The Year Ahead
The Industry Will Continue to Expand in 1996, but So Will Its Vulnerabilities.
Navigating the treacherous real estate markets of the first half of this decade required an intense concentration on immediate pitfalls and hazards. Short-range vision had to be acute: for many, the survival of entire enterprises was at stake. As the new year begins, though, the real estate industry finds its point of view has shifted farther down the road. Alert to improved conditions, investors, builders, and lenders are accelerating growth plans rather than practicing the tactics of defensive driving. Strategy is rotating to the fore, and the longer perspective is now the essential framework for analysis.
Real corporate profits are at unprecedented high levels. At midyear 1995, after-tax profits were $355.8 billion, up 10.7 percent for the year. About $220 billion was distributed in the form of dividends, with the remainder retained to finance future needs. The amount of cash being retained suggests that the big firms will continue to pursue the aggressive merger and acquisition route, and that the era of consolidation and downsizing has not yet run its course. Thus, the demand for corporate facilities, especially in the office sector, will again be weak in 1996.
Year-over-year gain in total nonagricultural employment was 1.7 million, or 1.4 percent, as of last August. The leading sectors for hiring were entertainment (268,000 jobs), health services (257,000), construction (191,000), and computer services (104,000). Such sectors were not completely exempt from the merger urge (for example, Disney/Capital Cities and IBM/Lotus), but overall the trend seems to be upward in these industries. In fact, the blurring of the border between the entertainment and communications sectors is already sprouting significant numbers of new firms requiring business facilities. Service firms supporting the explosion of the Internet (up to 3.2 million host computers now, a 45 percent increase between January and September 1995) are generating space demand from a technology once presumed to drastically erode the need for offices.
Ominously for retailing prospects in 1996, consumer indebtedness is reaching record levels, approximately $968 billion at midyear 1995. At 16.1 percent of pretax personal income, household balance sheets are stretched. Credit card delinquencies are at a near-record high of 3.3 percent, during a period in which the economy is expanding rather than dipping into recession. A good deal of economic zip has been provided by borrowed money during the past two years, a period in which installment debt has climbed 30 percent. This trend probably will slow drastically in the coming year.
Since 1992, the manufacturing sector has sustained double-digit percentage increases each year in plant and equipment spending, a rise in the industrial production index from 106 to 121, and a manufacturing capacity utilization rate of 83 percent, up from the recessionary level of 78 percent. The hard-goods sector is driving the improvement, and year-to-date employment figures for durable manufacturing firms show an increase of 117,000 jobs.
Partly in consequence, construction activity in the industrial category (which is mostly factory and assembly facilities) and other commercial (including warehouses and retail) has now returned to the level of 1988 to 1990. Office and hotel development, by contrast, is still only 60 percent of the levels of the late 1980s. The building industry is inching its way back.
Commercial construction lending grew by 2.7 percent in 1993, and 4 percent in 1994, according to Federal Reserve Bank figures. The upward curve is likely to steepen in the next three years as the office market recovery matures. The spread on construction loans has reportedly narrowed from 250 basis points over the London interbank offered rate (LIBOR) to 125 basis points. Such real estate lending appears more lucrative to banks than standard business loans, where spreads are even narrower. But the risks of construction lending should remain fresh in the minds of lenders.
In 1996, the U.S. economy will come close to the long-term trendline for gross domestic product (GDP) and employment growth, although the Fed will be attentive to the fragility of the expansion. For real estate, user demand will be adequate in most property types and the commercial real estate price recovery will be rising faster than the year's macroeconomic indicators.
Office Markets Heat Up
A potent combination of improved returns in the present and growing confidence in the future is propelling office markets forward as 1996 begins. As supply-and-demand measures have advanced, the stream of capital flowing to the office sector has grown. Investors, though determined to avoid the excesses that led to the loss of billions on the office market in the down cycle, perceive that the odds have shifted in their favor.
Pension funds' appetite for additional office properties has been whetted by solid improvement in the performance measures tracked by the National Council of Real Estate Investment Fiduciaries. Total returns for the $7.3 billion of pension fund equity investments in office were a solid 5.9 percent for the year ending in the second quarter of 1995, the best showing for this property type since 1986. Income returns for the year were 9.9 percent of the market value of these assets. Although the funds were lightening their portfolios in the West, where values were still in decline in early 1995, they were buying properties in the East and in the Midwest, regions where income yields topped 10 percent.
The industry now generally agrees that a resumption of the construction cycle will herald the next broad step upward in office rents and values. Commerce Department data on office development indicates an annualized 12.8 percent rise in construction volume for 1995. But this is merely a modest rise from depressed levels, and total office building volume is still only half that of the 1984 to 1990 period. For the first time in years, though, speculative office projects are actually in development. Therefore, investment analysis for the office sector will once again need to factor meaningful supply additions into market projections.
Consequently, the extended decline in vacancy rates that has marked the 1991 to 1995 period will likely decelerate in 1996. For 60 major metropolitan markets, vacancy dropped from 16 percent to 14.5 percent between the second quarters of 1994 and 1995. The 1996 figures will likely show a less significant drop, with the national vacancy rate to stand at slightly more than 13 percent at the beginning of 1997.
For the fourth time in the past five years, Orlando tops the Landauer Momentum Index, which ranks 24 of the nation's key office markets. Its rating reflects the current strength of the market-a vacancy rate of 12.7 percent, below the national average-and its very strong growth prospects. Orlando's economy will produce another 19,000 office jobs by the year 2000. Downtown actually boasts a slight advantage in occupancy over the suburbs. Information technology firms, insurers, and corporate owner-users are key demand generators.
The Southeast is also the regional home of another top-ranked market, Charlotte, North Carolina. The booming state economy has been fueled by the emergence of Charlotte as one of the nation's key banking centers. Space is virtually impossible to find in the central business district (CBD) due to the appetite of the financial institutions, and it is scarce enough in the suburbs, where occupancy is more than 90 percent. There are at least six office projects in the development pipeline, including one on a fast-track construction program. The absorption rate should be slowing in Charlotte in the second half of this decade, and projections based on recent history alone will likely prove overly optimistic.
Prospects in the Middle Atlantic and southern New England cluster of markets are more dour. This region has experienced the most severe effectso f banking mergers, and 1996 will be a year when layoffs wash through the economy in a big way. Philadelphia faces layoffs at PNC Bank and Meridian Bancorp, and the metropolitan statistical area (MSA) could be looking at net negative absorption over the short haul. With the exception of the more affluent Bucks County suburban markets, this looks like a risky year and Philadelphia's ranking reflects only sluggish recovery through 2000, at an average office employment growth rate of 1.1 percent.
New York City is at the bottom of the Momentum Index list for the fourth consecutive year. Citywide employment was flat in 1995, and other sectors must make up for the 4,000 jobs being trimmed by the Chemical/Chase Manhattan merger. There is good news: New York City is becoming one of the major commercial beneficiaries of the explosion of the Internet due to the agglomeration of communications, entertainment, graphics arts, and computer specialties in town. Nevertheless, New York will not escape double-digit vacancy rates until the early years of the 21st century.
In the Midwest, there has been a sharp contrast between the stubbornly high vacancy in the Chicago CBD and the steep decline in available suburban space. The rating of the MSA office markets has risen this year, based on a projected gain of 67,000 office jobs by 2000. A narrowing rental differential between suburban space and the Chicago Loop eventually will correct the disparity in submarket absorption. For now, though, downtown remains a tenants' market.
The statewide employment growth of 260,000 jobs in Texas in 1995 has finally propelled Dallas into the upper echelon of the 24 large markets. High vacancies in the CBD are retarding the overall performance of this market. Like New York City, investor interest in Dallas properties is on the rise, albeit at bottom-fishing prices that have seen downtown towers trade at less than $70 per square foot. Houston has not seen nearly as much enthusiasm, with its vacancies stuck at more than 20 percent. Austin, San Antonio, and Fort Worth all are posting substantial occupancy gains.
The user market (as measured by supply-and-demand balance) and the investor market (as measured by cap rates and investment flows) are headed in the same direction in 1996. These reinforcing trends imply a very active year in this sector, and a period of increasing optimism. The markets are still fairly fragile, and even a modest rise in construction will slow market improvement. On balance, though, the office sector is on an upward path for the rest of the 1990s. The comeback is underway.
The Industrial Markets
In 1995, returns for industrial real estate began flowing at double-digit rates to purchasers.
Real estate investment trusts (REITs) specializing in industrial properties registered a 12-month total return of 17.7 percent (11 percent price appreciation and a 6.7 percent dividend return). These REITs have been on a buying binge, with more than 75 deals booked in the first half of 1995 alone. Wall Street appears determined to increase the share of securitized equity in warehouses, light industrials, and self-storage facilities, which had a total market capitalization of $6.7 billion, or 13.4 percent of all equity REITs as of September 30, 1995. This compares to allocations of 23 percent in apartment REITs and 28.5 percent in various forms of retail-oriented REITs.
But the activities of REITs should give the industry pause. About one-third of the deals by industrial-oriented REITs involve development of some sort. While most of them are build-to-suit deals, expansions of existing facilities, or projects with significant preleasing, there is enough speculative development to cause concern. If it were only the securitized players, the impact on the market would not be enough to unsettle the pattern of recovery. But a look at industrial property development in 60 markets shows that the construction curve is once again rising steeply. Warehouse starts in 1995, for example, will be virtually identical to the 1990 total of 65 million square feet, and will be up 28 percent from the 1994 construction volume.
As the business cycle ages, the manufacturing sector will cool off considerably during the next two years. Expect only limited improvement in consumption growth over the same period. The U.S. net export situation should improve, buoying markets linked to the international economy. But even these cities face uncertainties, including the timing and extent of a Japanese rebound and the sorting-out of North American trade issues.
Industrial properties are extremely sensitive to swings in GDP. If we see another recession before 2000-and the odds are good that we will-this property sector will hit a major pothole. For the time being, there is room for moderate improvement in supply-and-demand fundamentals in 1996 and consequently additional gains in rents and values. In 1997, however, the positive curve will begin to flatten and the "hot money" could head elsewhere in a flash.
Slow-growth demographics and an aging stock of industrial properties handicap the Northeast metropolitan areas. Only Boston finds a place in the top market rankings, in the research and development (R&D) category. This, in itself, is a victory over the naysayers who predicted irreversible decline in the wake of the mini-computer debacle that enervated DEC, Wang, and other New England technology firms. The IBM acquisition of Lotus Development Corporation once again focused attention on Boston's deep intellectual capital resources. At $5 per square foot, R&D effective rents are competitive with other technology centers across the United States, and tenant demand is forecast to be brisk in the coming years.
All factors considered, there has been no industrial market more active than Atlanta in the past year. Year-end 1995 warehouse construction totals are estimated to be 5.5 million square feet, up 15 percent from 1994 and back to the development volume of 1988 to 1989. Industrial job gains are robust-7,200 (3.5 percent) in the past year. Though the MSA is likely to see a post-Olympics slowdown in 1997, expect the games to stimulate even further interest on the part of foreign firms. As the hub of the Southeast, Atlanta should continue to prosper as the region's major distribution center.
Despite the unsettling effects of the Mexican peso crisis on NAFTA-related businesses, Texas is still well-represented among the top industrial markets this year. Austin led the top markets last year, with a 7 percent gain in manufacturing jobs, almost all in computer-related industries, which is reflected in its high ranking in both R&D and assembly facilities. High-tech rents, at $7.80 per square foot, are among the highest in the nation. Dallas is in the midst of explosive construction activity, which has driven vacancy back up to 10 percent. The Metroplex is established as a telecommunications center, and can be seen as the implementation center for the technology coming out of Austin. A note of caution: REITs are reportedly starting to bring on spec industrial because they cannot find enough product to buy.
Seattle and Portland, Oregon, in the Pacific Northwest, are becoming accustomed to their strong industrial performance. Import/export volumes are still rising substantially, and Russian trade is now strong. Names like Microsoft, Nintendo, Intel, and others highlight the high-quality jobs generated in the region. Industrial occupancies are in the mid-to-high 90 percent range. Portland is starting to see a development cycle, and Seattle should see warehouse starts rising in the late 1990s. But there is little sign of imbalance on the horizon, and these distribution markets are the best in the nation through the year 2000.
The Shine Is Off Retail
After a long run as the darling of professional investors, shopping centers find themselves eclipsed entering 1996 by gathering strength in other commercial property sectors. It is a reminder that cycles are the dominant fact of life in the real estate business.
At this point the weakness is key mall stores, rather than anchors. The apparel sector has gonenowhere for years, and the goods producers and the merchandisers have plenty of blame to share. Shoppers are tired of the depressing sameness at most clothing and shoe stores and are staying away in droves. Through July 1995, women's specialty store sales were down 2.3 percent from the previous year and shoe stores gained a virtually invisible 0.6 percent. Despite a few laudable exceptions like The Gap and its offshoot, Old Navy, soft goods retailers account for most of the disappointment in sales-per-square-foot figures in the malls.
However, consumers have been spending. Computers and appliance sales soared 16.9 percent after an outstanding 1994 sales year. Jewelry store sales were up 8 percent, and sporting goods outlets cranked up a 7.6 percent gain. And, with home sales rebounding thanks to lower interest rates, furniture stores posted a 6.6 percent increase.
Discounters and power centers are still formidable players in the retail sector, and investors frequently cite concerns about competition from these sources. But the discounters are seeing troubles of their own. Jamesway, Caldor, and Bradlees all found their way into bankruptcy court during 1995. Marshalls was sold to T.J. Maxx, and Filene's Basement has been buffeted by negative reports in the trade and general press. Consolidation appears to be coming to the discounters in the late 1990s, as it did to the anchors during the past eight years.
Urban retailing is coming back. A half-dozen or more downtowns are seeing a wave of store openings: Barnes & Noble or Borders superstores, Disney and Warner Bros. shops, Crate & Barrel, The Body Shop, Liz Claiborne, and even IKEA are opening facilities along the nation's main shopping streets, taking advantage of revivals in the center city.
Power centers are flexing their muscles around Philadelphia, especially in suburban King of Prussia. Upscale retailing in the form of Neiman Marcus and Nordstrom is also on the rise there. Suburban centers around Washington, D.C., are sparking interest; a 105,000-square foot community center in Fairfax County, Virginia, sold for an aggressive $212 per square foot in August 1995, and suburban Maryland is a potential site for a new development on the scale of the Mall of America. Some caution should be observed, however. The growth rate of the nation's capital district will be slowing in the late 1990s, with median household income doing no better than the national average over that period. This is not the time for aggressive projections.
Volatility is no stranger to the Phoenix retail market, either. California investors, including the public pension funds, seem to be following the population movement into the Valley of the Sun. West Coast entities were busy buying shopping centers in Mesa and Scottsdale in 1995. Retail starts are surging once again in the communities in and around Phoenix, as demographic trends have accelerated. This market can be rapidly oversaturated with stores, as it has been many times in the past. Let buyers heed the lessons of history.
On the West Coast, also, there may be bruising competition in the last years of this decade. Megamalls must be reckoned with in both the San Francisco Bay area and Seattle. Power centers and big boxes abound, and malls will be hard-pressed to justify the pricing levels seen in the last several years, typified by cap rates in the 7.5-to-8.5 percent range.
Retail property, in summary, finds itself in an unaccustomed position near the bottom of investor preference in 1996. This is not cause for panic; it is part of the expected order of cyclical change. More deserving of concern is the fundamental capability of the merchants themselves to provide the quality of goods and services that will return shoppers to the malls. Another worrisome trend is the proliferation of retailing segments cannibalizing the consumer's limited pocketbook. As was the case with department store consolidation, these issues will sort themselves out over time, a textbook example of economist Joseph Schumpeter's dynamic of creative destruction.
Multifamily Markets Hit Their Peak
What do you call it when building permits for multifamily units rise nearly 22 percent in a year when absorption for unsubsidized rental units slows by 21 percent? When the vacancy rate for apartments edges upward from 5.5 percent to 5.9 percent, but the loan-to-value ratio for mortgages on apartment complexes shifts from 66 percent to 71 percent? When pension funds again raise their stake in the multifamily sectors by buying class A properties at cap rates of 9 percent or less, driving REITs toward older and smaller properties, second-tier markets, or new development in search of yields?
These are clear signs of the peaking of this property type.
Though 1995 housing construction figures will show only modest aggregate change, the statistical totals will mask the sharp acceleration of multifamily activity during the year. Construction of apartment complexes comprising five or more units is estimated at 272,300 units for 1995, up 21.6 percent from 1994. The Commerce Department's Value of New Construction Put in Place indicates an increase of 24 percent in the inflation-adjusted dollar amount of multifamily development activity. Some will argue, defensively, that such figures-and any building volumes reasonably forecast for the remainder of the 1990s-are a mere fraction, 50 percent or less, of the 1980s cycle. True enough, but irrelevant; the disastrous, tax-motivated boom of the last decade is no appropriate benchmark of market needs. The present volume is too high for most markets around the country and, if sustained, will limit investment returns in this sector until 2000.
Last year was a good time for investors to begin considering the timeliness of realizing capital gains through sale or refinancing. That is still good strategy for 1996. Upward pressure on values will be easing in the coming two to three years as more product is delivered to market and as vacancies start to push upward. Residential assets enter 1996 in good shape in most parts of the country, but in most markets fundamentals will be softening during the later years of the decade.
The Apartment Consolidated Indicators Scale combines, on a scale of zero to 100, the performance of multifamily markets as measured by occupancy, rents, affordability, renter demand, and new construction.
The top markets in the nation are disproportionately found in the West. Las Vegas, the nation's top apartment market a year ago, slipped to tenth place this year, though its quality rating is still good. Vacancy has edged upward and may rise further as multifamily permit activity for the first half of 1995 was a vigorous 3,944 units. As Las Vegas absorbs yet another huge expansion to its hotel room inventory, it remains to be seen whether the frenetic growth pace of the early 1990s can be sustained. Frankly, given the lack of local economic diversification, it is hard to see how this can be accomplished. A more conservative outlook on this market's prospects is now justified.
Houston still has a steep climb back to accomplish. A substantial employment gain of 50,000 jobs in 1995 didn't produce anything in the way of improved apartment occupancy or higher rents for this market, which still has a vacancy rate of 8 percent. Based on a forecasted growth in renter households through 2000 and a slower pace of apartment construction, Houston's prospects will improve later this decade.
Apartment conditions still appear solid in Midwest markets like Chicago, Minneapolis/St. Paul, Detroit, and Indianapolis. Construction activity is constrained compared with the Sunbelt and the Pacific Northwest. Rents are rising in many of the Midwest markets, though they remain low from an investment perspective in St. Louis and Kansas City. The likelihood of a deceleration of the Midwest economy, which has enjoyed an excellent rebound from the recent recession, accounts for the middle-of-the-pack rankings typical of this region.
Investors who moved into the multifamily sector five years ago should be extremely pleased with their foresight. There is now a window of market stability to reap the gains. One of the characteristics of a peak, though, is the downslope that ensues. Don't wait too long before executing those exit strategies.
What to Watch For
The expected performance of most real estate markets in the year ahead gives reason for optimism. Supply-and-demand forces are still moving in favor of improved commercial property returns. Abundance of capital is supporting a pervasive price recovery. Still, the enthusiasm is not unalloyed. The maintenance of market discipline as more development deals come up for financing remains a source of concern. Having learned hard lessons in the down cycle, now is the time to put them into practice.