suits over the past several years. Many of these tenants are related to the manufacturing sector, which surged in 2004, partly due to the weak dollar but also because of greater business investment and sustained consumer spending.

New construction generally has been very tame. Completions for 2004 totaled 94.3 million sf, near 2003 levels and down 40 percent from average peak levels in 2000 and 2001. Construction is expected to decline further this year, with 74.5 million sf forecast to come on line. Furthermore, the amount of development in the planning phase remains quite low, in contrast to the retail and office sectors where planning has escalated much more steeply. However, while supply generally remains disciplined, pockets of speculative construction are a concern. A lack of quality for-sale product and demand for bigger buildings have led to speculative building, particularly in national hubs with low barriers to entry, including Phoenix, Chicago, Dallas-Fort Worth, and the Inland Empire.

Warehouse rent losses abated by year-end 2004 and stronger leasing activity slowly will translate into rent growth. As demand ramps up, rents should grow by nearly 1.6 percent this year.

Hotels Fill Up

National hotel occupancy rates continued to climb in third-quarter 2004, rising 2.8 percentage points over the previous year, to 64.2 percent. Strengthening business and leisure travel mean stronger demand, and the total number of hotel rooms absorbed reached 80,000 by the end of 2004, the strongest annual increase since 2000.

Developer restraint also has improved the hotel market. In 2003, completions totaled 35,283 rooms; a more moderate yearly average of 30,708 rooms is expected this year. As a result, national hotel occupancies will continue to rise steadily.

However, signs of recovery already have sparked renewed development interest, and the volume of hotel rooms planned was up 11 percent in August 2004, according to McGraw-Hill Construction. Current hotel construction is relatively broad, but has been focused lately on the luxury and midpriced segments, each totaling 20 percent of current construction. Hampton Inn is by far the most active chain currently, with more than 9,000 rooms planned or underway across 54 markets tracked. Marriott Hotel, Holiday Inn Express, and Residence Inn chains also are active builders, each with more than 5,000 rooms underway or planned.

Room rates and revenue per available room have begun to rebound from their dismal performance during the last three years. From 2001 to 2003, room rates dropped an average of 2.1 percent per year, while RevPAR, which factors in occupancy and room rates, fell by 3.7 percent per year due to the impact of the terrorist attacks, weak economic growth, and severe acute respiratory syndrome. Positive growth is expected this year as the economy recovers.

The markets that are expected to have the strongest average annual RevPAR growth from 2005 to 2009 are Orlando (8.2 percent), Orange County, Calif. (6.6 percent), San Francisco (6.7 percent), and Charlotte (6.5 percent). Not surprisingly, some of the smaller metros including Pittsburgh (1.8 percent) and New Orleans (1.9 percent) are among the markets with the weakest forecast RevPAR growth.

The economic recovery continues to hum along, although growth this year will moderate from 2004's strong pace. Renewed business confidence and spending have stepped in to support the economy, and this must continue as consumer spending slows and the effects of recent fiscal stimuli fade. An improving national economy has stimulated office job creation across most regions of the country, which should create a positive domino-effect among commercial real estate markets.

The 2004 presidential election, which also had been a source of uncertainty for the economy, has been decided. However, concerns over the global situation and the domestic economy are still present. It remains to be seen whether or not there will be a change on the horizon or business as usual will continue. The performance of real estate over the past cycle has been relatively attractive versus other investment classes. While the value of stock market portfolios quickly evaporated during the downturn, real estate, by comparison, generally has held its ground during the recent cycle as investors by and large received cash from rent-paying tenants rather than empty stock certificates. However, a continued rebound in the economy, including increased business spending and stronger job growth, will be necessary to further drive real estate demand in the year ahead.

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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