Maintaining the Balance
Commercial Real Estate Markets Hold Steady While Waiting for the Economy to Regain Its Footing.
The U.S. economy is walking a tightrope. While the recession that officially began in March 2001 has not yet ended, gross domestic product -- the broadest measure of the economy's output -- has been expanding since the beginning of 2002. Yet as of last October, employment was down by 519,000 jobs compared to 12 months earlier, and this sluggishness gave way to speculation about a jobless recovery and a double-dip recession similar to that of the early 1980s.
The economy's struggle for balance mirrors the government's struggle for focus. A disciplined federal monetary policy continues to provide economic stimulus in the form of interest rate cuts. But Congress and the White House have ignored fiscal policy, instead pursuing diplomatic and military matters. As a result, the equity market contracted in 2002, impeding the economy's recovery. One significant threat that could further hinder this slow rebound is a severe disruption in energy supplies due to military action in the Middle East, which might push consumer price index inflation upward suddenly.
Stable Value Despite Softening Demand
As a result of low interest rates, commercial real estate investors gained exceptional leverage last year, keeping values surprisingly stable as rents and vacancy rates softened. Lenders enjoyed a satisfying spread in mortgage coupon rates over Treasuries of comparable maturity, and borrowers found opportunities in purchasing at overall capitalization rates that were 200 to 250 basis points higher than prevailing mortgage rates. In many ways, the commercial property markets were shielded from the immediate effects of an adverse economy.
However, the duration of this exemption remains uncertain. Rising vacancy rates and softening rents have weakened commercial property markets nationwide. For example, in the office market, declining employment has led to negative net absorption and an increase in available direct and sublease space. Offices had negative net absorption of 19.2 million square feet per quarter in 2001. By third-quarter 2002, the occupancy slide slowed to 5 million sf, but it still was enough to push vacancy above 16.8 percent, according to Grubb & Ellis' U.S. Market Trends.
But a remarkable feature of this real estate cycle is construction activity's quick response to signs of economic weakness. For instance, office development is down 40 percent in the past two years, and industrial construction has dropped 70 percent since peaking in 1998. Only multifamily continues to see moderate increases in development.
A look at the specific property markets reflects the delicate balance between supply and demand in recovering sectors and the struggle between short-term uncertainty and the stronger long-term outlook for markets still bottoming out.
Nation's Capital Tops Office Market
Although office construction has pulled back sharply, some 75 percent of new supply is coming on line in the nation's suburban markets, where vacancy has surpassed 16 percent. Downtown office vacancies are at 12.9 percent. Washington, D.C., (5.4 percent) and Sacramento, Calif., (6.9 percent) have the lowest central business district vacancy rates in the nation, according to CB Richard Ellis. Boston, Midtown Manhattan, and San Diego also have CBD vacancies of 10 percent or less.
Office investment activity continues to favor the coastal markets, according to the second-quarter 2002 CCIM/Landauer Investment Trends Quarterly. In the Northeast, office buildings are trading well above $200 per square foot on average and the Mid-Atlantic states posted nearly 12.5 million sf in office deals in the second quarter. On the West Coast, prices have cooled considerably in the wake of the dot-com implosion, but more than 11 million sf of office inventory changed hands in the second quarter. Investors report ample capital is available, and the search for good deals is intense. The Southeast also is gaining attention, where the mean price of office buildings has risen to nearly $160 psf.
Two elements are mitigating the recession's impact on office buildings. First, staggered lease expirations in multitenant office properties means only a fraction of the leases in large buildings likely will turn over in any given year. Second, history shows that contractions are relatively short compared with expansions. In the nine complete U.S. business cycles since the end of World War II, contraction phases averaged 11 months while expansions averaged 50 months. If this recession started in March 2001, the worst is over and the economy should accelerate in 2003.
Nevertheless, the supply/demand balance in the nation's office markets varies widely. Of all the major cities, Washington, D.C., is best poised for superior performance this year. The federal government long has made the nation's capital a recession-resistant economy. CBD vacancies are less than 6 percent, and the suburbs are at 11.2 percent. Construction is minimal with just 11 million sf in a 300 million-square-foot metropolitan market. Signs point to continued firm rents and sales prices during the coming year, which is the most notable exception to the generally risky outlook for offices in 2003.
Manhattan also is a strong office market. Vacancies have jumped, especially downtown where the World Trade Center cleanup and subsequent infrastructure reconstruction have disrupted normal business activity and transportation access. However, a huge amount of money will be spent revitalizing lower Manhattan -- more than $5 billion on transportation alone -- and eventually a new office complex will be built on the Trade Center site. In the meantime, tenants are flooded with government subsidies to stay in New York.
Times Square, the hub of Uptown's development, is achieving rents of $60 psf. But further layoffs in finance are expected. Thus, New York faces a sharp downshift in its short-term economy and a difficult 2003. Despite this, long-range prospects for the nation's premier business center are excellent.
Other markets with favorable balance include Charlotte and Raleigh, N.C. The overbuilding in Charlotte's CBD has ended, allowing demand to catch up with supply, and even modest growth in 2003 will return downtown vacancies to single digits. Raleigh's midyear 2002 CBD vacancy was 9.5 percent; its employment base of government and education protects it from the corporate layoff volatility occurring in the surrounding Research Triangle markets.
On the West Coast, San Diego is the standout -- a true city of tomorrow. It exhibits a good mix of tourism and growth industries such as biotechnology and is a major international trade port. San Diego has shown year-over-year employment growth of 1.8 percent through last September -- one of the best performances of all large U.S. metro areas.
In fact, Southern California could give birth to the next phase of national economic growth. As the financially based East Coast markets cope with the aftermath of the stock market downturn and Northern California works its way out the tech wreck, San Diego, Orange County, Calif., and the Los Angeles basin have a powerful opportunity to attract and grow businesses looking for a diversified economic base, strong demographics, and a deep labor pool.
But most office markets are not so fortunate, especially in the next 24 months. In particular, suburban-dominated metropolitan statistical areas such as Atlanta, Dallas, Phoenix, and Tampa, Fla., should brace themselves for a long, slow recovery. Even the suburban areas around New York, including the Westchester, Long Island, and northern New Jersey markets, will underperform in 2003 as office space in the urban core becomes more affordable.
New Demographics for Multifamily
Usually the favored investment choice in uncertain times, multifamily hit a bump in the road as the recession started: The lowest mortgage rates in a generation turned thousands of renters into homeowners. However, the U.S. Census Bureau housing vacancy survey reports that rental units improved their occupancy ratio in second-quarter 2002, even though multifamily housing production remained fairly steady.
More than 32,000 multifamily units were sold in second-quarter 2002, at an aggregate price above $2.5 billion. The Pacific and Southeast regions each contributed more than 9,000 units to this total, evidence of their strong demographic fundamentals. Prices were highest, though, in the Northeast, as New York's residential market snapped back resiliently.
Real estate investment trusts and pension funds accounted for just 17 of the 136 transactions reported in the multifamily sector, but represented $819 million in total acquisition volume, or 31.9 percent of dollars spent. These major buyers picked up 5,778 units, paying more than $140,000 per unit on average, according to ITQ.
Despite the power of the institutional players, small investors still can find plenty of deals in the multifamily sector. The median price for multifamily transactions in second-quarter 2002 was $12.1 million, and about one-fourth of the transactions were priced at $5 million or less. And even with a mean cap rate of 8.3 percent, positive leverage was available, as multifamily mortgages averaged a 6.9 percent coupon rate during second quarter. This has great appeal to the small investor who is financing a purchase with conventional debt.
Multifamily rental growth is strongest in the Southeast, according to Reis data. Since multifamily demand often correlates closely with employment growth, many areas show disappointing absorption rates. But suburban Virginia and Maryland posted strong increases in rent through mid-2002, as did Orange County in the West.
The densely populated Northeast has the important advantage of relatively high barriers to entry. Land costs are steep, environmental regulation and zoning are strict, and construction lenders are very risk-averse. Philadelphia, for instance, reports just a 3.1 percent multifamily vacancy rate.
Many developers building apartments on the basis of last decade's population patterns have excess inventory due to the combination of increased homeownership and a sudden drop in growth. Austin, Texas, has a multifamily vacancy of 11.5 percent and little new demand until the tech sector rebounds. Charlotte (10.9 percent), Atlanta (9.6 percent), and Memphis, Tenn., (9.6 percent) are other markets caught in the switch.
Markets to watch for relatively quick occupancy improvement are San Antonio, Texas, Richmond, Va., Nashville, Tenn., and Columbus, Ohio. Government jobs are a significant component of their economic bases, and they are key distribution cities for their regions. But this is not a luxury-housing story -- it's all about basic garden apartments for young households.
Retail Remains Steady
Investors are keeping an eye on consumer behavior, acknowledging that household spending has performed strongest in the past several years. Consumers account for two-thirds of the GDP, but in 2001 that percentage rose to nearly 70 percent.
Accordingly, retail property investment spiked in 2002 at its highest level since early 1996. Investors showed a solid tendency to pursue a “rooftops” strategy that follows the population migration to the South and West. The Pacific Coast states and southeastern areas such as Florida, Georgia, and Virginia have benefited. Another trend is “picking winners” among the merchandisers, as investors use bond-like investment structures to hedge risk. These can range from high-credit triple-net leases to build-to-suit developments for value chains such as Walgreens or CVS. Highly visible national franchises, such as fast-food outlets, also trade in a national market, with specialized buyers and brokers seeking deals nationwide.
Market breadth was the salient feature of last year's retail sector, a healthy sign of continued liquidity for shopping properties. Hot money looking for quick, high yields and a rapid exit is not as prevalent as it was in the mid-1990s. With the dominant regional malls largely under the control of a few publicly traded operating companies, retail real estate investors are focused on thousands of community and neighborhood centers and on select redevelopment opportunities in secondary malls. Urban retailing opportunities still are available in a handful of 24-hour cities, but the competitive environment requires a clear strategy and strong operating experience for successful entry.
Fast-growth regions are highly favored, in contrast to the mature, stable markets noted in the multifamily sector. Retail rents are pushing upward most strongly in Sacramento, Denver, Portland, Ore., and Oakland, Calif., according to Reis data. But the best absorption is happening in the South Atlantic markets, led by Atlanta, which saw more than 600,000 sf of net retail absorption in second-quarter 2002 alone. Most large West Coast markets, including Seattle, San Francisco, and Los Angeles, report retail vacancies under 5 percent -- indicating further upward pressure on the market in 2003.
Interestingly, the South is struggling with the highest overall retail vacancy --nearly 10 percent. Houston, New Orleans, and San Antonio all register double-digit retail vacancies. Dallas had negative net absorption in 2002's second quarter. The Great Lakes states also are sluggish, with negative absorption in Indianapolis, Cleveland, Cincinnati, and Chicago. Weak population growth and troubled job markets are the primary problems, and 2003 holds no rapid turnaround.
Industrial Holds Back
This recession began in the manufacturing and distribution sectors, as excess inventories built up and worldwide demand fell. While the most dramatic story unfolded in the technology sector, few areas of the industrial economy were exempt. Research and development properties suffer from double trouble: not only is the high-tech sector down, but the softness in office absorption eliminated demand in the flex property segment.
Technology-based Austin (21.6 percent), ports Jacksonville, Fla., (21.9 percent) and Baltimore (19.5 percent), and Charlotte (19.3 percent) are among the softest industrial markets in the country, according to CB Richard Ellis third-quarter 2002 reports.
But this is hardly the entire picture. In fact, markets of considerable size have solid single-digit vacancy rates that are stable or even falling. These include the vast Los Angeles market (8.9 percent), Midwest distribution centers in and around Indianapolis (9.9 percent), and areas around New York such as Long Island (5.6 percent) and northern New Jersey (9.9 percent).
Development of warehouses, light assembly plants, and R&D facilities has dropped far and fast. So, while vacancies still are rising, the rate of change should flatten soon.
A measurable surge in the industrial property sector is unlikely until overall economic signs strengthen. Weak exports hinder this sector, and international uncertainty, exacerbated by the possibility of another outbreak of hostility in the Middle East, keeps investors on the sidelines.
Right now, both the GDP and the industrial sector are struggling up out of a trough. It may take a while before they hit stride.
Hospitality Sees Slow Improvement
Hospitality transactions softened with the onset of the recession and then collapsed after the terrorist attacks. But signs of improvement slowly emerged in 2002 with major property sales in a few large downtown markets and increased resort sales activity.
Several fundamental differences exist between the risks in the hotel sector in this down cycle and the catastrophic collapse of the industry in the late 1980s and early 1990s. First, the building boom of that era was not duplicated this time around. Second, hotels have done a tremendous job of examining their cost and occupancy structures. Where occupancies of 65 percent or more were typical of hotel break-even points a decade ago, now most hotels are profitable at occupancies in the upper 50 percent range. And debt levels have been slashed, further reducing foreclosure risks.
Barring a disruption in travel, large cities should work their way back to better occupancy and improved revenue per available room performance as the economy improves in 2003 and 2004. New York, Washington, D.C., Chicago, Boston, San Francisco, and Atlanta could be the top candidates for gains, especially given their promotional campaigns for conventions and conferences. Orlando, Fla., and Las Vegas, with enormous inventories of hotel rooms catering to tourists, will recover more slowly in a weak travel market. Secondary corporate and convention markets, including Philadelphia, Denver, Dallas, and Los Angeles also will struggle. New Orleans, which always is a popular meeting site, might be a sleeper.
Restoring Long-Term Balance
Real estate finds itself in a challenging time. However, that is not a reason to give over to a gloom-and-doom perspective. The U.S. economy is the world's engine -- never more so than at the start of the 21st century. Once that engine finds its next gear, there will be plenty of demand for commercial property to house the economic activity producing some $10 trillion dollars of GDP annually. By the end of 2003, the nation should start to hit its stride again. If the real estate industry can maintain equilibrium in the short run, the balance of this decade should be very good indeed.