MARKET HIGHLIGHT, APRIL 2006

PHOENIX IN FLIGHT
Bob Pearlstein, Brad Goff, Karyn McClintock, Mark Seale and Jerry McCormick

Everywhere you look in the metropolitan Phoenix area, it seems demand has a good lead on supply. The market’s strong population and job growth are helping that.

Retail

The metro Phoenix retail market continues to be fueled by the area’s expanding population and job growth. In 2006, there will be as many, or more, new and planned retail projects throughout the Valley as were seen the previous year.

At year-end 2005, there were 923 existing retail centers in the metro Phoenix area, totaling 121.7 million square feet. First quarter 2006’s 5.25 percent vacancy rate marks the 11th consecutive quarter of declining vacancy.

Like the other Valley commercial real estate sectors, increased construction costs and land prices are impacting rents in new retail developments. In the last 2 years, costs have caused shop space rents to rise 20 to 30 percent. Due to increasing costs in 2006, along with city development and impact fees, expect shop space rents to remain flat or rise an additional 5 to 15 percent.

While rising land prices may be causing Phoenix developers a certain level of angst, the Valley is still more desirable than other markets such as Las Vegas and Southern California. Expect to see developers from other parts of the country continue to enter the Valley in search of more development opportunities. Consequently, this increased developer activity will result in additional upward pressure on land prices.

Retail developers, like everyone else in the development community, are having to speculate on land years before the project is ready for development. As new housing developments push the boundaries of metro Phoenix, developers will continue to speculate on land for new opportunities farther beyond the Valley’s edge.

In 2006, expect to see developers shift more of their attention from selling pads (out parcels) to users, preferring to build to suit or ground lease instead.

Anchor tenant retailers are also looking at the peripheral areas and making commitments 3 to 5 years ahead of the first housing starts. New and future retail hotspots include Queen Creek, Johnson Ranch, Surprise, and cities in Pinal County such as Maricopa, Casa Grande, Coolidge and Florence.

In terms of tenant mix, the Phoenix market continues to welcome newcomers and those that reflect the area’s changing population. Metro Phoenix’s growing Hispanic population, for example, is prompting developers to recognize its potential as a development opportunity. Hispanic-themed centers are already beginning to crop up throughout the Valley and more are expected in 2006 and beyond.

Newcomers to the market include not only new tenants, but a new size of anchor tenant. In the Southeast Valley, Cinemark, one of the largest motion picture exhibitors in North America, and Bass Pro Shops are expected to open stores this year. In the West and Southwest Valleys, look for Cabela’s new outdoor sporting goods store and Hobby Lobby Creative Centers.

Traditional grocery anchors exceeding 40,000 square feet are making way for a smaller 20,000- to 30,000-square-foot anchor tenant. These non-traditional anchors include fitness clubs like Gold’s Gym and LA Fitness, specialty grocers such as Henry’s Grocery Stores and Sprouts, and hardware stores, like Ace Hardware.

Drug and traditional grocery stores will continue to expand into newly developing areas on the Valley’s edge. However, their expansion will be more cautious as they keep their eye on the aggressive expansion of discount and specialty stores.

— Bob Pearlstein is a first vice president for CB Richard Ellis in Phoenix.

Multifamily

Low interest rates and a great supply of single-family homes drove vacancies to a 10-year high in 2003. In 2005, however, there was a huge decline in vacancy from 8.03 percent in the first quarter to 6.77 percent in the fourth quarter. The Valley of the Sun saw a market-wide burn-off of the majority of concessions in 2005. With rents beginning to increase significantly, concessions should remain very small, if not totally disappear, in the latter half of 2006.

With total construction of less than 5,000 units and employment growth of more than 83,000 jobs in Phoenix in 2005, there is a significant demand for housing. Currently about 1.5 units are absorbed to every unit being built. In addition, continued condo conversion will place further upward pressure on rental rates. Condos will remain a popular choice as single-family home prices remain high, even after the record-breaking absorption seen in 2005.

In 2005, permits were pulled for more than 63,000 single-family homes, a far greater sum than the 50,295 issued in 2004. Multifamily permits totaled 8,467 (exceeding 2004’s total), but less than 5,000 units were built. Currently, declining cap rates and rising construction costs are discouraging multifamily construction. However, rising interest rates and the median single-family home resale price having reached an all-time high of $268,000 should rejuvenate the apartment construction sector.

Rents increased at an average of $13 in fourth quarter 2005, from $731 to $743, and by 4.15 percent year-over-year. Rent gains in 2003 and 2004 were less than 1 percent. With single-family homes being priced out of many renters’ capabilities, the apartment rental property or condo conversion is the only available choice. Landlords are realizing this and raising rents significantly and in accordance with the single-family price gains.

2005 was a record year for apartment sales, with 217 properties exceeding 100 units changing hands for a total of $4.05 billion in sales. The year witnessed a 21 percent increase in per-unit pricing. On average, cap rates remain in the sub-6 percent range, with Class A properties in desirable locations trading at less than 5 percent. 

The current Phoenix-area vacancy, which reflects the strongest occupancy since 2000, should decrease significantly by third quarter 2006. With little construction and job growth expected to be around 70,000 for 2006, demand should exceed supply for the rest of the year and in 2007. Phoenix had negative absorption in fourth quarter 2005, but this isn’t a sign of slowing, just the condo market being strong as evidenced by the 4,174 apartment units lost to conversion. Expect multifamily rents in 2006 to increase by more than 7 percent on average, with the possibility of 10 percent in some submarkets.

— Brad Goff is principal and Karyn McClintock is transaction manager for Apartment Realty Advisors in Phoenix.

Office

High demand and relatively low supply of new product continues to be the theme of the metro Phoenix office market. The first quarter vacancy rate declined for the 12th consecutive quarter to 12.3 percent, down from 15.2 percent a year ago. Predictions call for the trend to continue throughout the rest of 2006, with the vacancy rate ending the year near 11.5 percent, down from 12.6 percent at year-end 2005. The Valley’s office market will remain a landlord’s market in virtually all submarkets throughout 2006.

Strong tenant demand, coupled with a desire to occupy the best space in the market, resulted in an increase in new construction in 2005, and that trend is expected to continue this year as well. There were 2.9 million square feet of office product under construction across the Valley at year-end 2005, with 857,000 square feet delivered for the year.

This year, office completions will create more than 2.5 million square feet of new product across the Valley. This will be the most new office space delivered to the market since 2002. The completions will occur despite increases in construction costs and overall land prices, which are making it increasingly difficult for development of new office product. Although higher construction costs are leading to rising rental rates, developers’ returns are not increasing in turn.

Tenants anxiously await the arrival of new Class A space. Pent-up demand will cause the number of large blocks of quality, contiguous space to decline even more in 2006, further driving rental rates upward. This will be especially true for Class A office space.

Average asking lease rates at year-end 2005 increased to $20.17 per square foot, up from $19.38 per square foot recorded at the end of 2004. Higher construction and land costs continue to push rents for new product to higher levels. Owners of existing product are raising their rental rates, while further reducing concessions. Rental rates will continue to increase in 2006. This is due, in part, to the imbalance between the supply and demand of available space and a 5 to 10 percent increase in operating expenses impacting building owners.

The downtown Phoenix office market will continue to tighten in 2006. The vacancy rate will dip below 3 percent by mid-year with no new product scheduled for delivery until 2008. Expect to see some $32 per square foot or higher lease transactions by the end of 2006, up from $28 per square foot in most of 2005.

Midtown Phoenix will continue to experience a decline in vacancy and finish 2006 with a vacancy rate below 14 percent. This is down from 23.4 percent in 2004. Rental rates for the best space in the submarket will reach $28 per square foot by year-end.

The Camelback Corridor submarket will end the year with a vacancy rate around 9.6 percent, down from 13.2 percent in 2005. Rates in this submarket will level off with the exception of the high-end Class A buildings, which may reach $40 per square foot.

The vacancy rate of the Scottsdale Airpark submarket in 2006 will remain at 2005 levels between 8 and 9 percent. This is in spite of 800,000 square feet of completions scheduled to come on line by year’s end. Average rental rates for this Class A product will be around $30 per square foot by the end of 2006.

— Mark Seale is a senior vice president for CB Richard Ellis in Phoenix.

Industrial

The metro Phoenix industrial market continues the momentum generated in 2005. The market achieved record activity in fourth quarter 2005, as more companies from across the country chose Phoenix to fulfill their relocation strategies. The healthy economy also continues to benefit the businesses currently located in the Valley. Many of these companies are increasing in size and in need of new or additional space.

Phoenix’s popularity as an industrial hub is a double-edged sword, however. Present demand has outpaced supply, leading to a sharp drop in the vacancy rate. Industrial vacancy at the end of the first quarter was near 5.3 percent. One year ago, the vacancy rate was 7.7 percent for all industrial product types. The low vacancy rate is making it increasingly difficult for tenants to locate or expand operations in the Valley. This trend should continue throughout the remainder of this year, with little change from 2005. This reduction in supply combined with continued demand for industrial space will once again make it a landlord’s market in 2006.

The southwest Valley distribution market will be especially impacted in 2006 by the lack of available space. The southwest Valley distribution market finished 2005 with a vacancy rate of 5.71 percent, down from 8.4 percent in 2004. Several developers have announced large projects as the Valley continues to be a popular distribution alternative to California. This is due in part to California’s increased land values, entitlement difficulties and workman’s compensation issues.

The combined effect caused by the lack of available product and the increase in both construction and land costs will create a significant hike in rental rates. Expect rental rates to increase 10 to 20 percent in 2006 for all product types. Other challenges facing industrial users and developers include land shortages and a resistance to industrial development from residents and municipalities.

A diminishing supply of developable land for industrial product throughout the metro Phoenix area will cause developers and users to look outside of traditional core industrial areas in order to develop and occupy space. New industrial hotspots will emerge in the outlying communities of Casa Grande, Eloy and Buckeye, where speculative product and build-to-suits will emerge due to the dwindling supply of land and significant increases in land values in the traditional industrial markets. These communities will provide a good alternative to higher priced submarkets, which will experience price increases ranging from 20 to 40 percent on remaining parcels in 2006.

A low level of enthusiasm for industrial uses throughout most of metro Phoenix has prompted many cities to require more intense development plans that will continue to make it cost prohibitive to develop industrial product. Increased construction costs will continue through 2006, with overall construction costs increasing from 20 to 30 percent.

Rail service remains a hot topic in 2006 with little, if any, improvement in service for many tenants in need. Union Pacific is looking for sites, and Burlington Northern Santa Fe has a planned project in the Northwest Valley.

— Jerry McCormick is a first vice president for CB Richard Ellis in Phoenix.

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