The Waiting Game
The Commercial Real Estate Industry Watches for Signs of Economic Recovery.
As expected, the U.S. economic recession brought all the typical hardships to the commercial real estate markets: lower demand, higher vacancy rates, and weaker rent growth. On top of these problems, property owners also face higher insurance premiums and increased security and safety demands.
Even though an economic recovery is in motion, commercial real estate markets are expected to remain sluggish for the remainder of the year. How quickly the four main property types -- office, retail, industrial, and multifamily -- will begin to experience positive growth depends on property owners' abilities to fill excess space and investors' willingness to re-enter the market.
Office Fundamentals Weak
The economic recession diminished demand for central business district office space nationwide. As a result, vacancy rates rose and concessions such as free rent and tenant improvement allowances plagued landlords.
Excess sublease space also has dragged down fundamentals in many major cities. Mainstream Fortune 500 companies have been downsizing, consolidating, and reducing space requirements as a means of cutting costs in a weaker economy. In addition, higher unemployment and lower job growth lessen the demand for space.
Markets with the greatest amount of sublease space typically are those that relied too heavily on the 1990s high-technology boom to drive their growth. These markets include cities such as Austin, Texas, San Francisco, Seattle, and Boston.
On the other hand, downtown markets that have diverse economic bases, high barriers to entry such as expensive land, tedious and time-consuming approval processes, costly construction, and little, if any, available land have been least affected by the sublease space glut. Major markets in this category are Washington, D.C., midtown and downtown New York, and Houston. However, Houston's fundamentals may weaken in the near future from the Enron collapse and the potential for additional layoffs from the proposed merger of Hewlett-Packard Co. and Compaq Computer Corp.
Aside from rising vacancy rates, the drastic slowdown in demand for office space placed tremendous pressure on landlords to lower rents. In turn, investors significantly lowered their average market rent growth rate assumptions from five years ago. The overall average market rent change rate for nine office markets peaked in the first quarter of 1998 at 4.1 percent, according to PricewaterhouseCoopers' first-quarter 2002 Korpacz Real Estate Investor Survey . As of first-quarter 2002, this average stood at just 0.92 percent, a 77.56 percent drop. Unfortunately, rental rates are not expected to increase significantly anytime soon.
Fundamentals for the national suburban office market also are somewhat bleak. Rents have continued downward, prompting landlords to concentrate on maintaining occupancy levels and strengthening tenant relations. With tenants now controlling the majority of markets, concessions -- mainly in the form of free rent -- have made a strong comeback over the past year. Until the market swings back in favor of landlords, leases will continue to require inducements to keep properties filled.
Analyzing the steady rise in vacancy rates reveals the extent to which the suburban market has softened. The overall vacancy rate for first-quarter 2002 stood at 18.8 percent, according to Cushman & Wakefield. By comparison, it was 17 percent for the fourth quarter of 2001 and 15.3 percent for third-quarter 2001. And just over two years ago, the national suburban vacancy rate was 11.3 percent. Unfortunately, with close to 50 million square feet of suburban office space under construction as of year-end 2001, 35.1 million sf being built in first-quarter 2002, and supply already outpacing demand, overall vacancy rates will continue to rise over the near term.
Even though steady, better-than-anticipated gains in overall same-store sales during the first three months of 2002 seem to suggest that the worst may be over for the retail industry, the fact that these gains are dominated by discount retailers, such as Wal-Mart, Target, and Kohl's, and not by department and apparel stores raises new concerns and challenges.
Although not too long ago department stores and regional malls outperformed value-oriented retailers, a noticeable reversal has occurred, in part due to the economy. Although the number of newly constructed big-box stores and power centers has declined significantly since taking the retail industry by storm in the mid-1990s, their popularity among cost-conscious consumers has not faded, especially during times of economic weakness. Consumers also prefer the one-stop shopping that these stores offer.
Consequently, the dominant big-box players such as Wal-Mart, Target, and even the Home Depot continue to expand throughout the country. By contrast, the number of department store closings and bankruptcies, such as J.C. Penney, Montgomery Ward, and Bradlees, is on the rise. According to the Bank of Tokyo-Mitsubishi, department store sales fell 3.8 percent in 2001, while discount store sales grew 5.7 percent. Furthermore, department store sales fell 0.4 percent and discount stores sales rose 10.3 percent between March 2001 and March 2002. In line with this shift, well-located, established power centers with popular value-oriented anchors should continue to pique investor interest.
Regardless of the ascendancy of value-oriented centers, top-tier fortress malls are expected to maintain their values or, at worst, to suffer minimal, short-term value declines as a result of reduced discretionary spending. Furthermore, many of these top-tier properties have been less affected by the recent wave of department store bankruptcies, theater and cinema closings, and inline store closings that have devastated lower-grade malls.
Although historically grocery-anchored shopping centers have shown resilience against economic downturns, tenants at these centers also felt the full force of the recession. Grocery chain Great Atlantic & Pacific Tea Co., which operates A&P supermarkets, Albertson's, the country's second-largest grocer, and drugstore chain CVS recently closed stores in an effort to cut costs and improve bottom-line profits. Still, consumers' constant need to purchase necessities such as food and to complete daily tasks such as banking and dry cleaning should continue to drive demand for grocery-anchored centers.
While each of the three main retail formats -- regional malls, power centers, and strip shopping centers -- present both positive and negative attributes, average discount rates indicate that strip centers are viewed as the least-risky retail investment, according to the Korpacz Survey . Nevertheless, this category also posted the lowest average market rent growth rate assumption and the highest average overall cap rate of the three national retail markets surveyed. The lowest average market rent growth rate ranking suggests that investors see little potential for significant rent growth over the investment period, which also would translate into lower net operating income growth and lower value appreciation. This limited potential for rent growth, NOI growth, or value growth typically translates into a higher cap rate. With a limited potential for rent growth and value appreciation over the investment period, many investors require a higher return upfront. While not a poor investment choice, strip centers simply provide more stability instead of growth potential.
With limited amounts of new retail construction expected through 2004 and consumer confidence showing signs of rebounding, higher retail sales and increasing property values could be right around the corner for markets with relative supply/demand balance, such as San Diego, Austin, Tampa, Fla., and Washington, D.C.
Industrial Demand Slows
Demand for warehouse and manufacturing space has shrunk as a result of the recession, a decline in imports and exports, and improved technology that allows more accurate and timely monitoring of inventory levels. As a result, most industrial markets across the country have experienced increased vacancy rates and decreased rental rates and property values.
Markets that are most affected include those that have experienced significant additions to supply, are dominated by large corporations that have reduced their space requirements or shut facilities due to weak economic conditions, and serve the ocean freight and air transportation hubs. The five weakest markets where supply is forecast to outpace demand significantly during the next 18 months include Houston, Riverside, Calif., Austin, Dallas/Fort Worth, and New York, according to Credit Suisse First Boston's first-quarter 2002 Industrial REITs report. Fortunately, although new projects continue to be completed in these markets, the number of new starts is down.
Due to the widespread impact of weaker demand, landlords are pursuing tenants aggressively by offering moving expenses, lease buyouts, and additional improvement allowances. Moreover, modest rent concessions have increased in a number of markets. Since overall market conditions are expected to remain weak before rebounding next year, landlords should expect to continue offering tenant inducements during the remainder of 2002.
The reduction in warehouse demand from manufacturers, retailers, and wholesalers has dampened investors' value expectations, driving up both discount rates and overall cap rates during the past year. Between year-end 2000 and the first quarter of 2002, the average discount rate and average overall cap rate for the national industrial market have increased 32 and 29 basis points, respectively, according to the Korpacz Survey . Higher cap rates translate into lower property values and suggest higher investment risks. With few industrial markets expected to realize any significant improvement in market fundamentals, these trends should continue for at least the remainder of this year.
Of course, not all markets are performing poorly. The five top markets projected to experience excess demand during the next 18 months are Cincinnati, Richmond and Norfolk, Va., Memphis, Tenn., and St. Louis, according to Industrial REITs . Other notable markets include Baltimore, Nashville, Tenn., northern New Jersey, Pittsburgh, and Phoenix.
While there have been encouraging signs that the economic recovery will affect the demand for industrial space positively, the recovery of most individual markets will not be fully evident until 2003.
Multifamily Expansion Expected
While a drop-off in rental demand, a decline in rental rates, and the reemergence of concessions have affected all multifamily property classes negatively to some extent, these trends have hurt class A properties the most. The reason is twofold. First, demand for class A housing typically diminishes during tougher economic times when unemployment figures are higher, layoffs are prevalent, and renters monitor their expenses more closely. Second, since too many luxury properties were built during the past economic boom, fewer investors have been pursuing them.
On the other hand, interest in both class B and value-added assets has increased. Of particular interest are class B properties in top locations, class B complexes with expansion possibilities, and class C properties that can be upgraded and renovated. Top picks include the urban and infill markets of top-tier cities such as New York, Boston, and Chicago. Since they appeal to a wider spectrum of wage earners than class A space does, class B properties should continue to draw strong demand from both renters and investors even after the recession has ended.
Other top markets for multifamily investments include Los Angeles, Orange County and Sacramento, Calif., Washington, D.C., Orlando and West Palm Beach, Fla., Richmond, and Charlotte, N.C. Although new supply has outpaced demand growth in a few of these markets, they are expected to recover gradually through 2006, according to the year-end 2001 issue of PricewaterhouseCoopers' Real Estate Value Cycles .
By contrast, the San Francisco Bay Area represents one of the most distressed multifamily markets. Following a stellar five-year performance, its vacancy rate continues to climb as supply outpaces demand. Within this region, the Silicon Valley apartment market has been hit the hardest. An 11.4 percent vacancy rate is forecast for year-end 2002, according to Merrill Lynch. Seattle, which was affected negatively by the onset of excessive new supply and the departure of Boeing, also should continue to struggle over the near term.
Despite some turmoil in a few markets, the multifamily sector is poised to follow the recovery of the economy closely and could start to expand again in 2003.