MARKET HIGHLIGHT, DECEMBER 2004

PHOENIX: DELIVERING IN THE DESERT
Robert Pearlstein, Bert Kempfert, Jim Watkins, Mark Linsalata and John Werstler

Phoenix’s residential growth continues unabated with positive ramifications for the city’s commercial real estate markets. Vacancy rates across the retail, multifamily, office and industrial sectors have generally decreased in 2004.

Retail

The metropolitan Phoenix retail market has remained amazingly resilient in the down economy, thanks in large part to the area’s booming housing growth. Just when observers believe the Valley’s sizzling hot residential market is due for a cool-down, it instead breaks another record, apparently undeterred by rising home prices and climbing interest rates. The number of single-family permits issued in 2004 is predicted to top 60,000, up from the 47,700 last year. Through August, 40,718 single-family permits had been issued in Maricopa County, up nearly 30 percent from last year.

These new residents, who are pushing ever closer to the outskirts of the Valley, obviously need places to eat, shop and play, and developers are racing to provide a host of amenities to fulfill their every desire. In fact, approximately 21.5 million square feet of new retail space will be added to the 113.5 million-square-foot base during the next few years, and market experts predict little, if any, impact on the vacancy rate.

Despite 1.1 million square feet of new space coming on line in third quarter 2004, the vacancy rate dropped to 6.6 percent, down from 7.02 percent in the second quarter and 7.54 percent for the same period last year. Experts believe vacancies could dip below 5 percent within the next few years due to the high level of demand for space and the fact that new projects are typically pre-leased prior to opening — sometimes even prior to groundbreaking.

As residential construction follows the alignment of the new Loop 202 freeway into the southeast Valley, so too does retail development. Vestar Development, Diversified Partners and Westcor, a subsidiary of The Macerich Company, three of the metro area’s major players, are blazing into strategically located high-growth areas where little retail competition currently exists. Vestar’s projects include Crossroads Towne Center at Gilbert Road and the Loop 202 and Gilbert Towne Center at Ray and Power roads. Meanwhile, Diversified Partners is underway with SanTan Gateway at Arizona Avenue and the Loop 202. Westcor is planning SanTan Village at Greenfield and Williams Field roads.

Overall, rents have reflected the relative health of the metropolitan Phoenix retail market. Asking rental rates for top-end properties have jumped from a standard in the $20-per-square-foot range to the mid $30s. Even Class B properties have benefited from the increases, with some of these properties fetching rents into the $20 range. Not surprisingly, available retail properties are receiving strong investor interest and suitors are competing for scarce product as soon as it hits the market. During the next year, the situation is expected to remain unchanged as the fundamentals continue their strong performance.

Wal-Mart’s entry into the neighborhood grocery business, with its 40,000-square-foot concept, will undoubtedly have an impact on the local market. The company plans to open 20 to 40 stores within the next 2 to 3 years.

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

Multifamily

Suffering a one-two punch at the hands of record-low interest rates and a soaring housing market, the Phoenix apartment sector appears to have hit the bottom of the cycle late last year. Accelerating population and employment growth and reduced apartment development in the Valley are credited with hastening the area’s recovery.

The fluctuation of fixed-rate mortgage interest rates in recent months and an improving economy have slowed the tide of rental refugees pursuing their dreams of homeownership and resulted in an incremental improvement in the apartment market. However, it’s still too early to characterize the situation as a complete recovery. Concessions are declining as interest rates rise and new apartment development slows due to lack of potential sites and rising materials costs like lumber and cement.

According to CBRE statistics, the soft market conditions have apparently had little effect on investor interest. Through the first three quarters of 2004, 67 apartment communities greater than 100 units changed hands, compared to 78 in all of 2003. The median price per unit for properties in the metro Phoenix area rose 34 percent to $53,441 per unit, with those built after 2000 fetching an average price of $84,016 per unit.

Twenty-two sales of properties exceeding $20 million have occurred already this year. Among the most significant transactions of the year were the 832-unit Archstone-Deer Valley Village for $68.25 million; the 497-unit Desert Club for $64.25 million; and the 856-unit Terracina for $42.65 million.

Why are investors so confident? One word: growth. Despite whatever dark-economic-cloud-of-the-moment hovers over the national picture, and whatever temporary economic vacancy has occurred locally to depress the marketplace, Phoenix is notorious for a sunny outlook when it comes to job and population growth.

According to the Department of Economic Security, between December 2002 and December 2003, non-farm employment in the metro area rose by nearly 40,000 jobs or 2.5 percent. Job growth in Phoenix during the last half of 2003 was the fourth best out of the 30 largest metropolitan areas in the country. Already this year, metropolitan Phoenix has racked up 40,000 non-farm jobs. High-tech, manufacturing, construction, health care, education and tourism expansion will add to payrolls, contributing to the 66,000 new jobs predicted for year’s end.

Meanwhile, population growth continues to bring more renters to the Valley. Census figures reveal that metro Phoenix had the highest in-migration of any American metropolitan area from 1995 to 2000. This trend helped the Valley grow by 2.8 percent in all of 2003, and similarly through third quarter 2004.

Additionally, investors find that Phoenix’s higher capitalization rates (6.5 percent range) allow their money to stretch farther than in other major markets like California, Washington and Nevada. With many investors armed with inexpensive debt and the desire to execute 1031 tax-deferred exchanges, the immense demand to place investment dollars is not surprising.

Multifamily vacancies have continued their downward spiral, with the metro-wide rate dipping to 8.4 percent as of third quarter, down from the double digits just a year ago. Average asking rents in the Valley were $718 as of third quarter, compared to $712 for the same period last year. Average apartment rents in upscale submarkets are $880, up from $860 last year.

A construction slowdown is also welcome news. Only 4,450 new apartments will be delivered to Phoenix’s 330,000-unit inventory this year.

— Bert Kempfert is first vice president of the Phoenix Apartment Private Client Group for CB Richard Ellis.

Office

The large metro Phoenix office market features a variety of submarkets in different stages of health. Office inventory during the last 10 years has expanded by more than 16 million square feet, mainly in the suburbs close to the newly constructed freeway corridors. While demand for office space in Phoenix has ebbed and flowed with the sporadic economic cycles, the market has never experienced negative absorption. Currently, the market is working off the excess of space that was created in the early 2000s and has fallen from a high vacancy of 20 percent at the end of 2002 to a 2004 mid-year vacancy of slightly less than 18 percent. This may sound high but, in a growing city like Phoenix, office space actually starts to be constrained in the 10 to 12 percent vacancy range.

In 1999-2000, the Phoenix office market experienced high demand with tenants absorbing 6 million square feet. Since then, demand has been right at 1 million square feet per year. This year, demand has definitely increased in conjunction with a more positive business climate, and net absorption is expected to top 1.5 million square feet.

The overall economy in the Phoenix market has significantly improved over the past year resulting in an increase in construction and development. Metro Phoenix has been known as a tenant’s market during the last 3 to 4 years, but now is leveling off in certain submarkets. However, certain under-performing submarkets are still experiencing high vacancy rates and, therefore, continue to offer strong lease concessions to try to attract tenants. Those submarkets include the Midtown or traditional high-rise central business district and Gateway (the airport area).

Office development is occurring primarily along the eastern portion of the Loop 101 freeway, some of which is on Native American land. North Scottsdale continues to lead in Class A construction and absorption due to access to Loop 101, vast retail amenities and upscale housing. Other major office development is non-speculative and centers on the USAA campus in northwest Phoenix, where the company just completed a 600,000-square-foot regional headquarters facility.

The Phoenix market is experiencing significant office leasing by homebuilders, the mortgage industry, financial services and high-tech firms. Major leases signed recently include Pulte Homes for approximately 145,000 square feet at Raintree Corporate Center in North Scottsdale; a 106,000-square-foot speculative office building in Chandler, which was purchased by Countrywide Mortgage; and a 24,000-square-foot headquarters lease in Chandler by Isola USA. Additionally, the metro Phoenix area has seen approximately 800,000 square feet of office condo development in the last 5 years, which was an entirely new product category.

The office market in Phoenix is regaining its health and momentum, making the future a bright one for developers, owners and investors. A strong continuation of the business recovery that started in the last year is expected for 2005. Businesses with anticipated expansion requirements, particularly in the suburban markets, should move quickly to acquire office space as certain markets will have fewer choices in the coming year.

— Jim Watkins is a broker for Lee & Associates in Phoenix.

Industrial

Overall, industrial real estate in Phoenix is benefiting from the rebound of the U.S. economy, with market conditions that may be stronger this year than any time since 2000. A variety of factors help drive industrial leasing and development activity in the market. For instance, well-located private land is scarce; thus there is an increase in state land auctions. Major trends include the increase of commercial/industrial development on Indian reservations and many parcels of the West Valley’s industrial land being sold to homebuilders.

This scarcity manifests itself in several scenarios. Industrial developers suddenly find themselves facing off against ravenous residential developers for land, even in submarkets like southwest Phoenix, where supply previously has been plentiful. The result is a land-grab in which industrial developers are being forced to bank property for future projects. Land values have increased 20 percent to 50 percent in most market areas.

Investors are also facing scarcity among buildings for acquisition. Property owners for the most part are finding it makes more sense to hold and refinance an asset rather than sell because replacements are so difficult to find. Owner-occupied buildings, presently the strongest segment of the market, are responsible for lease rates remaining stable. However, as vacancies continue to drop, lease rates will certainly begin to rise. Asking rents are ranging between $0.25 NNN for warehouse distribution space and $1 NNN for flex and back-office, depending on location and product quality.

Though rates experienced a slight upward tick to 8.6 percent in the third quarter, up from 8.34 percent the previous quarter, the single-digit figures reflect a competitive metro Phoenix marketplace that has multiple suitors competing for scarce product.

Back-office continues to be the weak link in the metro Phoenix industrial market, as owners struggle to fill space vacated by now-defunct high-tech companies. Look for emerging bioscience firms to help absorb the excess as Phoenix’s biotech community takes off.

Some significant industrial transactions include DBL Distributing’s purchase of a 144,020-square-foot corporate headquarters with an attached distribution warehouse and Buzz Oates Enterprises’ sale of an approximately 1.2 million-square-foot industrial building for $53 million or $42.38 per square foot. The following major leases recently closed: State Logistics for 278,142 square feet at 10397 West Van Buren St. and Atlas Cold Storage for 194,977 square feet at 6101 West Washington St.

The majority of Phoenix’s industrial development is taking place in the southwest and southeast areas, where the availability of affordable land is high and many new master-planned residential communities are being built. Industrial owners are trying to attract distribution and warehousing tenants in the southwest submarkets and clean technologies/biotech companies in the southeast and northeast markets. The University of Phoenix and Wells Fargo Bank Services are absorbing a large amount of industrial flex space.

New freeway systems, housing developments and retail space as well as the new Phoenix Coyotes sports arena make the West Valley submarket one to watch in the future. Also, land availability to the southeast will support continued growth towards Tucson, Arizona. The Phoenix market should continue to see positive absorption in the 2 to 3 million-square-foot range during the next 6 to 12 months. By year’s end, speculative construction will total 4.8 million square feet and net absorption will hit 2.5 million square feet. The Phoenix industrial market should continue to improve in the next year due to the area’s rapid growth.

— Mark Linsalata is a principal at Lee & Associates in Phoenix. John Werstler is first vice president at CB Richard Ellis’ Phoenix office.

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