STILL PRIMED

Despite Credit Market Shifts, Investors Will Continue to Acquire Western Commercial Real Estate Assets

Assef

By Kevin Assef, Marcus & Millichap
Published online 02/08/08

     The diverse markets comprising the Western commercial real estate region have been impacted in varying degrees by the credit crunch and subsequent devaluation of the U.S. dollar that manifested itself in the last half of 2007. Despite fallout from the subprime mortgage crisis, prices for well-located Class A product have remained relatively stable and will continue to increase steadily in 2008, particularly in cities such as San Francisco, Los Angeles and Seattle. Investors will monitor smaller, secondary markets and the performance of Class B/C assets closely this year as pricing shifts become more apparent.

APARTMENT INVESTMENT TRENDS

Denver
Renter demand for Denver apartment properties will remain strong in 2008, supported by an expanding pool of renters and the metro’s fifth consecutive year of healthy employment growth. While job gains will be more modest in 2008 than in recent years, population growth will generate additional renter demand, with an annual average of 29,000 new residents forecast to enter the metro in the next 5 years. On the supply side, apartment builders will accelerate construction activity this year, particularly in the Aurora-South submarket, where deliveries will result in a 5 percent inventory gain by year’s end. Higher levels of condo construction, some of which could ultimately enter the market as shadow-rental stock or high-end rentals, may provide some competition for apartment owners, especially in the Denver-North area.

Los Angeles
Apartment properties in Los Angeles are expected to record strong performance in 2008 due to tight operating conditions and low housing affordability. Layoffs in housing-related industries have slowed employment expansion in recent quarters, but job growth is forecast to accelerate slightly this year, supporting renter demand for apartments. In addition, the income required to purchase the median-priced home is nearly $100,000 higher than the metro’s median household income, and with credit for marginal buyers essentially nonexistent, the transition from renting to owning has become more difficult. With homeownership out of reach for the foreseeable future, some renters will look to upgrade into high-end apartments, particularly in the west side cities, which are expected to record the metro’s strongest absorption and lowest vacancy rate by year-end 2008.

Phoenix
Strong population growth and uncertainty in the local housing market will sustain renter demand in 2008, positioning the Phoenix apartment market to record relatively healthy performance. The metro’s strong long-term demand drivers, including the projected addition of 40,000 new households annually in the next 5 years, supports a positive forecast for apartment fundamentals in the years to come. However, some pockets of the market, such as the rapidly expanding Chandler/Gilbert submarket, have an excess of newly built single- and multifamily homes that may compete with top-tier apartments until the housing market begins to rebound. The shadow-rental market will cause metrowide vacancy to push higher in the near term, and concessions will likely return closer to historical norms. The renter pool is expected to continue to expand, however, as tighter residential mortgage requirements and the resetting of adjustable-rate mortgages create a climate where current renters are hesitant to leap into the for-sale market.

San Francisco
San Francisco’s healthy economy is driving apartment demand, as both employment and population growth are forecast to record increases in 2008 that are considerably higher than the metro’s long-term averages. The market’s very high desirability among renters and active hiring in its largest employment sector — professional and business services — will continue to support apartment demand. Housing affordability remains among the lowest in the country, forcing many of San Francisco’s new residents into the renter pool. Development costs are elevated to the extent that few apartment properties are brought online, as builders instead choose to construct for-sale condo units and office space. Given the metro’s healthy demand drivers and lack of significant new apartment construction, metrowide vacancy will tighten in 2008, with the Haight-Ashbury and Outer Richmond/Sunset submarkets recording the strongest improvements. In turn, occupancy gains this year will provide apartment owners leverage to aggressively raise rents.

Seattle
Economic growth in the Puget Sound area will be among the strongest in the nation this year, creating renter demand for apartments and driving hearty rent growth. Local employers, particularly technology companies such as Microsoft, Yahoo and Google, are aggressively leasing large blocks of office space in the eastern parts of the metro and expanding payrolls at a healthy pace. In the next 5 years, growth will be concentrated in the 20- to 34-year-old age cohort, which should expand by 86,000 residents, a rate that is nearly twice as fast as the metro’s total population growth. This age group is increasingly drawn to the benefits of downtown living and should provide sufficient demand for apartment properties in the market’s core growth areas, including the Downtown/Capitol Hill and North Seattle submarkets. Several high-end condo developments are under way downtown, although these units are unlikely to compete with apartments due to the wide gap between renting and owning in the submarket.

OFFICE INVESTMENT TRENDS

Denver
Developers in 2008 will deliver double the metro's 5-year average, after several years of relatively limited supply growth. Although office-using employment growth is expected to slow to its lowest rate since 2003, years of built-up tenant demand for new space will result in healthy absorption of new supply. In recent years, robust rent growth in the Mile High City’s Class A properties has created spillover demand into the lower tiers. As additional competing space comes online, absorption in Class B/C assets is expected to slow. Overall, vacancy will increase modestly to the mid-15 percent range. New construction will have the greatest impact in the Midtown and CBD submarkets, which are projected to receive nearly half of the metro's completions this year. Due to stiffer competition, the steady decline in vacancy the CBD submarket has recorded in the last 4 years will be reversed in 2008. Absorption is expected to remain strong along the rapidly growing Interstate 25 corridor; most notably the Southeast submarket is forecast to post a 350 basis-point improvement by year’s end, building on last year's 120 basis-point decline.

Los Angeles
Modest economic expansion in 2008 will continue to support tenant demand for office space in Los Angeles County. Employers are expected to add jobs at a fairly steady pace, and the metro will record another year of positive absorption, albeit more modest than in 2007. Construction activity will pick up in 2008 after a lull last year; however, deliveries will be concentrated in the San Fernando Valley. The area, which features one of the tightest vacancy rates in Los Angeles County, will receive more than 1 million square feet of new space this year. Elevated deliveries will push metrowide vacancy slightly higher in 2008 after 5 consecutive years of occupancy improvements, although supply-constrained areas such as the west side cities and Long Beach/South Bay will receive minimal new construction, and conditions in these submarkets should remain tight.

Phoenix
Modest economic growth will continue to generate tenant demand for Phoenix office space in 2008. As a result, metrowide vacancy is expected to hold relatively steady, with only a modest uptick projected. In an effort to increase market share and serve a rapidly expanding population, service companies will continue to expand into Phoenix’s lower-cost environment. Wells Fargo, for example, recently opened its West Valley hub in Glendale; the new facility will house administrators for all West Valley branches and transplant jobs to the area. Furthermore, Wachovia announced plans to locate its Arizona headquarters to downtown Phoenix in 2009. While employers are expected to remain active this year, overall job creation will fall short of last year’s growth. On the supply side, construction will taper off in 2008, offsetting slower demand. New supply will largely be concentrated in outlying areas, such as the Mesa/Chandler submarket, where the addition of nearly 800,000 square feet of space will push vacancy up to the high-14 percent range.

San Francisco
The San Francisco office market is enjoying a strong resurgence that is expected to continue through 2008. Tenant demand for office space is being driven by the expanding information sector, which is forecast to add another 800 jobs this year. Growth of local tech firms is also generating increased construction activity. For example, Alexandria Real Estate Equities has announced plans to deliver approximately 2.2 million square feet to Mission Bay in the next few years, properties that will be marketed to traditional technology and biotech companies. This year, more than half of the metro’s scheduled new supply will come online in the South Financial District. Despite the impact of new deliveries, pre-leasing activity has been strong and vacancy in this submarket is expected to remain near the metro average, allowing owners to implement healthy rents gains this year. In addition, properties in the lower tiers may outperform, as rents have increased significantly throughout the metro in recent years, and many firms may choose to transition to less expensive space when leases expire.

Seattle
Conditions in the Seattle office market will remain tight this year, though new construction will outpace demand growth modestly, leading to an uptick in vacancy. Buoyed by the technology sector, office-using employment gains will measure well above the national rate again in 2008. Companies are choosing to expand their operations in the Seattle metropolitan area, where the talent pool rivals Northern California’s tech strongholds. As such, leasing activity among these companies has accelerated, as evidenced by Yahoo’s recent commitment to 115,000 square feet in Bellevue. The new lease marks the removal of one of the last large, contiguous blocks of space available in the market. Developers, however, are responding to new demand by ramping up construction. Vulcan Real Estate, for example, is building a 1.5 million-square-foot office campus widely rumored to be the future headquarters for Amazon.com. Additional speculative building is also taking place — nearly 1.1 million square feet of office space is planned in Kirkland, and an additional 500,000 square feet is slated for delivery in Issaquah next year. New supply will ease some of the pent-up demand in the market toward the end of the decade.

RETAIL INVESTMENT TRENDS

Denver
Developers are responding to modest economic expansion in Denver this year by slowing the pace of retail construction, which should support steady operating performance. The cooling housing market will cause retail sales growth to moderate this year, but an expanding population and healthy employment growth bolster the market’s extended economic outlook. Job growth is expected to be widespread again in 2008, with the leisure and hospitality sector, which typically serves as a peripheral gauge of overall retail health, forecast to post significant gains. As a result of stable demand and reduced construction activity, vacancy is forecast to tighten by year’s end. On the supply side, developers are concentrating on high-density mixed-use projects, particularly in urban infill locations. Builders and tenants will likely target locations near Denver’s FasTracks light-rail stops, such as the 335,000-square-foot mixed-use development that recently broke ground at 16th and Delgany streets. Extensions of the light-rail system along major freight corridors and routes that link suburbs to downtown may also offer redevelopment opportunities.

Los Angeles
Retail properties throughout Los Angeles County will record healthy performance in 2008, despite moderating economic expansion. Land constraints and elevated development costs will keep retail construction below the market’s historical average, and projects scheduled to come online this year have significant pre-leasing commitments already in place. For example, two major developments opening this spring — the 475,000-square-foot Americana at Brand in Glendale and the 400,000-square-foot Streets of Brentwood — were almost completely pre-leased by the end of 2007. Strong tenant demand for available space is driving healthy rent growth, although gains are expected to slow somewhat this year due to more modest consumer spending. With a lack of land available for development, builders will look to expand existing locations, including the planned 550,000-square-foot Village at Warner Center in the San Fernando Valley, which will connect to the Westfield Topanga and Promenade Center to create one of the largest retail complexes on the West Coast.

Phoenix
Turbulence in the local housing market is expected to curtail local economic growth in 2008, but the Valley of the Sun’s outstanding long-term demand drivers still support a positive extended outlook. Developers have already begun to respond to the changing climate, as metrowide construction is projected to slow from last year’s pace. Construction in Peoria, Avondale and Buckeye, however, will increase as builders target premium locations in the path of future population growth. The West Valley is expected to record explosive expansion — Avondale’s population will nearly double during the next 10 years, while the number of residents in Buckeye is forecast to more than triple by 2010. In addition, the metro’s infrastructure continues to improve, with the expansion of Interstate 10 serving as a catalyst for future employment growth. In Glendale, the completion of the University of Phoenix Stadium will continue to transform the city into a unique shopping, entertainment and residential location.

San Francisco
Steady hiring among local employers and a lack of new construction will lead to healthy performance in the San Francisco retail market in 2008. The metro’s largest employment sector — professional and business services — will continue to expand, underpinning local economic growth. In addition, demand drivers, such as consistent population growth and strong tourism revenues, will stimulate retail spending moderately higher again this year. Elevated development costs and legislative hurdles are limiting retail construction and pushing vacancy lower throughout the San Francisco market, supporting healthy rent growth. Investors may want to monitor the progress of the San Francisco Planning Department’s Eastside Neighborhoods Plan, which could transform some of the area’s industrial space into high-end housing and boutique retail space. Additionally, the Union Square area is attracting luxury retailers, as evidenced by the late-2007 opening of Barneys, as well as the planned arrival of De Beers and Prada early this year, which should support additional rent growth going forward.

Seattle
Seattle’s strong economy and healthy demand drivers underpin an optimistic outlook for the local retail property market. Retail spending is expected to exceed the national rate this year, as demographic trends in the metro remain mostly favorable. For example, the cost of living in Seattle is only marginally higher than the national average, leaving residents with more disposable income than in comparable markets. New construction, however, will outpace demand growth this year and put upward pressure on vacancy. Lower occupancy levels will be short-lived though, as development in close-in areas remains difficult and costly, prompting builders to have significant lease commitments in place before breaking ground. Big-box retailers are beginning to consider smaller layouts around the metro due to the limited availability of developable sites in urban neighborhoods.

     The shifting regional economy and repricing of commercial investment real estate in many western markets will require savvy brokerage and real estate services companies to return to the basics when it comes to valuating properties. In 2008, properties will be valued based on their current or achievable pro forma income. By all accounts, that will be a positive trend that many embrace in the New Year.

Kevin Assef is senior vice president and managing director of Marcus & Millichap Real Estate Investment Services. He can be reached at (909) 456-3450, or kassef@marcusmillichap.com. Assef wrote this article in conjunction with Adam Christofferson, David Wetta, Jeffrey Mishkin and Gregory Wendelken of Marcus & Millichap.