Waiting for a Winning Hand

Retail and multifamily hold all the aces, while other property types wait for economic recovery.

By Hugh F. Kelly, CRE

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.

Yet 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' equity.

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. metropolitan market.

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 marketplace risks.

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.

Economic 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.

Yet 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.

Although the 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.

Recent 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 2006.

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.

But 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 takes hold.

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 should increase.

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.

Developers 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.

However, 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.

Defense 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 Washington, D.C.

For 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.

Barrier-to-entry 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.

There 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 threshold.

Only 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.

International travel 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 markets.

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.

Geographically, 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.

The 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.

Hugh F. Kelly, CRE, is principal of Hugh Kelly Real Estate Economics in Brooklyn, N.Y. Contact him at 718.871.2325 or hughkelly@hotmail.com.

Las Vegas retail and hospitatily markets have hit the hackpot due to increased population growth and tourism.
Credit: Las Vegas Convention and Visitors Authority

Office demand should pick up quickly in Atlanta as job growth resumes.
Credit: Chris Voith

Domestic travel should be strong this
year, making mountain and coastal
resorts popular vacation destinations.
Credit: Marriott Vacation Club
International

2004 Legislative Update

While many public-policy issues on the federal, state, and local levels will impact the commercial real estate industry this year, a handful of them deserve particular attention.

Anti-Money-Laundering Rules. Enacted in 2001, the U.S.A. Patriot Act requires all financial institutions to establish anti-money-laundering programs. The term financial institutions includes �persons involved in real estate closings and settlements.� In early 2003, the U.S. Department of Treasury's Financial Crimes Enforcement Network, or FinCEN, sought public commentary on how this term should be defined and who deserves to be exempt.

The CCIM Institute's reply stated that, �While financial analysis is essential to the commercial real estate broker's skill set, it is better defined as a specialized activity related to the link between buyers and the best property for their investment, not finding or arranging financing.� This is the core argument against including commercial real estate brokers in the definition. Additional arguments consider factors such as the high cost of compliance and administrative burdens.

While FinCEN may find those arguments compelling, the idea of real estate transactions as money-laundering opportunities has taken hold; therefore, the commercial real estate industry can expect to see this issue continue to resurface until the Patriot Act's enforcing agencies better understand the nature of real estate brokerage.

Tort Reform. The most important factor driving up commercial property costs and liability insurance premiums is the astronomical level of punitive damages awarded in class action and individual lawsuits. Today, U.S. tort costs reach $205 billion annually, stifling economic growth and complicating many American businesses' financial health.

While Congress debated tort reform bills last year, the states took action on tort reform measures regarding asbestos litigation, limits on noneconomic damages, punitive damages, and medical and civil liabilities. According to the American Tort Reform Association, last year was the busiest for state civil justice reform legislation enactment since 1995. Watch for states to continue this trend and for the insurance industry and business community to continue lobbying Congress for national reforms.

Mold. In 2003, 56 mold bills were introduced in 21 states. Only 10 of those were signed into law. A majority of the legislation proposed setting standards or licensing programs for mold inspectors and remediators, while other bills focused on public education programs about mold.

For example, Texas passed a bill prescribing mold remediator license requirements. In addition to overseeing the remediator licensing, the Texas Department of Health must conduct inspections, investigate complaints, and provide statewide mold and indoor air quality education. The bill prohibits underwriting decisions based on previous mold damage claims for residential property insurers but stops short of including commercial property insurers.

While Congress has its own mold bill, the Toxic Mold Safety and Protection Act, the issue has been met with reluctance on the federal level, in part due to a lack of definitive answers from the scientific community regarding mold exposure's effects on humans. The National Academy of Sciences report, �Damp Indoor Spaces and Health,� will provide a summary of current literature and findings, suggest further study where needed, and recommend guidelines for public health intervention. The report will be instrumental in developing federal mold legislation.

� by Cheré LaRose-Senne, CCIM Institute's legislative liaison in Chicago. Contact her at 312.329.6033 or clarose@cciminstitute.com.