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COVER STORY, DECEMBER 2005
2006 BROKER OUTLOOK
Brokers from across the West take a look back at 2005, look forward to what 2006 has in store.
Lara Fuller
In most western markets, each year seems to be better than the last. Will this trend continue in 2006?
Orange County/San Diego
Orange County experienced a record-setting year in terms of activity and diminishing cap rates in 2004. This year has been much of the same as the area continues to see lots of activity and still lower cap rates. “2005 answered the question of how low can cap rates go,” says John McDermott, Sperry Van Ness' senior vice president and regional manager for Orange County, San Diego and Long Beach. “An overabundance of capital and low 10-year treasury rates for long-term loans has continued to fuel the frenzy, through the first three quarters of the year.”
This year, retail sales reached $200 per square foot on average, with strip centers reaching around $300 per square foot, says McDermott. A cap rate of 6.9 percent neared the 2004 record-low cap rate of 6.6 percent. Vacancy also remains low in the retail market with strong absorption of new products.
In the office sector, the market continues to greatly improve. “The Orange County office market is one of the strongest markets in the nation for class A high-rise office space,” says Dave Girty, senior vice president with Transwestern Commercial Services in Irvine, California. The vacancy rate is 2 percent, down from 25 percent just 2 years ago, says McDermott. The average asking rental rate for class A space in all of Orange County is $2.34 per square foot, adds Girty. “With the continued, steady demand for class A office space and without any significant amount of new product being delivered during this time frame, we can expect an even more competitive environment ahead,” says Girty. The Orange County industrial market is also a strong sector. “Industrial, particularly flex, has continued to be the investment of choice and in great demand,” says McDermott. “Flex has averaged $117 per square foot and achieved 7.2 percent cap rates with general industrial at $91 per square foot and also at 7.2 percent cap.”
Though 2005 has been a strong year overall for the Orange County area, the last quarter of the year has begun to show signs of a transitioning market. “2006 should be interesting,” says McDermott. “Rising construction costs, rising interest rates, declining consumer confidence, sellers who may have waited too long, global demand, the trade and spending deficits are all wild cards moving forward.”
In general, San Diego is experiencing the same changes that Orange County as a whole is facing. “Having enjoyed the strongest market for commercial real estate over the past 3 years, San Diego is beginning to show the tell-tale signs of transitioning,” says McDermott. The condo-conversion frenzy has cooled, quickly and dramatically, which has also fueled the drop in California apartment rates for the county over the past 2 years. In addition, housing affordability continues to be a major factor. “But with rising interest rates for home loans, converted condo units, followed by an over abundance of high-rise condos, could be a major factor in the market,” says McDermott.
The retail sector is doing well, as retail is still in high demand. Strip centers are closing at $213 per square foot at 7.4 percent cap rates, while malls and larger centers are seeing $227 per square foot and cap ranges in the high 6 percent range.
In terms of industrial, flex trading is at $187 per square foot with 7.2 percent caps, and general industrial trading is at $101 per square foot in flex. Overall vacancy rates for the market are in the single digits, with a few pockets at more than 10 percent.
“All of the same macro issues facing Orange County apply to San Diego, however strong construction, particularly related to Mexico, as well as industrial and distribution, bolster the overall market,” says McDermott. “2006 will be a transitioning market for both Orange County and San Diego counties with increasing sales activity as sellers begin to recognize that 2005 was the market's peak in nearly all product categories.”
Las Vegas
Las Vegas has been a hot market in recent years and is on the track to remain one for a few more. Industrial is just one Las Vegas sector that is booming. “The Las Vegas industrial market is experiencing phenomenal growth and momentum,” says Mark Bouchard, managing director with CB Richard Ellis (CBRE) in Las Vegas. Some reasons for the increase in activity include the continuing population and economic growth in the area, the regional distribution hubs that continue to be located in the city, and the close proximity to the Southern California and other regional markets, says JJ Peck, associate with CBRE. The current vacancy rate is at approximately 4.84 percent, net absorption is at 2.3 million square feet and there is 5.2 million square feet of gross leasing activity. More than 3.9 million square feet of industrial space is currently under construction.
On the office side, the market is strengthening, making improvements over the last few years. “Compared to past years, the market has done very well in 2005,” says Bouchard. “The market has been consistent in user activity and has continued to strengthen throughout southern Nevada.” The vacancy rate in the office market is currently at its lowest point in 12 years, at approximately 10 percent. Rates are expected to decrease further before the year is over. “The reason for this trend downward is increased user demand from local expanding tenants and a steady flow of out-of-state tenants still coming into the market,” says Bouchard. There is currently more development in the planning stages or under development than there has ever been in the past.
Retail in Las Vegas has been very strong over the past few years and will continue that trend into 2006. The total market vacancy rate is at 3.23 percent, which is an all-time market low. New retail development is constantly underway and mixed-use projects remain popular as the cost of land continues to rise. “Supply and demand continues to drive the Las Vegas retail market — as we continue to post low vacancy developers struggle to keep up with the demand,” says Bouchard. “The trend continues for 2005 and 2006, showing a healthy, active retail market.”
In the multifamily sector, the market is growing with rents rising 8 to 10 percent and vacancy rates decreasing (currently at approximately 4.76 percent). The current conditions in the multifamily market are due to condo conversions, reduced new supply, strong job growth and tear-downs of existing units for redevelopment, says Spence Ballif, senior vice president with CBRE. In 2006, “The market will continue to tighten, vacancies should be below 4 percent and rents are expected to grow an additional 6 to 8 percent,” he says.
Los Angeles
In Los Angeles, the multifamily market has remained very healthy in 2005. In previous years, many of the new class A properties were sold to apartment operators. “In 2005 there has been a radical shift in the market as most transactions are going to for-sale buyers (either condo converters or home builders),” says Curtis Palmer, managing director with Transwestern Multi Housing Capital Advisors in Los Angeles. “Because the housing market is so strong and the cost of construction is continually increasing, developers are having a hard time meeting return on cost hurdles which would allow them to build apartments. This will ultimately lead to improvements in the operating numbers of apartments, as less new product is delivered to the market while existing assets are being removed from the stock of rental housing and converted to condominiums.” Vacancy rates continue to decline, with a 97.6 percent occupancy rate in metro Los Angeles. Employment growth is expected in Los Angeles over the next year, which will help bolster the apartment market. “Furthermore, as operations improve and with the lack of available product, investors will continue to pour money into the sector,” says Palmer.
Los Angeles, which has the largest industrial market in the country, has seen good progress in that sector. There has been growth in the leasing and investment areas, declining vacancy rates (currently at approximately 3 percent) and rising rental rates. “Fueling the industrial market sector is vigorous international trade,” says Timothy O'Rourke, senior vice president with The Staubach Company. “Together, the ports of Los Angeles and Long Beach are the largest combined port complex in the country, handling approximately 35 percent of all of the nation's container activity. Since approximately half of the international product coming into Southern California via the ports stays within a 300-mile radius of Los Angeles, we are seeing a marked increase of warehouse capacity needs.” O'Rourke expects no cooling in the industrial sector as transportation costs continue to increase and demand for warehouse space remains high.
In the office sector, the market isn't seeing much in terms of new development though there is relatively high demand. “The market is still absorbing space left over from corporate consolidations and the dot-com bust of the early 2000s,” says Rick Buckley, principal with Madison Partners. “Today, the lack of developable sites on the west side [of Los Angeles] is driving the demand to outlying submarkets like South Bay, San Fernando Valley or downtown Los Angeles.”
Current asking rates for class A space in West Los Angeles are around $2.75 to $3.75 a square foot, says Buckley. The vacancy rate sits at just below 10 percent. “Tenants with time left on their leases should begin negotiating now, since the skyrocketing cost of raw materials has made relocating that much more expensive, thus reducing their leverage with existing landlords',” says Buckley.
Bob Safai, principal with Madison Partners, says, “For 2006, the investment market should continue at the same vigorous pace provided that capital is still available. However, the imminent up-tick of interest rates will adjust cap rates upward and effect investor's total return.”
Portland/Seattle Portland's economy is continuing to improve, with steady growth in most real estate sectors. “Oregon has recorded the third largest drop in unemployment rate in the past year,” says David Squire, vice president and managing director with Grubb & Ellis in Portland. “In addition, Oregon's economy is growing steadily, with the state registering the seventh-fastest increase in jobs among all states.” In the office sector, the vacancy rate is currently 12.7 percent, with year-to-date net absorption of 958,730 square feet through the third quarter.
Over the next year, Squire believes that the demand for suburban office space will move west from Washington Square/Kruse Way to the Sunset Corridor. Construction is picking up in response to lower vacancy rates and increasing rental rates in some submarkets. “Look for the vacancy rate to continue to drop, rental rates to spike in the tightest submarkets and concessions to be all but gone by the end of 2006,” says Squire.
The industrial market in Portland continues its eighth consecutive quarter of improvement. “Portland's industrial market now stands at 7.1 percent vacant with year-to-date net absorption at an impressive 3.2 million square feet, setting up the market for the strongest annual net absorption in 5 years,” says Squire. “Improvements were felt in both the manufacturing/warehouse/distribution sector and the R&D/flex sector.” Construction in the area is beginning to pick up, with 1.5 million square feet currently underway. In 2006, Squire predicts that rates will begin to increase for the first time in several years. “Landlords are beginning to hold firm on terms and are offering less in the way of concessions,” says Squire. “With the manufacturing/warehouse/distribution vacancy rate at just 6 percent, expect those developers that have been sitting on sites to begin speculative construction in the tightest submarkets.”
In terms of retail, the market continues to see steady growth. The vacancy rate is currently just below 5 percent and is predicted to remain close to the same next year. The strength of the retail market is tied to two major factors. “First, there is an Urban Growth Boundary (UGB) that surrounds the metro area that works to eliminate urban sprawl,” says Dean Weir, senior associate, retail properties, with Norris & Stevens. “This artificial constriction limits the growth of new centers and big box retailers, but has the benefit of having investors and retailers invest or redevelop in existing centers and urban areas. The second factor that contributes to the success of the retail market is Portland's reputation for livability and affordability that continues to attract college-educated people from California and the Midwest. These new residents are pushing for retailers that have not entered our market and the retailers are listening.” In the multifamily sector, the year has been a challenging one. “On the surface, it would appear that rents have fallen consistently over the past 3 years,” says Brian Bjornson, managing director with Norris & Stevens in Portland. “The average rent for a newer two-bedroom dropped from $740 per month in 2002 to $732 per month last summer. Like most of the country, our market has been impacted by the economic downturn that began in 2001. This particularly affected vacancy rates in apartments, as people suffered job loss or relocation.”
The next year is expected to be an improvement on 2005, in part because of the stabilization of the job market. “Steady growth is in the cards for Oregon in the near future,” says Bjornson. “Vacancies will continue to fall and rents increase as the economy recovers and demand increases.”
In Seattle, the market is recovering from several slower years. “Job growth has increased in Seattle creating the need for businesses to expand,” says Rob Aigner, managing director with the Seattle office of Colliers International. In the office sector, the past year was better than expected, with activity picking up and vacancy rates declining. “The market remained fairly flat through 2003 and 2004,” says Aigner. “We expected the same for 2005.” However, the Seattle office market rebounded higher than predicted. In turn, tenants in the office market are upgrading their space because rental rates are still relatively low. Currently, the downtown Seattle office vacancy rate at the end of the third quarter was 13.32 percent with 550,000 square feet of positive net absorption for the year.
On the industrial side, Aigner expects 2006 to be more of the same. “The vacancy rate is already less than 10 percent in the region,” says Aigner. “The lack of available land on which to build new warehouses has led developers further south toward Olympia creating an industrial market that didn't exist before.”
San Francisco
The San Francisco retail market is recovering from the economic conditions of the past few years. “Economic conditions are improving overall,” says Vince Schwab, vice president of investments with Marcus & Millichap in San Francisco. “Conditions in the region continue to improve as employers pick up the hiring pace and in-migration accelerates trends that will continue in 2006.” Some reasons for the growth in the market include an additional 15,000 jobs created in 2005, compared to the 1,000 that were created in 2004. “Retailers are feeling the positive effects of the economic rebound, and retail sales growth was expected to register approximately 6 percent in 2005,” says Schwab. The strengthening retail market will encourage the expansion of retail stores over the next year, in turn reducing the current vacancy rate of 6 percent. In 2006, Schwab predicts that investors in multi-tenant retail properties will head east, causing dollar volume in the East Bay area to rise. In terms of single-tenant, net-leased assets, the demand will remain high. “Demand outstripped supply in San Francisco during 2005 and we expect this trend to continue next year,” says Schwab.
The San Francisco office market remains strong. “Occupancies are steadily climbing,” says Schwab. “The demand for office acquisitions is quite strong despite questionable economics.” Much of the office activity has been focused in the East Bay. Over the next year, it is forecast that both the retail and office markets will hold their steadily improving positions. “I suspect it is going to be strong, but cap rates will be level until the stock market comes back and confidence returns,” says Schwab. “I think that real estate is going to be the alternative of choice.”
The apartment market in San Francisco is similar to the city's other markets in that it continues to turn around from recent slow years. “Improving fundamentals and a growing economy have combined to boost investors' confidence that the San Francisco apartment market is well on its way to recovery,” says James Devincenti, vice president of investments with Marcus & Millichap. “Vacancy is working its way down to 6 percent and rents are showing signs of modest growth as owners pull back on concessions.” The increased number of jobs is benefiting not only the retail market, but the multifamily market as well. Tenant demand is expected to increase over the coming year because of the new jobs and because of limited new construction. Six hundred units were added to the market in 2005, compared to the 1,400 added in 2004, says Devincenti. “Vacancy in San Francisco is on the mend,” he says. “Our forecast for further improvement in vacancy is reinforced by a lack of development, modest employment growth and soaring home prices.”
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