Market forecast

Property Market Predictions

Amid Economic Uncertainty, Most Property Types Are Expected to Hold Value.

Since fourth-quarter 2000, U.S. economic growth has slowed dramatically, especially in the Deep South and the southern Midwestern states. While the overall economy has not stopped growing, some sectors and regions have experienced declines. On the East and West Coasts and in the South Central states, growth has continued at a moderate pace, yet the rest of the country experienced only slow growth during the first half of the year.

Though the Federal Reserve Board has decreased interest rates dramatically, commercial banks have been monitoring borrowers very closely and have tightened their underwriting standards, which will slow the impact of an expansionary monetary policy. Likewise, many companies have postponed expansion plans, which has reduced the number of loan applications.

While the economy's advance or retreat for the rest of the year bears monitoring, by the time the government calculates statistics for all of 2001, an annual growth rate in gross domestic product of 1.75 percent to 2 percent likely will be reported.

Mirroring the economy as a whole, commercial real estate maintains slow growth, yet some property segments are experiencing more rapid declines than others.

Retail Market Rundown Despite the gloomy eulogies being prepared for brick-and-mortar retail outlets, Internet sales have not spelled the end of the shopping center. E-commerce sales totaled $68.7 billion during fourth-quarter 2000; and although this represents a 67 percent increase over fourth-quarter 1999, it still is just 1 percent of all retail sales nationwide.

The Gartner Group, a technology consulting firm, recently lowered its forecast of Internet sales activity by more than $1.3 trillion, now predicting annual worldwide sales volume of about $6 trillion by 2004. Audio and video sales are expected to be the most active e-commerce commodities, because customers can sample those products via downloads before purchasing.

WEFA, formerly Wharton Econometric Forecasting Associates, predicts that retail sales in general will slump by 16 percent globally over the next four years. The decline isn't apparent yet, though. Nationwide, same-store retail sales increased 2.1 percent in January, compared to 12 months prior. In regional performance, the Southwest scored the biggest increase, 3.1 percent, while the Northeast exhibited a 1.1 percent gain.

Tourism centers should continue to produce the strongest retail sales through year-end. San Francisco, Miami, and New York are expected to see increased values for certain well-located retail properties. For instance, while others were beginning to batten down the hatches, approximately 11,000 people were waiting to enter Miami's new Dolphin Mall on its opening day in March. More than 30 new centers across the nation were under construction at year-end 2000, more than twice the number built between 1992 and 1995, according to PricewaterhouseCoopers. This alone indicates that there are bound to be some losers among the projects in the pipeline.

However, the wake-up call already has begun. The National Real Estate Index shows that the average price per square foot for class A retail space fell 0.4 percent between third- and fourth-quarter 2000.

Retail property types expected to have the most difficulty include unanchored retail centers, power centers, and big-box retailers. The latter has been overbuilt and a significant portion of the inventory is ripe for e-commerce strategies.

Secondary regional malls also are expected to experience lackluster performances this year. It is likely that many class B and C regional malls will be put on the market in the coming months, as competition from recently opened and renovated malls draws tenants and customers.

Moreover, movie theater chain bankruptcies — including General Cinema Theatres, United Artists Theatre Co., and Edwards Theaters Circuit — and the resulting theater closures also are hurting shopping centers lacking other major draws.

The theater industry's problems also have killed some planned retail-entertainment projects, such as the Sundance Film Center in Portland, Ore.'s Pioneer Place, and cast doubt on others. A recent report by UBSPaineWebber indicates that nearly 10,000 of the 37,000 movie screens across the country will need to close to return theater chains to profitability.

Though several theater chains and some major retailers — including Circuit City and Good Guys — are cutting back to protect themselves from the slowing economy, the contractions are minimal compared to the massive layoffs occurring in the telecommunications and manufacturing fields. The retail sector, in general, is not expected to suffer excessively. In fact, the national retail vacancy rate is expected to hover between 9 percent and 10 percent through year-end.

Hospitality Market Forecast The hospitality sector seems to be fighting itself. Lenders have redlined development in certain areas (especially for large, convention-type hotels) despite record-breaking profits. As one PricewaterhouseCoopers analyst puts it, “Everyone is afraid of hotels, but you can't get a room.”

While occupancies may suffer from a slowdown in corporate travel in 2001-2002, tourists should help make up the difference in popular cities. Overall, the lodging industry is expected to be affected by the softening economy, however. The next 18 months to 36 months particularly may be difficult for hoteliers, according to Curtis Davies, first vice president/regional director with CB Richard Ellis' hotel/leisure group. This should present some excellent buying opportunities, as nervous owners try to escape before the bottom falls out.

Properties in gateway cities such as San Francisco, Los Angeles, Miami, and New York, and other key destinations including San Diego and Boston, should weather the coming storm. However, in Miami, luxury and full-service hotels along Brickell Avenue could be headed for trouble given the level of recent development there. Even those in hot markets are preparing for a deceleration, though. One boutique hotel owner with several properties in New York says, “If I get through 2001 with no more than a 10 percent to 15 percent drop-off in sales, I will be happy.”

The worst-performing segment in this sector is limited-service projects. The NREI rates their investment potential the lowest in the six property sectors analyzed (central business district office, suburban office, industrial, retail, multifamily, and hospitality).

Office Market Overview Strong office market performance has mirrored more-than-healthy economic expansion during the last several years. Such rapid growth and dramatic price increases simply could not be sustained into 2001, particularly in the face of an economic slowdown. Now past its peak, the office market is responding to forecasts of a continued economic downswing with a corresponding decrease in activity, which is especially dramatic for cities that had a strong dot-com presence.

Amid an indisputable downturn, substantial erosion of lease rates and vacancies should be restricted to markets that saw the most unrealistic spikes in lease rates and sales prices, which for the most part, were driven by the venture-capital-funded Internet frenzy. Where speculative new-economy investment caused lease rates to jump by more than 100 percent, a significant readjustment should occur. For instance, San Francisco, Seattle, Denver, and Washington, D.C., all are likely to see rents drop to more sustainable levels. In general, suburban markets are likely to witness a more serious correction than the CBDs because of an increase in construction activity over the past year and the resulting fears of oversupply.

While San Francisco, Silicon Valley, and Seattle are among the areas that have shown the largest recent increases in vacancy rates, they have climbed from very low levels. Other markets, including Kansas City, Mo., Indianapolis, St. Louis, and Columbus, Ohio, where economic performance has been mixed, also have seen vacancy increases.

Despite the highly publicized downturn in the nation's office markets, stable growth is expected to continue. Outside the centers of new-economy activity, traditional office market sectors are experiencing relatively solid economic performance. Falling lease rates should firm up at levels higher than they were prior to the start of the Internet frenzy in the second half of 1999.

Development activity has slowed from last year's pace and is not likely to return to previous levels for some time. Throughout the balance of the year, however, completions sparked by 2000 starts will drive supply upward, particularly in the suburbs. Going forward, construction will be restricted to build-to-suit and pre-leased projects.

As a result, office space absorption should remain positive, albeit at lower levels than the past two years. Overall net absorption will be similar to the square footage of new supply. Vacancy rates, in turn, will rise slightly but are not expected to skyrocket. Midyear 2000's office market conditions were the tightest ever seen and, even if a mild recession develops, the U.S. vacancy rate should end the year around 10 percent. While this may be an increase compared to recent statistics, it remains similar to rates seen in 1999, which were historically low at the time.

Industrial Market Expectations Across the country, with minor exceptions in the Northeast and Mid-Atlantic, manufacturing has slowed, generally in response to increasing inventory levels. As inventory levels are reduced later in the year, several manufacturing sectors once again will begin to expand.

Like office, industrial markets have mirrored the general economy over the last several years. Similarly, rapid growth meant unsustainable expansion rates. As the economic growth has slowed, so have most industrial markets.

Thus, industrial market activity around most of the country should remain stable or grow more slowly than it did in 2000. Only markets where lease rates have soared during the last two years will see any substantive deterioration in rates and vacancies. Such declines will be from unrealistically high levels that resulted from the speculative nature of new-economy investments. Markets like San Jose, Calif., and Seattle, for instance, will see rents drop back to levels that can be sustained over the long term. However, even in these markets, rates should firm up at levels higher than before the effects of new-economy speculation took hold in the second half of 1999. Other markets such as Oakland, Calif., and Denver, which both have a traditionally broader industrial base, will see rates holding firm or even increasing by several percentage points.

The better-than-average economic performance of the Southeastern states has resulted in lower vacancies over the course of this year. This performance should continue in areas such as Atlanta and southern Florida. It is important to note that while San Francisco, Washington, D.C., and Silicon Valley are among the areas that have shown the largest recent increases in industrial vacancy rates, they have climbed from very low levels and still remain very low compared to the national average. Kansas City's industrial market has remained strong despite mixed economic performance. Over the balance of 2001, vacancy rates will increase slightly. Industrial vacancies should finish the year near the long-term national average of 8 percent.

Throughout the country, industrial market construction has slowed from its pace in 1999 and 2000. It is not likely to return to those levels before year-end. Like office, much of the construction activity will be for build-to-suit tenants or will break ground only after significant pre-leasing.

Industrial absorption also will continue to be positive. Though slower than last year, absorption rates should stay very close to the rate of new construction.

Multifamily Market Projections Amid signs of sluggishness — and reports that some dot-com refugees are turning in their apartment keys and moving back home with mom and dad — it is worth remembering that apartments were the first property type to recover from the early 1990s recession.

Renter demand exceeds supply in certain markets, such as San Francisco, Boston, San Diego, and Los Angeles. The Bay Area (including San Francisco, Oakland-East Bay, and San Jose) is one of the tightest multifamily markets in the country, with an overall year-end vacancy rate of 1.9 percent. This region has also enjoyed the sharpest increases in sales prices and rents.

These trends are expected to continue. In fact, the NREI predicts that class A multifamily properties in Oakland, New York, Orange County, Calif., Boston, and San Diego will be among the top markets for return potential relative to other markets during the next two years. These markets also receive a large share of the country's new immigrants, which will provide them with a steady stream of renters.

Some pockets of possible profitability exist in the Midwest, too. In Minneapolis, for instance, government resistance, expensive land, and elevated property taxes create tough barriers for apartment developers. These factors run parallel to high single-family home costs.

Most Sunbelt markets need to let absorption of existing product run its course. According to CB Richard Ellis Investors, the South has accounted for almost 40 percent of the country's new multifamily supply in the past five years, while the Northeast and California have been responsible for 14 percent and 10 percent, respectively. This has affected rental rates, vacancy rates, and investment returns. In the past five years, the strongest National Council of Real Estate Investment Fiduciaries performers have been in the Northeast and Pacific regions.

Jim Carr and Bridget Novak

Jim Carr is president of Xceligent in Independence, Mo. Contact him at (877) 628-5300 or [email protected] Bridgett Novak is managing editor of CB Richard Ellis\' National Real Estate Index. Contact her at (415) 733-5322 or [email protected]

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