COVER STORY, DECEMBER 2006

BROKER OUTLOOK FOR 2007
Commercial real estate experts weigh in on what to expect in nine major markets across the West.
compiled by Brian A. Lee

Despite many challenges, including a slowdown in the residential sector and rising construction costs, the West is poised for another strong year in 2007. Western Real Estate Business contacted some of the foremost brokerage firms in the region to get their take on commercial real estate next year.

San Diego

The condo conversion trend may have stalled in San Diego, but strong fundamentals like population and income growth keep the market as attractive as its weather. Rental rates are increasing downtown, especially in the area around Petco Park where mixed-use redevelopment has caused a surge in business and consumer interest.

San Diego’s commercial real estate market will remain strong in 2007 despite moderate slowing across all property types. With the nation’s housing market slowing, most are asking what impact this is having or will have on commercial real estate. In San Diego, most notably, the condo conversion craze that swept through the county in 2005-2006 has stopped and will not be evident in 2007. As a result, many of those converted condo properties are coming back on the market as apartments, and many apartment developers are looking for land to backfill the demand for rental units. While the cost of single-family homes decreases across the country, housing costs in San Diego still remain too high to draw individuals out of apartments; therefore apartment occupancy is very high and will remain high in 2007.

San Diego’s job growth and investor outlook for 2007 is positive, which could potentially lead to business expansion. New office building construction was high in 2006, specifically in the Kearny Mesa, Del Mar, Carlsbad, Rancho Bernardo and downtown submarkets. In 2007, most of these buildings will come online, outpacing demand and causing vacancy to rise. This increase in vacancy coupled with continued high land prices and construction costs are expected to slow new construction in 2007.

The industrial, retail and investment markets will experience some moderation in 2007, but will not see dramatic changes from 2006. Industrial construction will continue on existing projects, most of which are in the extreme northern and southern portions of the county, but new project construction is expected to slow. Retail vacancy is predicted to stay very low as population and income growth remain strong for San Diego, while land constraints will keep property and rental values high. 

— George Gramm is director of market research for Grubb & Ellis|BRE Commercial in San Diego.

Los Angeles

2000 Avenue of the Stars in Los Angeles’ Century City submarket

If the 2006 commercial real estate market resembled an action-packed blockbuster movie laden with big-name stars, 2007 will probably look more like an art-house film: slower paced and with fewer big stars, but richly rewarding nonetheless. Vibrant job growth and corporate expansion — the most important back story of 2006 — will continue to shape the Los Angeles office and industrial real estate markets in 2007, albeit more evenly, as the economy pulls back to a more sustainable pace over the course of the year.

The Los Angeles basin will face 2007 with a year of record-setting job growth, rent growth and corporate expansion behind it. More than 100,000 new jobs were added to the market in 2006, along with a new influx of venture capital to the tech market. The subsequent demand for office and industrial space has not yet been satisfied, with positive absorption continuing well into 2007.

Larsen

Industrial hotbeds like the north San Fernando Valley, Santa Fe Springs and portions of South Bay will begin to see more new construction as the existing supply dries up. In the office sector, 2007 will see tenants, priced out of upscale markets like Pasadena, Burbank and Westlake Village, look to more cost-conscious, quality submarkets like Glendale and the west San Fernando Valley.

A very modest amount of new office construction will be in the pipeline in 2007, including one new high-rise in Century City, and developers will use 2007 to seek out redevelopment, conversion and value-added opportunities in the office market. At last, building values and rental rates will begin to stabilize toward the end of the coming year, with consolidation and mergers expected to create breathing room. However, rental rates should still grow at a healthy pace of 6 to 8 percent per year, meaning that tenants won’t have the edge at the bargaining table until 2008.

— Jonathan Larsen is executive managing director, tenant advisory, for Transwestern’s West Region.

Hawaii

Honolulu’s commercial real estate market posted its fourth consecutive year of robust performance, which was marked by falling vacancy rates and sizeable increases in rental rates and increased institutional investor interest. Fueled by strong job growth, record construction activity and rising personal incomes, the hotel, office, retail and industrial real estate sectors gained significant traction going into 2007.

Hawaii’s commercial real estate markets should continue to post above-average absorption rates and significant increases to asking rents. Development activity will likely slow as a result of increased construction costs. Prime properties will continue to appreciate as demand from institutional investors drives up values for hotels, office buildings and retail shopping centers.

Despite the healthy economic performance for 2006, inflationary concerns will likely weigh heavily on the pace of growth for 2007. Price increases for vital resources such as labor, raw materials and fuel oil have already boosted construction costs, shipping charges and airfares. Honolulu’s low unemployment rate of 2.4 percent further exacerbates the hiring difficulties many employers are faced with.

Tight labor supply exists among the construction trades and has resulted in a jump in construction costs. The overabundance of construction projects has forced general contractors and their subcontractors to be increasingly selective on the projects they bid on. Construction price increases have already resulted in several major projects being shelved.

After several years of dramatic jumps in median home prices, Honolulu’s residential market topped out at a $640,000 median sales price during second quarter of 2006. This is a 55 percent increase since 2003. At this price level, affordability becomes an issue for many prospective homebuyers. A slowdown in sales activity is being witnessed among the many luxury high-rise condominiums and single-family homes. Should the rest of the residential market mirror this phenomenon, Hawaii’s currently vibrant economy is likely to follow.

— Mike Hamasu is director of consulting and research for Colliers Monroe Friedlander in Honolulu.

Salt Lake City

Momentum across all product types continues in Salt Lake City and the Wasatch Front. Rental rates and sale prices have fully recovered from the downturn earlier this decade. New spec construction is occurring in office and industrial product throughout the valley, with the accompanying increase in land, financing and construction costs pushing rents up rapidly.

Some of the most significant Salt Lake activity to look for in 2007 includes:

• The Church of Jesus Christ of Latter-day Saints is planning a major mixed-use community redevelopment project downtown in the area close to Temple Square. It expects to spend well in excess of $1 billion redeveloping the ZCMI and Crossroad Malls and several contiguous blocks into a new community featuring retail, residential, office and educational components. The project will take place over the next 5 years.

• Class A office vacancy in Salt Lake City’s central business district has been falling rapidly and is approaching 3 percent.

• A vibrant rental market for Class A office space in the south end of the Salt Lake Valley has triggered a significant number of new, speculative office projects.

• Union Pacific’s $100 million new intermodal facility west of Salt Lake City has commenced operations. This new “inland port” brings in containerized product from each of the three major ports Union Pacific serves — Los Angeles/Long Beach, Oakland and Seattle/Tacoma — by high-speed intermodal trains. This development assures that Salt Lake City will continue the trend of becoming the distribution hub for the Intermountain West. The recent Costco distribution facility and more than 2 million square feet of speculative high-cube, bulk distribution projects surrounding the facility are evidence of this.

Assuming interest rates remain steady and there is no major downturn in the national economy, the Salt Lake/Wasatch Front area is poised for continued growth. The workforce is young and well educated, and Salt Lake offers a low-cost environment, one that is very competitive for employers.

— Ed Johnson is a senior associate with NAI Utah Commercial Real Estate.

Las Vegas

Higgins

In Las Vegas, everyone’s a winner, including the major players in the commercial real estate market. The hospitality sector continues to move at a rapid pace and looks to be the hot product category in 2007, with many new projects underway or planned. As the driving force behind Las Vegas, the hospitality sector will offer new products to outdo the competition and drive tourism to the region.

Expected to exceed $7 billion, MGM Mirage’s Project CityCenter is one of the largest privately financed developments in the United States. The project will feature approximately 2,800 units of luxury condominiums; a 400-room luxury hotel and casino; two 400-room, non-gaming boutique hotels; and more than 470,000 square feet of retail, dining and entertainment venues. Additional hospitality developments that will affect the market include Steve Wynn’s Encore and Boyd Gaming Corporation’s $4 billion Echelon Place.

A large industrial development that will affect the market will be Northern Beltway Industrial Center, which is situated on 100 acres. As the largest industrial park announced in the last 2 years, the 2 million-square-foot project will comprise seven distribution buildings ranging from 189,000 to 415,000 square feet. From 2006 to 2007, the largest change Las Vegas’ industrial market will experience will be the rental growth. There is currently a discrepancy between sales rates and rental rates. The market will see an increase in rental rates in the next 6 to 12 months, allowing a closer correlation in rates.

Interest rates could be one critical factor affecting the Las Vegas residential real estate market in 2007. If interest rates rise and the housing market continues to cool, the commercial real estate market will feel the effect. A political issue that might affect Las Vegas includes an item of note on the ballot for November, which is the People’s Initiative to Stop the Taking of our Land (PISTOL) law. The PISTOL law would make it illegal for state and local governments to force property owners to sell land for use in private projects. The outcome of this law could cause infrastructure issues and adversely affect redevelopment.

— Kevin Higgins is a senior vice president in Voit Commercial Brokerage’s Las Vegas office.

Denver

The Denver market by all signs will be all systems go for 2007. Vacancies in all property types will decline as lease rates rise. Office leasing will continue to lead the pack in activity levels, but apartment vacancies will also reach 5-year lows. Given sustained consumer spending, the retail market will hold its own despite significant new development activity.

The CBD and southeast suburban submarkets will continue to garner the most attention with the southeast light-rail line opening and several speculative developments proposed for each area. The northwest corridor may be a sleeper submarket for 2007, attracting tenants seeking newer space at still affordable rates. Development could begin in this market as well by the end of the year.

The investment market will remain heated, though rising overall expenses and tax rates could be a factor for owners of smaller properties, especially retail and apartment buildings. Investment dollars will also see a reallocation from retail to other uses as value-add opportunities are foreseen in expanding property types. While larger and newer properties will be sought after, smaller buildings may experience a slight increase in cap rates. In the industrial market, a significant shift is expected to occur as interest rates increase, pushing some companies out of the owner-user market and toward leasing options. An unknown but potentially significant driver is the impact that potential developments in renewable energy or oil shale technology could have on leasing and development activity in the region.

— Errin Welty is research manager for Grubb & Ellis Company in Denver.

Portland, Oregon

After enjoying the upper hand for several years, Portland-area tenants and users will find 2007 a much different environment, both in the office and industrial sectors. The big question is the impact of a housing slowdown on the Portland-area economy and its effect on the commercial real estate market.

In the office market, vacancy rates are dropping in all submarkets, and tenant activity is brisk. For the first time in many years, tenants are competing with each other for space. Landlords will continue to raise rents, particularly in the central business district (CBD) and Kruse Way area, as market metrics improve. Tenants coming out of 5-year leases in these submarkets may see 20 to 30 percent increases in their rental rates. Focus will be on the CBD as several major new developments vie for anchor tenants to kick off their projects. Kruse Way area construction will continue in response to the successful lease-up of recent development projects.

Construction is also picking up in the industrial market, particularly in the warehouse/distribution sector. Look for increased development activity in Rivergate, the Interstate 5 corridor and the Northeast Columbia corridor. After years of compression, shell rental rates are beginning to increase, making speculative construction more feasible. Tenant-improvement dollars are shrinking in response to the tightening market and rampant construction costs. Increasing capacity at the Port of Portland will help the area compete with highly congested West Coast ports for major import/export carriers.

The Portland investment market will see strong activity through 2007, but rising interest rates will shrink the pool of buyers. Highly leveraged buyers are interest-rate sensitive and, as rates rise, traditional cash buyers will become more competitive. Cap rates have bottomed out but strong expectations for rent growth will keep pressure on pricing. The commercial condo market in Portland is still unproven. Rising interest rates will have a negative impact, and projects that are not selling well may revert back to traditional rental developments.

— Patricia Raicht is senior research manager – West Coast for Grubb & Ellis Company in Portland.

Seattle

Seattle continues to be one of the most desirable cities in the nation for institutional real estate investment in office properties. Civica Office Center, a 305,000-square-foot Class A mid-rise building located in downtown Bellevue, Washington, led the way with a record selling price of $458 per square foot not less than 18 months ago, only to be soon outdone when it recently “flipped” to another buyer for another record price — this time $575 per square foot. Real estate investors are obviously quite bullish on the prospects for continued labor and business growth in the Northwest, not to mention the prospect of achieving significantly higher rents.

For the first time in 5 years, Seattle’s overall office vacancy rate has dipped below 10 percent and is dropping quickly. The vacancy rate for the Eastside/Bellevue market is nearing 7 percent. As a result, rents will continue to rise during the next 6 months, possibly by as much as 20 percent. Consequently, tenants whose leases are up for renewal in the next few years will be in for some sticker shock.

Seattle investors and developers continue to snap up available multifamily properties. Condo converters and investors bullish on increasing rental rates are largely fueling the high demand. Since the price being paid for these properties still remains below replacement costs, given the recent surge in construction costs, cap rates continue to remain at record lows ranging between 4 and 5 percent. To the chagrin of many apartment owners and investors, rental rates are rising due to the diminished supply and the improving local economy.

The scenario could change, however, since the condo market in Seattle’s downtown is beginning to show signs of softening with more than 7,000 new units scheduled for delivery downtown in the next few years. How this will affect the supply of apartments and expected rents will be seen in 2007.

San Francisco

Mishkin

An improving local economy is supporting rental demand in San Francisco, prompting owners to build on last year’s rent gains by implementing increases that are higher than at any time since the technology bubble burst. Economic conditions in the city are solid, as employers are adding jobs for a third consecutive year and household growth will turn positive after declining throughout the decade. Employers are expected to add 9,100 jobs in 2006, increasing payrolls by 1 percent. As a result, the major property sectors, in addition to the hospitality segment, are expected to perform well in 2007.

Apartment vacancy is on track to post a 60-basis-point decline to 4.1 percent by year-end 2006, with the Civic Center/downtown and South of Market submarkets leading the charge. Analysts are forecasting 6.7 percent growth in asking rents and 8.8 percent effective rent growth in San Francisco by year-end 2007. Despite improving market fundamentals, investment activity is slowing, with the exception of properties in San Francisco’s prime locations.

Office fundamentals improved dramatically in 2005 and are poised for more strengthening throughout this year, which should reward investors with solid revenue growth in 2007. Increased space demand will lead to a decline in vacancy this year and enable owners to raise asking rents.

San Francisco office properties continued to register gains in 2006. Recent sales, like that involving the Bank of America building, have encouraged optimism in the overall economic state of the office market. While the outlook is positive, investors will increasingly weigh the effects of interest rate increases. Prices have not appreciated as dramatically as in other markets, but rising interest rates may necessitate higher cap rates to sustain buyer demand.

The hospitality sector made a full-fledged comeback in the San Francisco Bay area. Greater volume in the leisure-travel segment helped to boost occupancy to 71.2 percent year-to-date through July 2006, a 160-basis-point improvement from a year earlier. Year-end 2006 average occupancy is expected to register 72.8 percent, a 130-basis-point increase from 2005.

Although sales velocity has started to slow for most property types in the San Francisco Bay area, solid economic and job growth, tempered levels of construction and the stellar hospitality sector will bolster the commercial real estate market in 2007.

— Jeffrey Mishkin is a first vice president and regional manager in the San Francisco office of Marcus & Millichap.

On The March: Imperial Valley, California Gild The Imperial Valley, located 2 hours east of San Diego, has fast become one of the most opportunistic regions in all of California. Often overlooked in the past, the region’s economy has flourished in recent years, gaining the attention it deserves from homebuilders, commercial developers, REITs and businesses across the country. The area has also not gone unnoticed in the national media with Inc. Magazine ranking the city of El Centro No. 15 in the nation on their list of “Hottest Small Cities for Business.” Always one of the most productive agricultural regions in the world, the Imperial Valley’s growth in the government (including the Department of Homeland Security), transportation, manufacturing, retail and service sectors have now brought more balance. Homebuilders have delivered thousands of affordable new homes for people who have been priced out of the San Diego County market. This growth has yielded a 34-percent population boom over the past decade with projections for more as Imperial County ranked No. 1 in California in projected average annual growth rate. Most of the growth has taken place in the three major markets in the trade area: El Centro, Calexico and Brawley. But what makes the Imperial Valley trade area unique compared to any other market in Southern California is its close proximity to the Mexican border. The two Calexico Ports of Entry combined quietly account for the third busiest border in the United States with close to 22 million crossings in 2004. Across the border is the city of Mexicali, the capital of Baja California Norte, with a population around 1.2 million that pumps an estimated $1 billion into the local Imperial Valley economy. The close proximity to the Mexican border, combined with the population boom and diverse economy, has triggered significant new industrial and retail developments in the Imperial Valley. On the industrial end, the onset of NAFTA transformed Mexicali into an industrial center with more than 206 maquiladoras, spawning demand for distribution warehouses on the U.S. side. Taking advantage of this demand, San Diego-based Phase 3 Properties will develop 600 acres at the East Port of Entry, which is used primarily for trucks. On the west end, Poway, California-based Silicon Border Development LLC is developing 10,000 acres for a world-class industrial area focused on providers of semiconductor and flat-panel display design and fabrication, manufacture and integration. The Imperial Valley continues its rapid retail growth. In March 2005, a joint venture between the mall REIT CBL & Associates and The MG Herring Group opened the Imperial Valley Mall, a 750,000-square-foot enclosed regional mall anchored by Dillard’s, Sears, Robinsons-May and JC Penney in El Centro. Surrounding the new mall are additional plans for new power centers. The Plaza at Imperial Valley, a development of The Russ Group, is a planned 350,000-square-foot center that will feature Best Buy, Bed Bath & Beyond, Ross Dress For Less, Marshalls and others. The mall developers also have plans for a similar open-air center adjacent to the area. Farther north in El Centro, retailers such as Lowe’s Home Improvement Warehouse, Target and Food 4 Less have opened stores in developments by Los Angeles-based KEH Development Company. Among the most active in the area has been Wal-Mart with the addition of two new Supercenters in El Centro and Calexico, and a third planned farther north in the city of Brawley. Redevelopment opportunities also exist in the Imperial Valley where savvy developers have repositioned centers to better serve the community. Newport Beach, California-based CT Realty is nearing completion of the transformation of the more than 200,000-square-foot Valley Plaza. After bringing in El Centro Ranch Market to serve the 75-percent Hispanic trade area, CT Realty has lured other national and regional retailers including Big Lots, Skechers, Aaron Rents and Ganga, a new division of a 100-plus store discount clothing chain based in Mexico. Also, the Hispanic Retail Group — a joint venture of Forest City, Streetscape Equities and The Legaspi Group — recently acquired the old mall in El Centro and plans to redevelop the center. Tony Gild is senior vice president of Sperry Van Ness San Diego.

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