real estate supply

Point of View How Long Can Real Estate Investments Defy Weak Supply/Demand Conditions? by Hessam Nadji* Overview Commercial real estate is in the midst of one of the most unique cycles on record, characterized by weakening supply and demand fundamentals and a relentlessly strong investment market. More debate is emerging regarding a pricing bubble, similar to if not quite as intense as the arguments that have been raging for the past year about a potential housing market bubble. The determinants of the outcome in both cases will be driven by many of the same issues—war resolution, further terrorist attacks against the United States, the post-war pace of business investment, consumers’ willingness and ability to keep spending. The most frequently published answer to the question regarding the existence of bubbles seems to be ‘‘it depends.’’ At a time when even the Federal Reserve does not have enough visibility to take a position on the short-term prospects of the U.S. economy, this should be of little surprise. In fact, enough uncertainty remains for things to go either way from an economic standpoint. From a GDP perspective, the risk of a double-dip recession has decreased significantly. However, from an employment point of view, the economy is not in a recovery mode yet. Even a favorable and quick conclusion to the war may not be enough to undo the negative momentum that built up over the past six months, particularly because of the drain caused by high energy prices, weak retail sales and slowing income growth. Double-dip or not, growth output has Journal of Real Estate Portfolio Management 89 *Marcus and Millichap Real Estate Investment Brokerage Company, Encino, CA 91436 or Hnadji@marcusmillichap.com. Hessam Nadji slowed, which means the labor market is not only on hold, it is more vulnerable to further cutbacks. This in turn pushes the recovery in user demand for most real estate sectors further out, well into 2004. Under the flow of negative data, constant war coverage and the short-range volatility of equity markets, there are positive forces building. Capital expenditures on IT equipment have been improving, further supporting the strong productivity growth of the past several years. Corporate profits may not be skyrocketing out of their worst slump in years, but they are clearly on the mend. Even without the pricing power needed to boost profits, improving bottom lines set the stage for the next round of investment and hiring. On the issue of war, although the U.S. met with more resistance than anticipated, some of the worst-case scenario elements have been removed. The majority of the oil wells are under coalition control and overall damage to the Iraqi oil assets has been minimal. The course and ramifications of any war are unpredictable, but assuming stability can be established in the region without any major surprises, a relief rally in business investment and equity markets can be expected. Coupled with lower energy prices and higher consumer confidence, a more decisive recovery should materialize in the second half. This momentum will be much needed in light of the nonwar related challenges the economy faces. The commercial real estate sector has experienced a not-so-mild cyclical downturn in demand. As usual, the construction pipeline was unstoppable by the time the market realized the scope of dwindling demand, leading to sharp increases in vacancies across the board. The hospitality, office and R&D sectors have been hit the hardest, followed by apartments and standard industrial properties. Even retail assets, the best performer during the recession due to strong consumer spending, has softened somewhat. At a time of rising vacancies and falling effective rents, investor demand for commercial real estate has been at record levels, sending prices higher and cap rates to historical lows. In the popular investment categories such as apartments and grocery-anchored retail centers, the shift of capital from the stock market to real 90 Vol. 9, No. 1, 2003 estate has produced a sellers’ market. Sellers, however, are faced with the dilemma of where to reinvest the proceeds, in turn fueling record demand for safer properties such as single-tenant net-lease investments, class B and C apartments, smaller, more stable office properties and value-added investment opportunities. The combination of increased capital flows to the real estate sector and a limited supply of for-sale properties has also supported price increases in these sectors. Real estate’s attractive yield, albeit well below its recent double-digit peak, combined with low interest rates and a lack of investment alternatives, is driving the market. However, real estate investors are becoming more selective in some markets and showing more caution in underwriting as rental market fundamentals have weakened and the economic picture remains cloudy. While real estate supply and demand fundamentals are poised to improve as the economy picks up, much is dependent on the timing of the economic recovery. Once the economy gains momentum and corporate spending and hiring resumes, tenant demand will follow, but the lag time must be planned for by owners and investors. The general expectation among most investors is that a steady improvement in occupancies and rents will follow the economic recovery within six to twelve months, depending on the property type. Adding today’s low interest rates into the equation, particularly with fixed rates, improving cash flows and income yields are still attractive to long-term investors. Depending on the assumption used for the exit cap rate in five or seven years, the appreciation component is more controversial for some investors who are concerned that an adjustment back to the historical norm for cap rates will limit profits upon exit. Cap rates are likely to move up as the economy gains momentum, normalizing the stock market, shifting capital out of treasuries and other safe havens and moving up interest rates. However, this transition is expected to be orderly and gradual since inflation is under control and the U.S. will still experience below-trend economic growth for some time. Relatively healthy GDP growth of 2.5% to 3% is currently expected for 2003. This is in line How Long Can Real Estate Investments Defy Weak Supply/Demand Conditions? with the long-term growth rate for the U.S. economy, but well below the historical average of 4.7% in the first four quarters and 5% in the subsequent four quarters coming out of a recession. Strong buyer demand, even after settling from current peaks, should remain as the supply/demand picture improves for most property sectors and new supply becomes even more disciplined coming off of another downturn. While select property types in select markets are likely to experience a price adjustment, a broad-based pricing crash is highly unlikely with these assumptions. While these general dynamics appear to be well balanced, more caution is justified in underwriting today’s transactions, primarily since the economic picture is not yet as clear as desired. Local market drivers of realistic job growth expectations, the short-term risk of additional layoffs and over-building potential should be carefully examined on a case-by-case basis, especially in harder-hit markets. Various property sectors will follow different paths to recovery. The retail sector will continue to lead as the consumer sector, although no longer expected to be a growth driver, will likely hold its own. Apartments will benefit from at least a leveling off in the recent rise in homeownership in the short term, and regain more respectable levels of demand as interest rates move up and jobs return. Industrial warehouse and distribution facilities will also be among the leading property types in a recovery as business activity picks up. Hospitality, office and R&D properties will be the last to recover, putting their prospects for the start of a correction cycle in mid to late 2004 in most markets. slightly in 2003. Warehouse and distribution space in particular will show recovery faster as the business sector improves. There is also the consideration of excess corporate owned space and shadow lease space, where companies own or lease space that they are not utilizing or not trying to market for sale or sublease at this time. As the business environment improves and new space demand is created, companies will first utilize this excess space before going into the market to take on new space. While investments perceived to having lower risk (i.e., class A properties with stable rent rolls in stable markets) are still generating heavy interest, especially among foreign buyers, projects with ‘‘hair’’—credit, rollover or vacancy issues—are finding less demand. It will probably take until 2005 before we see a significant recovery in the office space market and it likely won’t return to equilibrium until the latter part of the decade. If the economic recovery is prolonged, we will start to see more distressed sales as rising vacancies, concessions and increasing expenses put a squeeze on some office owners. Investors Covet Apartments Demand for apartment properties by private and institutional investors continues to outpace available inventory, pushing up prices and lowering cap rates. The divergence between the rental market, which has experienced decreasing net cash flows due to concessions and even rent reductions in some markets, and the investment market has raised concerns about a possible ‘‘pricing bubble.’’ In general, most investors do not believe there is a pricing bubble in the market. The inclination would be to expect the investment market to cool off in 2003; however, the drivers that produced such a strong investment market in 2002 are basically unchanged for 2003, pointing to continued strong transaction volume. However, there are harder hit markets that represent a greater risk of possible price adjustment. Many investors are tolerating lower returns because of the availability of low interest rate financing. Variable rate borrowers believe as interest rates go up, an improving economy will Journal of Real Estate Portfolio Management 91 Office Turmoil Presents Opportunities The economic recession and weak recovery has put a major dent in the office sector. The national vacancy rate is hovering around 17%, while effective rents have diminished by 20% to 30% over the past twenty-four months due to increasingly generous concessions. The lack of job creation in the current recovery does not bode well for near-term office fundamentals. On the leasing side, because the business recovery has been sluggish, demand for office space remains weak, although it will improve Hessam Nadji generate jobs and strengthen rental market fundamentals, thus offsetting the increase in debt service. Fixed-rate borrowers are accepting low short-term returns, anticipating strong income growth and higher returns over a five- to ten-year period. In stable or strong markets, the investor expectation is that an improving economy will lead to higher occupancies and rents in the next two to three years, allowing fundamentals to ‘‘catch up’’ with values. Tenant demand for apartments has already bottomed out; although absorption will remain subdued in 2003 as low interest rates continue to lure renters into entry-level homes. The apartment sector will still feel the effects of low interest rates and increasing homeownership, which have converted an estimated 500,000 renter households into homeowners since 1997. Absorption should pick up starting in the second half of the year and begin to normalize by 2004. Construction starts will contract for the next two years, setting the stage for a recovery in vacancy, which was 6.5% at year-end 2002, up from a recent low of 4% in 2000. 2003 should be another strong year for apartment investments; however, prices will rise at a slower pace than the double-digit gains observed in most markets in 2002. Class B and C properties will continue to outperform due to their more stable renter base. rents grew 1.4% in 2002, down slightly from the 1.5% growth recorded in 2001. Vacancy rates drifted upward last year, but remain relatively healthy and are historically low for this point in the cycle. Overall vacancy finished 2002 at 10.5%, up from 9.9% in 2001. A second-half stepup in the economic recovery will generate stronger tenant demand, pushing down vacancy rates by 30 basis points by year-end. The effects of the economic malaise have produced uneven effects on the various retail formats; some have proven more resilient, while others have languished. The hot-ticket items include well-located, strong grocery-anchored centers with solid national and regional tenants and single-tenant netlease properties with high-quality credit tenants. Because of this disparity in performance between retail formats, a large number of investors are focused on a small selection of properties, which has pushed up prices and compressed cap rates. A lack of available product also has contributed to the pricing/cap rate pressure; similar to apartments, many property owners have taken a wait-and-see attitude, preferring to hold investments until the economy perks up and fundamentals improve. The high-quality properties, with good locations and credit-worthy tenants, are generating unprecedented amounts of investor enthusiasm and offers. Such properties can attract ten to twenty bidders and usually sell at a premium. With interest rates so low, if a property has low-risk, long-term leases in place, investors will pay a higher price because they are locking-in the yield they are seeking. Conversely, for properties where the income stream is not as certain, there is not the same investor confidence and pricing premium. Investors are also seeking second-tier properties that offer value-added opportunities through turnaround or repositioning strategies. The valueadded arena is dominated by private investors, who have been able to outbid institutions on many of these investments through their ability to utilize higher leverage. Consumer Spending Buoys Retail Sector Consumer spending fueled by low interest rates and mortgage refinancing served to cushion the retail sector during the recession, while other property types struggled. And despite the recent lackluster economic growth, the retail sector remains healthy. Retail construction has been the most disciplined of the major property types, with most new development driven by tenant demand. Retail starts and completions will further decline in 2003; a 30% drop is expected. However, neighborhood and community center completions will jump approximately 50% after falling 30% in 2002. Retail 92 Vol. 9, No. 1, 2003