Market analysis

When the Going Gets Tough(1)

The commercial real estate market remains strong, but investors must work harder in 2007 to identify opportunities.

Commercial real estate has had it good for the past five years and extremely good for the past two years relative to stocks, bonds, and money markets. But performance marked by over-the-top returns was bound to catch up with investors and users. Simply put, commercial real estate now is fully priced and finding good, predictable investment or user situations is virtually impossible. As a result, alternative investments are becoming more attractive.

During the past five years, every investment angle and financial investment structure has been tried, tested, and expanded upon, bringing the market to a level of maturity and sophistication never before seen. But this market now is bracing for downside volatility, and with it comes the recognition that the easy money is a thing of the past. For 2007, investors and users must seek new frontiers and exercise creativity in their approach to buying and selling commercial real estate.

2007: Markets to Watch

RERC has generated an econometric model that utilizes various transaction and proprietary data to rank the markets from a vlue vs. price perspective. The following list of top 10 markets by property type is based on RERC's price/value analysis, which also utlizes RERC's valuation expertise, market knowledge, and financial modeling capabilities to identify the markets.

Table 1

Table 2

The Investment Environment

Sizing up the economy and capital markets helps to put commercial real estate's coming performance in perspective. While the U.S. economy may be slowing down, it
remains quite resilient. Gross domestic product slowed during the second half of 2006, but growth is expected to remain relatively stable at about 2.5 percent during the year. Consumer confidence took a hit with the slowing housing market and volatile energy prices, but employment is strong, inflation remains in check, and consumer spending continues. Even though geopolitical concerns remain, interest rates have stabilized and corporate earnings in many industries are higher than expected. Most importantly for commercial real estate, businesses are continuing to invest.

In this still-solid economic environment, record amounts of capital continue to flood the investment market. Valued at $26 trillion and $14 trillion respectively, the U.S. stock and bond markets continue to attract the most interest. However, the institutional-quality real estate market has increased as well, estimated at approximately $4.2 trillion in 2006, about $0.7 trillion more than in 2005.

Despite the record-level gains amassed by the Dow Jones industrial average and other stock indices in late 2006, real estate returns have been even greater. Office, industrial, retail, apartment, and hotel property returns ranged from 17.2 percent to almost 21 percent on an unleveraged basis last year, well above the 12.5- to 13- percent range during the last 10 years, according to the National Council of Real Estate Investment Fiduciaries. Properties that were leveraged or had debt in place saw even higher returns.

These strong returns largely are a function of net asset value appreciation, driven primarily by capitalization rate compression rather than net operating income growth. With the space markets improving, NOI has finally begun to grow as well. However, the across-the-board gains created by cap rate compression, which favored all property types without regard to quality and location, is mostly over. Cap rate compression now is driven by anticipated NOI increases, indicating a shift from a capital market focus to a space market emphasis.

Investors need to identify the property types and locations where landlords have pricing power. This especially is true where expenses are going up faster than the rate of inflation. Given the recent stellar performance of commercial real estate, Real Estate Research Corp. predicts that the market is at an inflection point and it is important to understand the long-term implications: Double-digit unleveraged returns are not sustainable in today's financial market.

There is reversion toward the mean for returns over time as illustrated in Table 1. This is the way the financial markets work toward equilibrium, and real estate is no exception to the rule. During 2007, expect the NCREIF 1-year return to begin declining toward the 15-year mean return of 9.3 percent. This decline in returns is expected to occur at a reasonably measured pace, which is a function of the strengthening market fundamentals. Given this, double-digit returns still should occur - albeit at much lower levels. However investors should not confuse declining returns with declining values; positive capital appreciation will still occur, just not at the levels experienced over the past few years.

As Table 2 shows, the market is pricing these total returns to decline to single digits and NCREIF returns are working downward toward RERC's expected, or required, returns. However, as Table 3 illustrates, on a cap rate basis, there is a narrower spread between RERC and NCREIF in reported 1-year unleveraged returns. Cap rates on an unleveraged basis have fallen some 200 basis points during the past five years, which is the source of all the value appreciation. Given that cap rate compression is over for the most part, commercial real estate will have to count on income in place plus value appreciation from improving net income levels. Regretfully, appreciation is not guaranteed and some properties will see a price correction.

Table 3

Table 4

Table 5

The Property Markets

This environment - a resilient economy, a huge amount of financial liquidity, historically high commercial real estate total returns that are expected to decline, and reduced cap rate compression - sets the stage for examining the major property sectors.

Office-With corporate earnings as a percentage of GDP near 40-year highs, the financial condition of office tenants is contributing greatly to the strength of the office sector. In addition, office-using jobs have increased by about 2 million throughout the last three years, and total U.S. office employment is at an all-time high. As a result, vacancy rates in the national office market declined for 14 consecutive quarters, according to Torto Wheaton Research, with 3Q06 vacancy at 12.9 percent. Net absorption and high construction costs are keeping new building in check. With office market fundamentals improving, the elusive balance between supply and demand finally is within sight.

Despite the obvious office market strength, there are risks worth noting, including slowing global and national economic growth, decelerating job growth, increasing operating expenses that reduce landlord rental pricing power, and possible excess new supply as an abundance of capital continues to chase higher returns. Even so, the average price of office space on a national level was $165 per square foot in 3Q06, as shown in Table 4. Further, as reflected in Table 5, RERC anticipates strong office performance, as investors look for higher returns relative to other property types.

Industrial- Given the importance of net population growth, consumer spending, and global trade to the U.S. economy, the demand for industrial space should increase for the foreseeable future. Industrial stronghold Los Angeles had a low warehouse availability rate of 5.4 percent, but even on a national level, availability rates declined to 9.6 percent for 3Q06, according to TWR. Further, landlord pricing power continues to improve, causing rents to move upward.

The industrial sector is not without its risks, however; the greatest of these would be a possible slowdown in consumer spending and the transition to a less-robust economy. In addition, the amount of investment capital available indicates that speculative building is likely to continue, and given the relative ease of warehouse construction, investors will be tempted to build instead of buy. This suggests that industrial availability is likely to remain near current levels for the short to intermediate term.

Retail - Powered by strong job growth, low interest rates, and rising home equity, consumer spending has accounted for more than 80 percent of cumulative economic growth during the last five years. As a result, retail sales have been strong, and retail property performance has been even stronger. Availability of retail space is at 8.4 percent according to TWR, and rental rates remain solid. With 300 million American consumers, shopping will remain a big part of America's national pastime, and it is difficult to imagine much slowing, despite possible risks.

But in our mature economy, less consumer spending resulting in retail property performance suffering is expected. The slowing housing market is affecting consumer dynamics, both directly, due to fewer sales of home furnishings and appliances, and indirectly, as home wealth extraction becomes more challenging. Furthermore, payroll employment growth has begun to slow, and while high energy prices recently have begun to decline, they remain volatile and add to consumer uncertainty.

Increased retail construction and planning suggests investor confidence in this property type, but it is more likely that retail vacancy and rental growth will be challenged, especially in areas with uneven population growth and household income. RERC's 3Q06 required going-in and terminal cap rates declined 20 to 50 basis points from the previous quarter.

Multifamily - For the first time since the 2001 recession, effective apartment rent growth exceeded inflation in 2006, due primarily to net absorption at record-high levels, removal of apartment stock by condominium converters, and only moderate net growth in supply. As a result, apartment vacancy rates are at or below long-term averages in most markets, with the national vacancy rate at 5.6 percent, according to The strength of the multifamily market has been driven by low unemployment, continued job growth, and higher interest rates that have caused homeownership growth to wane. As a result, landlord pricing power has returned, which could not be timelier now that the era of cap rate compression generally is over.

Despite strong positive net appreciation and the highest risk-adjusted returns among the core property types in 2006, according to the NCREIF property index, fundamentals should even out as additional new apartment construction, combined with shadow competition from condominiums and rental houses, make it more difficult for vacancy rates and rents to further improve. However, markets with high concentrations of echo boomers - those born between 1977 and 1989 - and high immigration levels should experience better-than-average rent growth, especially in the renter by necessity apartment sector.

Hospitality - Although it has taken five years, hotel fundamentals have come almost full circle since the terrorist attacks of Sept. 11, 2001. The growth in household wealth has supported the increase in leisure travel, and growing corporate profits have supported a rise in business travel. These dynamics, along with minimal new supply, have led to a well-performing hotel sector during the last few quarters.

Strong performance is expected to continue for the near term, with the occupancy rates peaking at approximately 74 percent for the full-service sector and 68 percent for limited-service, according to TWR. In addition, with high demand, the average daily rate increased approximately 10 percent over prior-year rates. The combination of high occupancy and high ADRs has driven revenue per available room into double-digits during the last few quarters.

Nevertheless, RERC suggests that hotels will continue to exhibit above-average return volatility, given ongoing terrorist threats related to air travel, slowing consumer spending, the possibility of recurring high fuel prices, plus the likelihood of additional hotel supply. Even though returns for the hotel sector are more stable than they have been for five years, risk remains.

Investment Opportunities

Real estate continues to be fully and rationally priced, and unless the economy suffers a major shock, real estate prices are expected to remain strong. Further, the narrowing gap between real estate cap rates and expected total returns suggests that investors are not expecting significant incremental appreciation from core real estate, and thus are not relying on further cap rate compression to drive returns.

The secular weight of capital, increased liquidity, and greater transparency provides continuing support for real estate valuation levels, given the numerous investors that are committed to the real estate asset class but remain under allocated relative to target levels. However, real estate risk does remain. Despite global and national economic influences, real estate is a local business, with investment performance a function of space market fundamentals and successful strategy execution at the property level. Cap rate compression can no longer be counted on to help offset poorly executed strategies or weak space market fundamentals. But there is no turning back; commercial real estate has reached a level of maturity and sophistication that will allow it to remain a viable investment for owners and investors.


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