A Mixed Bag
1999 Outlook Contains Good News for Some Property Types but Questions About Others.
Since mid-1997, the transition to a new world economic order has been neither smooth nor painless. The question moving into 1999 is whether the shift can continue without significant disruptions to the U.S. domestic economy. The answer will chart the course for the commercial real estate markets in this country into the first years of the new millennium.
Fall 1998’s gloom-and-doom scenarios for the real estate industry were excessive. The concepts of a global meltdown, accompanied by worldwide deflation, and the collapse of the capital markets have been far overblown.
More likely, demand growth should moderate in 1999 and proceed at a lower level into the early 2000s, an indication of the natural maturation of the post-1994 real estate recovery. There is no sign that the commercial property sector should brace itself for a replay of the severe cyclical contraction of the early 1990s.
Overall, 1999 offers a mixed bag for commercial real estate, containing promising outlooks for retail and multifamily property markets, but some questions about the future of the industrial, office, and hospitality sectors.
The Market Quality Ratings used in this Landauer Associates forecast project supply/demand characteristics to compare various markets. The MQR follow a one-to-seven scale, in which MQR 1 represents an exceptional "landlords’ market" where demand exceeds supply over the five-year forecast horizon. An MQR 7 represents the other extreme — oversupply conditions dominate the markets throughout the projection period. The system considers markets with ratings of MQR 1 to MQR 4 to be favorable in terms of their fundamentals.
Office Remains Top Investment
The office sector continued to lead all property types through mid-1998, capturing about 33 percent of investment totals, with average prices per square foot in the $140 to $150 range. Mean capitalization rates were under 10 percent, and cap rates for assets priced at more than $20 million were an aggressive 8.2 percent.
Currently, the labor market is near saturation, with unemployment under 5 percent. The global slowdown will cost between 1.5 and 2.0 percentage points in U.S. GDP growth in 1999, which will flatten the hiring curve. Most significantly, financial industry mergers and downsizing among high-risk investment players will cause real contractions among commercial and investment banks in the coming year. This could affect vacancy rates, rents, and pricing parameters for offices, especially in large cities.
On balance, though, office markets enter 1999 in sound shape; 44 of the 60 office markets evaluated have an MQR 4 or better standing.
San Francisco is the top-rated office market for 1999. Vacancies virtually have disappeared, but tight development controls make it hard for builders to meet the existing level of demand. San Francisco has the potential to create about 8,500 office jobs per year, which quickly will deplete its 2.7 million sf of remaining office vacancies. This looks like a tight market for the next five years.
Three other West Coast markets achieve MQR 2 ratings: San Diego, Seattle, and Orange County, Calif. These midsize metropolitan areas with between 50 million and 60 million sf of inventory now enjoy single-digit vacancy rates. Each is in the midst of an economic boom, largely due to the concentration of technology-related businesses.
Last year’s top office market, Phoenix, slips to third position. Job growth rose 5.2 percent in the last 12 months. Even in a slower economy, this market still looks demand-rich for years to come. The same can be said for Orlando, Fla., which maintains its MQR 2, with vacancy under 7 percent. Again, population growth is the key: Each year, millions of visitors flock to Orlando for recreation and some of those move there.
Some of the nation’s largest cities may face more challenging times in 1999. New York, which gets an MQR 4, in a terrific improvement, pushed its office vacancy rate down to 7.2 percent. But Merrill Lynch, the largest single office-space user in town, slashed jobs in response to declining profits. Likewise, bank mergers will constrain other financial industry giants. Still, Manhattan office construction has not moved into high gear, so risks are somewhat tempered.
The financial-industry turmoil could affect Boston as well, but with less damage. With lower vacancies of 6.4 percent and less dependent on Wall Street trends, Boston may see a modest slowdown in absorption, leading to an MQR 3.
Chicago has ridden the robust Midwest economic boom nicely, maintaining good discipline in construction volume and keeping its MQR 3. Several speculative CBD office projects are being discussed, with some stunning site acquisition prices. Overall market vacancies still are not tight enough to warrant aggressive new ventures, and the recent risk-aversion from capital sources may keep development in check a while longer.
Retail Ratings Up
Last year exceeded even optimistic expectations for retail. Personal spending was up 6.1 percent on an annual basis at the end of the second quarter.
Buoyed by signs of fundamental improvement and seeking to capitalize on the potential for an industry turnaround, investment interest in shopping centers of all sizes surged throughout the year and has substantial momentum going into 1999.
Pricing parameters have improved, along with investor returns. Stores and shopping centers experienced a steady decline in cap rates; by second-quarter 1998, the mean cap rate had descended below 10 percent.
Just two years ago, not a single market rated better than MQR 4; 1999 ratings are dramatically higher.
Two metropolitan areas, Chicago and Portland, Ore., have risen to MQR 2. After five consecutive quarters of disciplined construction, Chicago’s retail vacancy rate is near 6 percent. Retail sales are $74 billion in this metropolitan statistical area, which has nearly 140 million sf of shopping center space. Portland boasted approximately 96 percent retail occupancy at mid-1998. It has a relatively small stock of retail centers, with 27 million sf, and local resistance to aggressive development mitigates overbuilding risk.
The number of markets rated MQR 3 has doubled to eight in the past year. Among these areas, Palm Beach County, Fla., has median household income projected to rise 3.7 percent annually and, while construction has recently hit a new peak, new store volume remains just half of the production level achieved in the previous decade.
The Washington, D.C., metro area, with median household income of about $60,000, just completed several large mall projects. Though retail vacancies are at 7 percent, rents show strength as disposable personal income rises.
In Atlanta from 1994 through 1998, retail construction boomed, pushing vacancy up to 8 percent. Prospects for improvement exist: The big-box surge has run its course, and near-term development should involve upgrading and repositioning regional malls. With some of the country’s best demographics, Atlanta will enjoy above-average household income growth at 3.1 percent annually.
About half of the retail markets evaluated are classified MQR 4, the lowest of the investment-grade categories, and can be found coast to coast. Middlesex, N.J., is the hot retailing sector for New York’s suburban market, with a $73,500 median household income. However, the densely populated Northeast corridor doesn’t allow for the rapid market expansion that typifies higher-rated MSAs, and only 2.9 percent income growth on average is expected through 2003.
Dallas and Denver undeniably are high-growth metro areas, but their volatile building cycles put them in the MQR 4 grouping. Retail vacancy in Dallas is up to 9 percent, a function of the profusion of power centers and stand-alone superstores.
Denver’s 7.5 percent vacancy rate is a bit better, and it has excellent income growth prospects at 3.7 percent per year. Recent mall sales illustrate investor interest in the Mile High City. Denver has seen a spate of recent construction too, but it looks like the next few years will see reasonable supply/demand balance.
Industrial Market Questions
Whether investors should be fearful about industrial real estate in 1999 is a question bearing careful scrutiny. The influence of the Asian Tigers from Korea to Indonesia will bear mightily in framing the ultimate answer.
In step with the economy as a whole, the industrial property market has posted impressive results over the course of the post-1992 period.
Now, the economic dislocation in Asia and its spread to other emerging nations is compromising the market for U.S. exports. While a soft landing is expected for the economy, it would be a mistake to underestimate the threat this year.
No markets qualify for MQR 1 or MQR 2 classifications this year. In fact, fewer than half the markets achieve the minimum investment-grade rating of MQR 4. Most markets are softening in supply/demand balance in the near future and there is caution about the prospects for improving rents and prices above 1998 levels in most places.
Despite the widespread concern about the international trade situation, the strongest-rated warehouse markets include major port cities like Los Angeles, Houston, and Portland, since it is total goods flow — not the balance of trade — that accounts for demand in distribution facilities. Other ports, including Miami and Seattle, have dropped off the top 10 list for 1999.
Increasing weakness exists in many of the Great Lakes states, where the export-disadvantaged industries have much of their production. The Breadbasket states, which export a large share of their agricultural output to Asia, also will undergo a difficult adjustment, as will the Pacific Northwest’s timber producers.
The economy faces serious threats, but the consequences should be merely a moderate cyclical easing for the industrial sector. The fundamental improvements earned by U.S. industry since 1985 will not evaporate overnight.
The multifamily sector’s ability to sustain equilibrium over the past five years is remarkable. At the end of third-quarter 1998, multifamily starts (in buildings of five or more units each) numbered 296,200, close to the 295,800 total units in 1997 and the 270,800 units in 1996. The Census Bureau’s multifamily vacancy rate was 8.2 percent in September 1998, up from 7.9 percent in September 1997.
Investors see apartments as an effective edge in times of market volatility. Apartment market cycles have been shorter than for other commercial property types. Multifamily investments also held their value better in the last downturn and buyers are paying handsomely for that greater security. Initial cap rates for multifamily purchases averaged 9.2 percent in 1998 vs. a 9.8 percent mean for all property types. The sample included 97 multifamily sales totaling $1.3 billion closed in the first half of 1998 out of a total of 693 transactions of all kinds, with an aggregate price of $9.2 billion.
Eight markets command an MQR 2 this year, four of them in California: San Jose, Orange County, Oakland, and San Diego. All have above-average ratios of renters to total households, strong median household incomes, impressive demographics, and very expensive median home prices.
Another MQR 2 market, Denver, is exceptionally tight, with a 3.5 percent vacancy rate, down significantly from 4.7 percent a year ago. With apartment rents under $700 per month, multifamily is very attractive when compared with single-family housing, even with today’s low mortgage interest rates. Projected demand growth indicates an immediate need for additional multifamily construction in Denver.
Honolulu also has an MQR 2. While it expects very little economic growth or new supply, the median home price of $305,000 — more than twice the national norm — pushes demand into the apartment sector. Almost half of Honolulu’s households are renters, compared with just one-third of all U.S. households.
The Northeast has some exceptionally tight markets, below 2 percent vacancy in the case of Boston and Middlesex, N.J. Boston rents are among the highest in the nation, more than $1,000 per month, bringing very attractive returns to landlords. Baltimore and Washington, D.C., are short of apartment supply as well, with vacancy just above 2 percent. Average rents in Washington are near the $1,000 mark, while Baltimore’s are closer to $700. The Northeast is difficult for multifamily developers: Most markets are mature and suburban expansion is slow, keeping supply in check.
The Midwest is showing middle-of-the-pack multifamily performance. Cleveland, Indianapolis, and Columbus, Ohio, tally MQR 3 ratings, and Cincinnati, an MQR 4 standing. Cleveland has cut its vacancy in half in the past 12 months, down to 2 percent. Indianapolis has dropped more than 3 percentage points to 5.4 percent. The single-family housing sector is very competitive in the Midwest, keeping rents comparatively low. But multifamily development is adding less than 2 percent per year to the inventories in these mid-America markets, allowing for excellent positive absorption.
Hospitality Needs Discipline
Stern discipline is needed in hotel development — and right away. Thirty-four of 61 markets analyzed had new supply additions exceeding fresh demand in 1998. The same number now has as many rooms as needed to be in balance. Because a decline to zero construction is improbable, a decline in market quality is anticipated.
Still, New York maintains its MQR 1, ranking first among all U.S. hotel markets. Occupancy is up 2 percentage points, exceeding 82 percent. New development should bring another 1,200 rooms in the next few years. But high barriers to entry should keep supply moderate and in tune with the projected 1.6 percent annual increase in room demand.
San Francisco also earns an MQR 1, moving up a notch. The 1998 sale of the Park Hyatt at Embarcadero Center at more than $300,000 per room illustrates the market’s strength. Several hotel projects are underway, but this is not a developer-friendly city and the pace of additions should be slow.
San Diego has 75 percent occupancy, earning an MQR 3. This market saw room rates jump nearly 15 percent in 1998, and builders have responded with numerous projects, ranging from a Ritz-Carlton resort to La Quinta Inns. Washington, D.C., also gets an MQR 3 and should see hotel visitation rise 2.3 percent per year through 2003. Some exceptional sales of full-service hotels have occurred, notably a pair of Ritz-Carltons in northern Virginia for more than $60 million apiece.
Boston’s rating decreased one step to MQR 4. Occupancy is 74 percent, and room rates are up 12 percent over the past year — but both indicators should level off soon. Recent hotel starts have rivaled 1980s peaks. This should remain a profitable market to operate hotels, but a tough environment for improving margins.
Las Vegas and Orlando find themselves stripped of their MQR 1 scores this year, but remain third and fifth in the nation, respectively. International tourism, especially from Asian visitors, may not rebound strongly until after 2001. Also, new projects keep coming on stream. Each city can absorb 1,200 new rooms annually through 2003, but this would be subpar production, which means softening in occupancies ahead.
Focusing on top markets, though, gives an overly sanguine picture of industry prospects. About 47 of 61 markets failed to make the MQR 4 cut for minimum investment-grade market conditions over the coming five years. Some, like Chicago — rated MQR 5 — are on the cusp. The Windy City has excellent current occupancy at 73 percent but also the highest level of new supply underway in a decade.
At the MQR 6 level, which includes Phoenix, San Antonio, and Baltimore, the message is to stop new construction because sufficient inventory exists to accommodate needs for the next five years. The MQR 7 metro areas, now below national average occupancy rates, likely will dip below the 60 percent utilization threshold by 2003. This includes some very significant spots, including Atlanta, Charlotte, Indianapolis, Cincinnati, and Portland.
Great Time to Buy
The new year begins as a great time to be a buyer, especially if high leverage is not required. Traditional real estate equity and debt providers will ride high early in the year. Capital should return to the securitized sector as early as first-quarter 1999, but it will take three to six months for these players to be fully back in the market. And, even then, they will be more conservative in their approaches.
Real estate got a splash of cold water in 1998 — a healthy alert to a market that was getting exceptionally hot.