Waiting for a Winning Hand
Retail and multifamily hold all the aces, while other property types wait for economic recovery.
The 21st century's opening years have proved
fairly risky for most investors. Those who rode the 1990s' rising
economy and bull market found the odds suddenly shifting against them
after spring 2000. For the most part, investors experienced a
substantial and unpleasant net worth decline between 2000 and 2003.
real estate was the exception. Incredibly, since the economy peaked in
2000, the median single-family home price has soared from $139,000 to
$177,500, according to the National Association of Realtors. The Office
of Federal Housing Enterprise Oversight's second-quarter 2003 Housing
Price Index was 15 percent higher than at the onset of the recession in
first-quarter 2001, without a single period of home price decline.
Taking advantage of historically low interest rates, homeowners
refinanced in unprecedented amounts to unlock their real estate assets'
The commercial property sector's story is
remarkably similar. During 2000, the CCIM/Landauer Investment Trends
Quarterly captured an average of 465 deals and $10 billion in aggregate
sales price every three months. With the exception of Sept. 11, 2001's
immediate aftermath, those figures rose steadily: By second-quarter
2003, the deal count was 786 transactions, amounting to $17.2 billion.
Meanwhile, capitalization rates dropped by approximately 100 basis
points, despite vacancy rate increases and rent softness in the wake of
the recession-induced drop in user demand in almost every U.S.
Many commentators concluded this
so-called disconnect was evidence that commercial real estate investors
were following dot-coms into a speculative bubble, where an excess of
capital pushed prices beyond any rational risk/reward horizon. However,
commercial real estate equity returns saw a 555-basis-point increase in
risk premium (assuming a 75 percent loan-to-value ratio for leveraged
transactions). Far from naively pouring cash into real estate,
investors reaped double-digit returns fully commensurate with
However, improving economic
conditions provide a mixed playing hand. The U.S. Commerce Department
estimated real gross domestic product growing at a 3.3 percent rate in
second-quarter 2003 and a prodigious 7.2 percent gain in the third
quarter. This year, economists now project 4 percent real growth in
total output. To achieve this rate, employment must rebound, most
likely in the range of 2 percent to 2.5 percent on a year-to-year
basis. Although this seems wildly optimistic, it implies 2.6 million to
3.3 million new jobs by the end of the year.
expansion, the federal budget deficit, and Iraqi reconstruction costs
indicate higher interest rates in the year ahead; thus, the bond
markets will compete more aggressively for capital, perhaps at the real
estate investment market's expense. Likewise, stocks should rally this
year, and the equity markets should recapture some of their asset
allocation from institutional investors and mutual funds. The financial
industry is firming up, with excellent banking and Wall Street profits
in 2003 predicting further growth. A declining dollar should help U.S.
export industries and promote inbound international tourism. Business
investment is rising, especially in technology and defense ? both of
which have strong multiplier effects.
On the other
hand, the refinancing boom has run its course, as have the tax cuts, so
consumers have to depend on actual earned income to sustain spending.
Overall, the hand we have been dealt looks reasonably strong but may
have mixed implications for real estate investment in the coming year.
Office Success Depends on Job Growth
Office investors will be more cautious this year. Vacancy rates likely
won't stabilize until 2006, and office buyers will demand higher
returns for taking on this risk. However, the good news is that
positive absorption in many markets should reappear this year and in
2005. The sector benefited from supply-side discipline, as few markets
had an excessive pipeline of new offices, and total construction volume
decelerated swiftly as vacancy rose.
despite manageable new development levels, office vacancy soared from
about 10 percent in early 2001 to above 17 percent in mid-2003,
indicating a vacant space volume that increased from 400 million square
feet to 680 million sf in just 30 months.
nation's large markets have lost approximately 278,000 office jobs
since 2001, employment loss accounts for only 62 million sf of the
vacancy. About 160 million sf of inventory was added, which leaves
approximately 58 million sf unaccounted - the so-called shadow space
that companies warehoused for future growth that never occurred.
evidence suggests that occupancy levels are stabilizing. Major
brokerages report vacancy hovering in the 16 percent to 17 percent
range during the first half of 2003. If more than 2 million office jobs
are added in the next five years, with perhaps 300,000 of those jobs
coming online this year, 460 million sf of demand will be generated by
2008. Most of this year's growth can be accommodated by existing space,
so net absorption will be modest. But there still will be a need for at
least 175 million sf to 200 million sf of new office space by the end
of the five-year period; therefore, development should accelerate by
Washington, D.C.'s office market outlook is
robust, building off its recent solid performance. The nation's largest
cities - New York, Los Angeles, and Chicago - each should add more than
100,000 office jobs by 2008. Demand will grow smartly in Sunbelt cities
such as Atlanta and Dallas, where risks are primarily on the supply
side. Florida will perform well, as will Southern California. However,
the technology-weighted Bay Area will spend much of the next five years
working its way back to 2001 office employment levels.
Expect Strong Retail Performance
Momentum clearly is running in the retail sector's favor. Due to
retail's double-digit total returns in 2002 and again in the first half
of 2003, pension funds and real estate investment trusts are committing
abundant capital to new shopping center assets. At the same time,
private-sector capital sources are structuring retail deals of about
$10 million each, often involving build-to-suit stand-alone properties
for nationally recognized brands. Such long-term leases will offer
bond-like returns. Consequently, as the chart "Investment Volume by
Property Type" illustrates, retail assets are taking an increasingly
larger share of overall real estate transaction amounts.
retail demand's fundamental drivers are shifting. Power center,
grocery-anchored center, super-size drugstore, and lifestyle center
development show signs of outstripping disposable personal income's
sustainable growth rate. Thus, sales per square foot in these segments
likely will be diluted by excess supply, holding rental growth down.
Also, these categories largely are aimed at middle-market consumers -
historically retail's most reliable customer base - but it is precisely
the middle-income households that will rely most significantly on
earned income improvements in the coming years, thus slowing the source
of buying power.
Faster growth will occur in the
high-end retail properties. The recent tax revisions heavily favor
upper-income households, affecting retailers catering to the wealthy.
The best potential exists in centers or free-standing properties
featuring upscale restaurants, gourmet foods and beverages,
electronics, sporting-goods stores specializing in leisure activities
such as golf and skiing, and luxury goods purveyors including
high-fashion apparel and accessories.
At the other end
of the scale, numerous middle-income households will need to watch
their wallets and shop more frequently at wholesale clubs or value
retailers like Target, Kohl's, and Wal-Mart. These two extremes will
squeeze many prominent American retail names, even as economic recovery
In the South and West, retail markets
should perform strongly this year. The outlook is promising for most
Southern California metro areas, especially San Diego and Orange
County, with Riverside providing an opportunity for value-oriented
retailing. Las Vegas should see very robust activity, from both basic
population growth and strong domestic tourism. Stores on prime high-end
shopping streets, including Beverly Hills' Rodeo Drive, Chicago's North
Michigan Avenue, and New York's Fifth and Madison avenues, will excel.
But even in the face of good job growth, overstored markets like
suburban Dallas and parts of southern Florida will struggle, as will
many traditional Midwest malls.
Suburban Boston's Route
128 corridor is a niche market that could see retail activity advance
quickly and substantially. Also, as more cities seek to create 24-hour
downtowns, central business district infill development opportunities
Thus, grocery- and drugstore-anchored
neighborhood and community centers likely will give way to
more-specialized retail properties as the focus of buyers' attention.
Given widening income disparities, high-end retailers have the
advantage this year; discounters have a solid base from bargain
hunters; and middle-market retailers face tough times ahead.
Industrial Markets Recover
Industrial property vacancy rates have held relatively steady in the 10
percent to 11 percent range since mid-2002, according to CB Richard
Ellis. But the stabilization is at an uncomfortably high level of
availability, and tenants dominate in all but a few national markets.
quickly caught on to the softening market: Industrial construction
volume has fallen since 1999. Investors also have been cautious in
recent years. Total industrial transactions typically have been $1
billion or lower in recent quarters, far below the levels for any
commercial property type other than hotels, according to ITQ.
2004 generally looks like a recovery year for industrial real estate.
Although manufacturing jobs are still in the doldrums, order backlogs
are increasing, and manufacturers have raised prices. As of last
September, new export orders were up for the 21st consecutive month,
and imports increased for the 11th month in a row. Since both imports
and exports need to move through the nation's warehousing and
distribution systems, fundamental demand for this segment should grow,
and absorption levels should increase in the next few quarters.
and technology sector gains should spark recovery in a number of
industrial markets, including San Antonio; Austin, Texas; Dayton, Ohio;
Albuquerque, N.M.; and Cedar Rapids, Iowa. Industrial properties could
be sleepers this year, since they feature relatively high returns and
steady cash flows at a time when investors value predictability. The
wild card is tech markets such as San Jose, Calif., that have been
battered severely and now may be ripe for investors willing to bet on
an equally strong rebound.
At present, the lowest-risk
industrial markets are in the New York metro area, specifically
northern New Jersey and Long Island. Denver has strengthened over the
past year, and Phoenix and Salt Lake City should benefit from economic
recovery spreading through the Rocky Mountain region. Positive
demographics should help South Florida markets, as land prices preclude
much speculative industrial development. Latin American trade
represents a long-term growth driver for Florida port cities, including
Miami and Fort Lauderdale.
Investors Still Want Multifamily
The apartment market has excelled in terms of investment flows during
the economic slowdown, and multifamily investors could be holding all
the aces as the nation enters expansion. Improving employment is a plus
for multifamily demand, and rising interest rates should bring the
rent-or-own choice to more normal ratios. Considerable pent-up
apartment demand comes from singles doubling up and college graduates
still living with their parents. If the job market improves enough,
those individuals will look for their own apartments - favoring
high-rises in 24-hour cities, including New York, Miami, Chicago, and
years institutional investors have used apartments as an effective
hedge against risk during economic downturns: Their price volatility is
lower than office, retail, and industrial properties, and the length of
time from trough to peak is shorter. Since apartments are typically on
annual leases, the ability to mark to market in recovery is more
immediate than in other forms of real estate, where tenants can lock in
rates for years at a time. Because of this, and the vast liquidity the
federally chartered housing finance agencies provide, apartments have
enjoyed the lowest cap rates of any property type for at least a
decade. Second-quarter 2003 average cap rates were less than 8 percent,
approximately 70 basis points lower than the mean cap rate for all
commercial property sales, according to ITQ.
markets enjoy a substantial advantage in realizing the strongest
multifamily investment returns. Apartment construction has continued at
a steady rate of 300,000 units or more, well in keeping with long-run
demand but producing an excess of supply in many markets, especially in
the South and Midwest where homeownership is affordable.
is no broader-based investment property segment than rental housing.
REITs, pension funds, life insurance companies, and large-scale
operators have a decided preference for 300-unit-or-more complexes to
achieve economies of scale in both acquisition and operations. But a
vast inventory of multifamily assets, ranging from suburban garden
complexes to central-city elevator buildings to modest four-plexes, are
suitable to small investors. This year the multifamily sector should
capture about one-fifth of total transaction volume.
Domestic Hotels Rebound
The hospitality market is still the joker in the deck. The worst of the
downturn appears to have passed, and hotel occupancy rates should edge
above 60 percent this year, after three consecutive years below that
domestic vacation travel looks promising, so coastal and mountain
resorts should be active. As families drive rather than fly to
destinations within 500 miles of their homes, middle-market brand name
hotels should perform fairly well.
will be slow again this year due to terrorism threats and global
economic weakness. Business travel also will remain tightly controlled.
Consequently, full-service hotels will struggle, especially in airport
Hotel completions were only about 75,000 rooms
in 2003, and development increases are not expected this year. Industry
revenues have been flat at about $112 billion for three years, but
analysts expect that to turn upward this year and in 2005, indicating
opportunities for investors with high risk/reward tolerances.
resort properties should have steady demand in Hawaii, San Diego,
Phoenix, and the southeastern coast. High-rise properties in South
Florida and in business locations including Manhattan, Washington,
D.C., and Chicago also should do well. New Orleans is back on the list
of popular destinations, bolstered by Louisiana's expanded casino
industry. Las Vegas is thriving, and Orlando, Fla., has enough
performance potential that developers will expand its already large
inventory by 7 percent by 2005.
For investors looking
for a turnaround play, San Francisco and Boston have all the key
elements of long-term demand: an excellent business travel base, good
domestic tourism demand, and popularity with international travelers.
Rapid improvement in these two markets is not a long-shot prediction.
coming year represents a turning point, a shift in cyclical advantages
in the investment sector, and within real estate, a reshuffling of the
various property types' positions. This year, expectations of more of
the same are unlikely to be realized.