Real Estate Investment Outlook

By Brian E. Mericle
The real estate investment brokerage company of Marcus and Millichap, in a new report, identifies three major factors that should support real estate pricing in 2004:

• Strong capital flows. An improving stock market would normally shift capital away from real estate and into common stocks. However, real estate has been a favorite for investors throughout the past economic cycle and should continue to attract both domestic and foreign capital despite lower returns over the short term.
• Orderly transition. Interest rates are likely to rise gradually as the economy improves and while this will result in an increasing cost of capital to real estate firms, it should be accompanied by improving rents and occupancies, so allowing fundamentals to catch up with prices.
• Expansion cycle. The U.S. appears to be entering a new expansion cycle with favorable projections for demographics and gradual job growth. This year, employment should expand by 1 to1.5 percent, below its historical average of 1.6 percent over the last decade.

Apartments: Can the Good Times Last?
The past three years saw falling demand and excess supply in the apartment sector as the stock market crashed and a jobless recovery prompted the Fed to drive interest rates to 40-year lows. As a result, single-family home ownership came within the reach of many former renters while simultaneously lowering the cost of developing new multi-family properties. The result was an increase in vacancy of up to 300 basis points from the cyclical low in 2000.

This year will see some relief for apartment operators but the market recovery will be a muted one. Rental demand will rise due to two factors: (1) falling single-family home affordability; and (2) demand for apartments from the many renters who doubled-up or moved back with parents during the past few years.

New Supply Hinders Recovery
The report notes that too many units remain in the development pipeline. With low cost financing available in most markets and investors ready to buy properties as soon as stabilized occupancy is reached, developers have incentives to keep building. The generally high cost of land and construction materials is forcing builders to construct luxury units despite the strong demand for affordable housing. However, strong markets, such as Southern California, the San Francisco Bay area and New York City, should be able to absorb all new construction without a significant increase in vacancy rates.

Concessions have been averaging one to three months of free rent in most markets, but this should begin to abate. However, many owners of Class A properties will need to continue offering incentives to renters since this sector suffers most from defectors to single-family homes. Concessions for Class B/C properties should disappear more rapidly. Overall, the report sees asking rents rising 1.5 percent this year.

MENU TOP

Demographic Support Gains
Since 2000, the median price per unit for Class A properties has risen 26 percent, while Class B/C have seen a 37 percent gain. Such gains during a period of weak fundamentals has caused concern that prices are too high. However, strong demographic and immigrations trends, including a jump in the population sectors most attracted by apartments and an end to increasing single-family home affordability, means that tenant demand will grow steadily over the next several years. While prices have been driven upwards by the relatively predictable returns offered by apartment investments, strong investor interest since the 2000 bear market in stocks has meant that many investors have been unable to buy properties. As s result, any price weakness is likely to be brief.

Office Building Sector Improves
Improving conditions are emerging in the office sector but investors will need to wait another year before a sizable shift in fundamentals signals the beginning of another up-cycle in the office market. As a result, price appreciation should slow to a more sustainable pace until vacancy rates drop at least 300 basis points or more from current levels.

The current down-cycle in the office market was demand-driven rather that supply-driven. The bursting of the tech bubble exposed the extreme hoarding of office space in a number of cities, especially Seattle, San Francisco, San Jose and Austin. The subsequent corporate scandals and the Iraq war impacted a variety of other sectors, including energy, entertainment and investment banking, resulting in a 900-basis point increase in office vacancies between 2000 and 2003. Owners were forced to reduce rents by an average of 13 percent over the same period, with much larger reductions in the worst markets.

Slow Recovery Seen
Now the worst appears to be over. Development has fallen sharply and with the economy on track to add jobs this year and next, office tenant demand should begin to rebound in the first half of next year.

Three forces, however, will keep absorption from spiking. First, there is little pent-up demand built into the economy so that companies will be reluctant to lease more space than is absolutely necessary. Second, a fairly large amount of underutilized space appears to still exist. Third, the current global labor arbitrage, while still in its infancy, will reduce tenant demand among large firms over time.

As office fundamentals improve, the relatively high cap rates in many markets will attract investors from other sectors, especially apartment and retail, where cap rates are 100-300 basis points lower. However, the double-digit increases of the past few years are not likely to recur over the near term.

MENU TOP

Retail Keeps the Lead
Retail construction, predominantly demand-driven, spared the sector from a sharp rise in vacancy during the recent down-cycle. In 2003, vacancies rose just 20 basis points, to 10.5 percent, which is likely to be erased this year as tenant demand rises in response to improving economic conditions.

Unlike previous recessions, the most recent economic downturn was largely due to a severe cutback in business spending, as opposed to a consumer pullback. While many retail bankruptcies occurred during the past few years, few came as a surprise and the result has been to strengthen those who remain. Retail investor demand is pushing prices to new heights and cap rates to new lows. Prices for shopping centers rose by an estimated 12 percent last year and the average cap rate dipped below nine percent, down 40 basis points from the previous year. Investors are likely to continue exhibiting high levels of confidence in shopping center assets in 2004, particularly those occupied by strong national chains able to post consistent profits during the recent difficult economic period.

Notwithstanding the impact on supermarkets by Wal-Mart’s Neighborhood Market and Supercenter concepts, grocery-anchored centers continue to be the darling of retail investors and are priced accordingly. Since further grocery closures and consolidations are likely, selecting a strong anchor for a neighborhood center will become more critical than ever.

Single-Tenant Cap Rates Low
Single-tenant net-lease retail properties have benefited from several factors over the last few years. These include low interest rates that permit low-cost financing, aging investors interested in low-maintenance properties and high volatility in the stock markets. Cap rates in the single-tenant sector have declined to just over eight percent, compared to 8.6 percent in 2002. Well-located properties with top-tier tenants can command cap rates as low as six percent.

Retail will continue to be the most stable commercial sector in 2004 and investor demand will remain strong. While tight markets with high barriers to entry will be attractive to investors seeking safety, others willing to assume some degree of risk will seek properties in need of repositioning in hard-hit markets.

Capital Markets: Moderate Increase in Rates
Commercial real estate investors may face higher borrowing costs in 2004, but the increase will not significantly alter the financial dynamics of most deals. Below-trend employment growth and a lack of inflationary pressures will give the Fed plenty of latitude to hold rates at or near the lows established in 2003 for much of 2004. With investors desperate for yield in a world of one-percent money market returns, and real estate's stellar performance throughout the recent bear market, financing with commercial loans offer a compelling investment alternative.

Lenders will keep spreads at or below their year-end 2003 levels for much of 2004. In the apartment and retail markets, this means spreads of 120 to 160 basis points over the 10-year Treasury for good-quality deals with loan-to-value ratios of up to 75 percent. Spreads on office deals will average 30 to 40 basis points higher. Seasoned borrowers will be able to book very low-leverage loans (LTVs of less than 50 percent) on top-quality properties with spreads at or below 110 basis points over Treasuries. As real estate market fundamentals improve, lenders are likely to ease underwriting standards, which will reduce costs for borrowers seeking higher leverage.

The Fed will maintain its accommodative stance for at least the first half of 2004, with little likelihood of a sharp rise in short-term rates prior to 2005. This means developers will continue to have access to very low-cost, short-term financing. On projects with longer development cycles, such as office buildings or large apartment complexes, build-and-hold investors may want to consider locking in the permanent financing now through construction/perm programs.

Brian E. Mericle is an investment broker and member of the National Retail Group of Marcus & Millichap. He can be reached at (213) 607-5048 or at bmericle@marcusmillichap.com.

Continue Reading - Editor’s Desk: New York Theatre

MENU TOP

Inquiries about material in the Monitor should be directed to
Alvin L. Arnold at (212) 885-8235.