Market analysis

Steady Gains

Despite economic uncertainty, the commercial real estate market continues its upward climb.

By Edward J. Finn |

Higher consumer prices spurred by near-record oil costs, tempered economic growth, rising interest rates, and a very hot housing market dominated first quarter’s economic news. Yet in the face of these mixed signals, the commercial real estate market hung tough, strengthening in many regions.

Last year’s performance led many investors and owners to have bright prospects for this year. Overall commercial real estate improved in 2004, with some segments faring much better than others. Retail was the top performer, with vacancies dropping in all subcategories. The industrial sector experienced rent increases and tightening conditions in the warehouse, research and development, and technology segments. Office remained somewhat weak as downtown class A rents fell and vacancies rose throughout last year.

Multifamily continued to boom, with some market analysts raising concerns of overheating. The hospitality sector also continued strong, with competition from multifamily-housing and condominium conversions adding to the demand in key markets.

Momentum from last year carried into the first quarter. Some office inventory slowly is being absorbed and strong development continues in the retail and industrial distribution sectors. Investors are driving condominium and multifamily markets to what may be unsustainable levels. Overall, commercial real estate vacancies should continue to drop and rental rates should rise this year, with gross domestic product growth of about 3.1 percent expected. The Federal Reserve’s slow but steady interest rate increases have not triggered a steep economic downturn, but the effects of continued rate steps remain to be seen.

Regional Highlights

Boston. Hard hit by the burst dot-com bubble, Boston’s commercial real estate markets should stabilize and improve this year. While Cambridge, Mass., class A office vacancies have increased slightly, the Route 128 submarket’s office vacancies have dropped nearly a percentage point to 18.2 percent for class A space and rental rates have begun to increase. However, this area has a long road ahead, as office rental rates only now are getting back to the levels experienced in 1996 and 1997.

Industrial activity in the Boston market is driven by user/buyers, as low interest rates continue to slant lease-vs.-own analyses toward purchasing. The overall industrial vacancy rate stands at 9.8 percent at the end of the first quarter, down very slightly from the 9.9 percent level reported at the end of 2004, while flex space vacancies rose to 17.4 percent from 17.0 percent at year-end.

New York. The city is experiencing strength in nearly all commercial real estate sectors and submarkets. Record-setting office sales continue in Manhattan: Tishman Speyer Properties purchased 200 Park Avenue for $1.72 billion, topping last year’s $1.4 billion purchase price for the General Motors building. The Midtown office market continues its stellar performance with vacancies down and asking rents rebounding to early 2002 levels. While the downtown area remains relatively weak, there are signs of an impending turnaround. Notably, the Securities and Exchange Commission has announced a move from Midtown into 235,000 square feet of downtown office space.

Hotel properties are a hot item in Manhattan as well, with more than 56,000 rooms sold for condominium conversion since late last year. The strength in the hospitality and multifamily sectors is expected to continue through the year.

Washington, D.C. An upswing in government activity related to homeland security and defense has made Washington, D.C., the fastest-growing market outside the Sun Belt. The federal government currently has approximately $5.4 billion in office projects under construction in the market and is seeking to lease an additional 200,000 sf.

The federal juggernaut keeps the entire region busy. Vacant office space in northern Virginia is being rapidly soaked up: Vacancy has dropped to 11.7 percent in first quarter from 15.0 percent at the same period last year. The drop has occurred despite the 5.1 million sf of new office space under construction in this submarket. Office vacancies in the Maryland suburbs have decreased despite the addition of approximately 200,000 sf of office space, with another 1 million sf under construction.

photo caption: Fully leased to the General Services Administration, the John M. Eisenberg Building at Redland Center in Rockville, Md., sold for $38.6 million or $288 psf in March.

photo: Advantis/GVA

Miami and South Florida. The Sunshine state’s multifamily market is on fire, with the world’s tallest condominium building in the planning stages. Now seeking city of Miami and Federal Aviation Administration approvals, the proposed Empire World Towers would occupy a two-acre Biscayne Boulevard site recently purchased for more than $37 million, almost twice its sale price when it last changed hands in April 2004. The 1,200-foot-high twin towers would contain 1,000 condominium units and 500 apartment hotel units. However, local market watchers think the multifamily market is overheated and becoming overbuilt, and they expect the market to begin to cool later this year.

Office activity remains hot in South Florida as well, with a net absorption in the first quarter of 1.5 million sf, driving the office vacancy rate down to 10.5 percent. Another 1.7 million sf is under construction and scheduled for delivery later this year.

Chicago. Overall, office market performance was somewhat disappointing at the end of the first quarter. Vacancies increased in the central business district by more than a full percentage point, spurred by the opening of a 1.3 million-sf office tower at 71 S. Wacker Drive. Combining the new space with negative absorption in several other submarkets, the overall class A vacancy rose from 17.6 percent at year-end 2004 to 18.8 percent in the first quarter. Absorption is expected to continue to be negative during the remainder of the year due to tenant space reductions and intra-market moves.

The Chicago area industrial market was strong for both leasing and sales in the first quarter. Vacancies dropped to 9.2 percent with net absorption of more than 6 million sf.

St. Louis. This market has experienced the effects of 2004’s general recovery in the first quarter as well. Overall, office vacancies have decreased to 15.5 percent downtown and 12.9 percent in the suburbs for class A space, and little new space was added to the market. Vacancies are expected to drop throughout the year, as speculative office construction slowly picks up.

The St. Louis industrial market improved in the first quarter, with 14 buildings added to the market and another 17 expected to deliver later this year. The overall industrial vacancy rate trended down to 7.5 percent — more than enough to spur continued construction. The high-tech/R&D sector also saw marked growth, with the vacancy rate dropping from 18.3 percent to 16.0 percent.

Milwaukee. Though the northeast Wisconsin market is picking up due to strong population growth, Milwaukee’s commercial real estate markets continue to lag. The office sector slowed at the beginning of the year, and though rents have remained stable, most submarkets only have seen limited absorption and increased concessions. The downtown finally has absorbed the nearly 500,000 sf of office space delivered in 2003, but the absorption came largely at the expense of older class A office towers as tenants moved to the newer space, but did not expand overall. No new significant office projects are under way in the downtown or the suburbs, although several downtown proposals are seeking anchor tenants.

While the office market may be soft, multifamily and retail are going strong in Milwaukee. Downtown is seeing unprecedented residential growth, with strong multifamily and condominium markets also feeding the retail sector, where vacancies are at 10.0 percent.

Austin, Texas. The market’s office rents rose 20 cents to $19.50 per square foot despite negative first-quarter absorption of approximately 200,000 sf. The office sector is expected to stabilize with overall positive absorption by year’s end.

Austin’s industrial market saw continued strength with slightly decreasing vacancy rates at year-end 2004 continuing into the first quarter.

Retail markets in Austin continue to be strong, with significantly increased activity in the first quarter. Overall vacancy is running at 6.0 percent, unchanged from year-end.

Phoenix. Growth in the heart of the Sun Belt continues. Class A office vacancy fell to approximately 15.2 percent from more than 18.0 percent at year-end. Office condominium projects in suburban submarkets are hot and numerous class B locations are being snatched up for development into high-priced office condominiums.

The land market remains very strong, especially land that includes utility entitlements. Parcels that include infrastructure are moving even more quickly. Planned engineered lots are running $20,000 to $25,000 each, with an additional $10,000 for improvements.

Multifamily properties are highly sought after, with more buyers than sellers and multiple bids on most properties. The area’s rental market is rebounding due to steep single-family home price increases.

Reno, Nev. Reno recently garnered the No. 1 position on Inc. magazine’s “The Best Places for Doing Business in America” list due to solid local job growth and a good balance of growth among various industry sectors. Not surprisingly, commercial real estate sectors performed well in the first quarter.

The industrial market was particularly strong, with vacancies dropping below 7.0 percent and several new projects underway. Approximately 1.7 million sf of additional industrial space is planned this year.

Reno’s hospitality market is driven by gaming, and that is being hurt by more casinos on Indian land in California. On the retail side, the vacancy rate has fallen slightly to 6.0 percent overall, as new product continues to hit the market. Retail should continue strong and absorb 250,000 sf of additional space slated to come on line later this year.

San Francisco. The Bay area’s recovery accelerated in the first quarter. Office market vacancy continued its downward trend for the fifth consecutive quarter, stabilizing at 15.9 percent –- the lowest point in three years. The first quarter also saw strong sublease space absorption of approximately 1 million sf. In addition, more than 7 million sf of space was leased in the first quarter.

On the industrial front, the Bay area’s R&D market is steady, with vacancy down slightly to 20.7 percent and average rents down two cents to 91 cents triple net. The 28,500 sf of new construction was more than taken up with a net absorption above 160,000 sf. Manufacturing was also a standout performer, with more than 400,000 sf net absorption and rental rates steady at an average 55 cents triple net.

Portland, Ore. The Pacific Northwest finally is realizing the promise of better economic times as employment figures in both Oregon and Washington have surpassed record-high 2000 levels.

Several years of pent-up demand is resulting in well-performing industrial manufacturing and office sectors. Continued population and job growth and politically restricted availability of developable land are forcing up land prices and supporting retail growth. First-quarter retail absorption was nearly 200,000 sf.

Multifamily is strong in Portland, with the first-quarter average market rents up slightly and landlord concessions down. Vacancies have trended down to 6.2 percent, from more than 6.5 percent last year. Vacancy should continue to decline in 2005, and rental rates should increase more significantly in the latter part of the year.

Southern California. Strong growth is anticipated over the next two years in the Los Angeles Basin general office market. Demand is expected to be at least 6 million sf per year, which should push the Los Angeles office market vacancy rates down from 13.0 percent to the single digits within the next 18 to 24 months.

In Southern California’s small industrial market the median price for the 82 small buildings sold in the first quarter was $179 psf, up more than 40 percent. Vacancy rates are 3.2 percent, down from 3.9 percent last year. Demand is driven by still-low interest rates. The purchase demand is expected to drive up rents in the next 12 to 24 months, as construction activity is restrained.

photo caption: The fully occupied Baldwin Park Industrial Center in Los Angeles sold for $36 million in April.

photo: Colliers Seeley International