COVER STORY, DECEMBER 2004

2005 BROKER OUTLOOK
Continued steady improvement predicted for next year.
Jennifer Orr and Brian A. Lee

Cities around the West continue to slowly recover from a series of unhealthy quarters. All sectors are improving, but Western office markets remain weak. Will the same hold true in 2005?

Denver

Matlock

The Denver commercial real estate market has been slowly emerging from the downward spiral that started in early 2000. Specifically, occupancy rates for the apartment market have been rising during the last few quarters and now hover around 10 percent, says Garrette Matlock, vice president/investments in Marcus & Millichap’s Denver office. “We’ve probably hit or passed the trough,” he says. “I think the worst is probably over. Occupancies will increase slowly and rents will follow. But right now we have a situation where we have considerable concessions and a pretty decent vacancy rate.”

The office market too is improving, but, having borne the brunt of Denver’s dot-com bust, has a lot of catching up to do in terms of absorption. Surveys show the city’s overall office vacancy around 20 percent, says Matlock. “Vacancy has peaked and is declining,” he continues. “The office market is going to improve, but it’s going to be slow.” Office buildings in Denver’s northwest and southeast submarkets continue to report some of the higher vacancy rates in the area.

Retail on the other hand has remained quite strong in Denver during the downward cycle of the last couple of years. “We don’t see any chinks in the armor there,” says Matlock. He reports an overall vacancy rate of 7 percent and in quality centers, a rate of less than 5 percent. He projects that vacancies will remain low throughout 2005.

Salt Lake City

The commercial real estate market in Salt Lake City is also experiencing a modest upswing from some previous unhealthy quarters. Scott McDonald, associate broker in Coldwell Banker Commercial’s Salt Lake City office, expects this trend to continue into 2005, especially now that 25,000 to 35,000 new jobs have been projected for next year.

McDonald

The industrial sector’s vacancy rate is about 11 percent and office is clocking in at 15 percent, says McDonald. “The interesting thing about office is the Class A market, where the vacancy is very low, approximately 5 to 6 percent,” he continues. “The real concern is the older areas of town, which have really good values, but high vacancies.”

Currently, the apartment market is flat. Though the multifamily occupancy rate is relatively high at 92 percent, rents are not increasing and little development is going on. Low interest rates are partly to blame as paying a mortgage in Salt Lake City is not much different than paying rent. McDonald predicts more of the same in the multifamily market in 2005 unless interest rates tick up.

The Salt Lake City retail market has been strong in 2004 and will continue to see more growth in 2005. Kohl’s is entering Salt Lake City and plans to open five department stores, which should generate additional strip center development in the immediate surrounding areas. Cabela’s is also moving to the area and will open a 150,000-square-foot sporting goods store in Lehi in late 2005.

McDonald expects 2004’s growth trend to continue into 2005, but doesn’t see the real estate landscape changing all that much in Salt Lake City. “We don’t see an increased increment of demand coming down the line,” he says.

Phoenix

Gosnell

The story in Phoenix reads much the same way as it does in Denver and Salt Lake City: the office and industrial markets are slowly recovering while retail remains strong. The more interesting aspect of Phoenix’s tale is the commercial real estate growth occurring in the north Scottsdale area, which Bill Gosnell, president of Lee & Associates, Arizona, compares to the Irvine market in Southern California. “North Scottsdale is cooking and is taking some of the ingredients of the stew out of existing buildings in Phoenix,” he says. “Some of the prominent law firms, instead of expanding along the financial corridor in Phoenix, will open satellite offices there. And the important thing is the infrastructure is in place — the restaurants, the shopping, the residential — to make that happen.”

A couple of factors contribute to north Scottsdale’s success, one being the completion of Highway 101, which loops through the Phoenix metropolitan area. Also, the Salt River Pima-Maricopa Indian Community has announced it will free more parcels of its reservation, which hugs Highway 101 in Scottsdale, for commercial real estate development.

Gosnell points to downtown Phoenix as another growth area, specifically for the office market. The Translational Genomics Research Institute plans to open a biotech research facility downtown, and Arizona State University is expanding its campus there. In addition, a new 1,000-room hotel will open in 2008, coinciding with the completion of the $600 million expansion to Phoenix Civic Plaza, the downtown convention center. “Couple that with the fact that residential is affecting downtown all of a sudden,” says Gosnell. “For the first time ever, we’re seeing strong residential growth downtown. You’re going to see some of the Class B and C office buildings actually convert to residential.”

While north Scottsdale will continue to be a hot opportunity throughout 2005 as the Salt River tribe begins to release more land, Phoenix, poised to reap the rewards of a new 21-mile light-rail system in 2006, can look forward to the realization of downtown’s potential further down the line, says Gosnell.

Las Vegas

In Las Vegas, the trend for 2005 is up, literally. Rodney Harbaugh, president of Lee & Associates, Nevada, reports that the price of land has driven the price for office building development from $9 per square foot to $12.50 per square foot, especially in the southwest area of Las Vegas. Plus, in 2004, steel prices jumped 84 percent, lumber prices were up 77 percent and concrete prices increased 18 percent. “You can’t build a two-story office building on expensive land and make it pay,” says Harbaugh. “You’re going to have to go higher.” Thus, the number of high-rise office buildings and office rental rates will most likely increase in the near future.

Harbaugh

The same applies for apartments, continues Harbaugh. And the demand for apartments in Las Vegas is higher than in most Western markets due to its growing population and elevated home values — the average single-family home costs $269,000. Because of these factors, Harbaugh expects apartment rents to increase in 2005. In 2004, rental rates rose 3 percent; Harbaugh predicts a 5 to 7 percent increase next year.

As far as retail goes, Harbaugh says the city could use more. “We only have three regional malls in this town, and we have 1.6 million people. There’s probably a need for at least another three regional malls.”

Though not a regional mall, the District at Green Valley Ranch increased the size of Las Vegas’s retail market earlier this year when it opened with 40 specialty retail stores and restaurants. The 400,000-square-foot project also includes a residential and office component. Harbaugh expects that Las Vegas will see more of these types of mixed-use developments open in the coming years.

Seattle & Portland

The commercial real estate market in Seattle remains weak as the city has yet to fully recover from the dot-com bust and Boeing’s downsizing. The office vacancy rate in the central business district is about 14 percent and lease rates range between $28 and $32, representing a 28 percent decline from the 2000 peaks, according to NAI research. Seattle’s suburban eastside office market struggles more, with rental rates in the $18 to $22 per-square-foot range, a 50 percent decline since 2000. NAI reports that though Seattle office tenants have been “actively blending and extending,” the office market’s growth and overall absorption has been flat to slightly negative.

Squire

Job growth was minimal in 2004 — 0.1 percent, according to NAI research — and so was economic expansion at 0.5 percent. Thus, vast improvements in the Seattle market are not expected in 2005. “I see continued slow, generalized improvement, but though Seattle is not a stagnant market, it’s a less dynamic market,” says Rhyne Brown, senior vice president in NAI’s Newport Beach, California office. “I think it will be characterized perhaps in 2005 by some minor increase in speculative building activity in the suburbs, but I don’t see any dramatic changes in rates. I don’t see any dramatic changes in the basic dynamics of that market.”

Seattle’s retail and industrial markets are healthier. Activity increased and vacancies decreased in Seattle’s industrial market this year. And average triple-net-lease retail rental rates are falling between $18 and $19 per square foot.

It’s difficult to paint Portland’s office and industrial 2005 outlook in broad strokes. Forecasts likely depend on the particular industry component and submarket. “Portland’s office sector will be the tale of two markets in 2005,” says David Squire, executive vice president and managing director of Grubb & Ellis’ Portland office. “The overall picture is getting better but some submarkets are way out in front while others have significant ground to make up.” Squire lists Kruse Way as by far the tightest office submarket , one that “sped past recovery and into expansion mode.” Equity Office Properties is already preparing a site on which to build an office tower in the next several years.

Squire reports that Portland’s CBD office market remains a challenge for landlords but the balance of power will tilt away from the tenant throughout 2005. Due to significant barriers to entry, other office development projects are not likely to break ground in downtown Portland for several years to come. South Waterfront, the largest redevelopment in the metro area, will alter the landscape of the submarket with its residential, retail and biotech space, says Squire.

Brad Fletcher, managing director of Grubb & Ellis in Portland, says that the city’s industrial market will return to solid footing in 2005 “but geopolitical forces and the pace of the semiconductor rebound could hamper the market’s recovery.” Competing industrial indicators will factor into the industrial market’s performance in 2005 — continued positive manufacturing job growth versus the warning signals emanating from elevated inventories and oil prices. “Port officials are working diligently to strengthen transportation infrastructure and recruit additional global players in the multi-modal shipping industry in an effort to solidify Portland’s position as a West Coast alternative,” says Fletcher.

Northern and Southern California

The situation in California differs little from what is occurring in neighboring states. “The southern half of the state remains in a slow recovery growth mode with spots of improvement in the marketplace,” says Brown, “but the explosive regional growth of the past seems over.” In 2004, the Los Angeles commercial market experienced a modest upswing, as did San Francisco.

Brown

The office markets in both San Francisco and Los Angeles improved slightly in 2004. San Francisco’s office vacancy rate decreased to 20 percent and rents in some neighborhoods have increased. However, absorbing the 16 million square feet of remaining vacant office space will take several more quarters, according to NAI research. Los Angeles’s office vacancy rate is about 15 percent, with suburban Class B space moving well, according to NAI.

Both cities’ industrial markets are healthier, with vacancy rates under 6 percent (Los Angeles: 5 percent; San Francisco: 5.9 percent). According to NAI, most of 2004’s leasing activity in San Francisco involved smaller spaces, less than 20,000 square feet. NAI also reports a new trend in industrial activity: more and more owner-occupied industrial buildings in San Francisco are converting to apartments and condominiums.

And retail remains strong in both the Los Angeles and San Francisco markets, with the exception of San Francisco’s downtown market, which has experienced higher vacancies (18 percent versus 3.5 percent for regional malls). According to NAI, the big boxes are beginning to invade the Los Angeles market, specifically West Los Angeles, Santa Monica, parts of the Wilshire Boulevard Miracle Mile, and most of downtown Los Angeles.

The 2005 outlook for San Diego’s commercial real estate market is sunny, much like the city’s weather. A strong, diversified economic base that continues to grow; a “business friendly” political environment; and the passing of several local pro-business propositions are a few of the reasons why San Diego real estate will maintain its momentum, says Stath Karras, president and CEO of Burnham Real Estate. The city added 37,000 jobs between December 2003 and August 2004, a substantial increase over the 23,538 jobs added during all of last year.

San Diego’s real estate roll is not without an occasional speed bump or two. “Our challenges include housing affordability, overall cost of living and transportation,” says Karras. “These issues are impacting individuals, causing some to move from San Diego and California. If this trend continues it will impact business growth and therefore real estate. Significant increases in interest rates could also be a deterrent.”

According to Burnham, San Diego’s 12 percent office vacancy at the end of third quarter could approach the 10 percent mark by year’s end with expected move-ins. Qualcomm, GenProbe and BioSite are developing a combined 1.45 million square feet of projects in the Sorrento Mesa submarket, says Karras. Burnham reports that more than 1 million square feet of industrial space has been absorbed year-to-date in San Diego County, contributing to a low 6.6 percent vacancy rate as of the close of third quarter.

San Diego’s downtown continues to bustle with activity after the opening of PETCO Park, the Padres’ new stadium, contributing to a 97.5 percent retail occupancy rate (exclusive of regional malls). Karras says that JMI and Lennar have announced plans for a 1 million-square-foot mixed-use development in the East Village submarket.

Looking ahead, office will continue to remain the weakest sector in both the Northern and Southern California real estate markets, according to Brown. “The situation in Southern California is perhaps brighter than in Northern California,” he says. “Industrial should be relatively positive. We’re seeing some real growth especially in Southern California. The sector that will remain most vibrant will be retail. Retail is probably the bright spot.”

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