MARKET HIGHLIGHT, MARCH 2010

PHOENIX
Brian Raczynski, James Hood, Adam Hood, William Hahn, Jeffrey Sherman and Mike Parker

Major investment in Phoenix’s core means the city will fly high once the economy turns. Meanwhile, healthy tenants and well-capitalized investors are in a position of strength and can pick their spots.

Office

What would it take to get you into this car today? The Phoenix office market hasn’t become like buying a car, but one might make the case that the office market is displaying similar characteristics and behaving more like a commodity than real property. Landlords are trying to fill their vacant buildings using a host of creative ideas, similar to dealers who throw in a year’s satellite radio subscription or free window tinting. Landlords are offering the standard concessions along with new options, such as taking a large space but paying rent on a smaller space for the first year.

Tenants are following the same commodity approach. No longer is brand loyalty important. It is all about the deal and where the best economics are. Tenants are viewing current lease requirements in much the same way they view a car lease. At the end of the lease, they turn it in and start all over. Tenants are not concerned with the implied equity of staying in the same building or even submarket for the long term. Leases are not being viewed as part of a long-term strategic plan that considers the impact on a company’s business. Finally, many tenants read commercial real estate articles and take the message as gospel — as though it were a full-color advertisement claiming, “Going out of business — no reasonable offer denied.”

Tenants in the market fall into three categories. First are those experiencing growth, such as higher education and healthcare. The second are those who are contracting, including mortgage and title companies, architects, engineers, construction and related services. The third group, aka the status quo, includes all other tenants waiting on the sidelines to see what will happen.

A game of musical chairs left the metro Phoenix office vacancy rate hovering at 25 percent and average rental rates in the range of $23 full-service, gross, at year-end 2009.

A wide-angle lens is not needed to look at 2009 and 2010 development activity. Three projects make up the majority of new office space predicted to deliver by the end of 2010. RED Development’s 500,000-square-foot CityScape will be delivered in downtown Phoenix. The Camelback Corridor is seeing the delivery of two projects: 24th At Camelback, a Class A 300,000-square-foot, 11-story tower developed by Hines; and Ryan Companies’ 3900 Camelback Center, a 185,000-square-foot Class A building.

Investors are anxiously waiting for product to buy, but it is just not happening. The few exceptions include the recent $112 per-square-foot purchase of the former 130,000-square-foot Dial headquarters in north Scottsdale by owner-user I.C.E. Gallery; and the sale by Principal Insurance of the 143,000-square-foot Union Hills Corporate Plaza to Pacifica for $131 per square foot on a 10 percent capitalization rate.

Real estate is real property and not a commodity. 2010 should be the year to start returning to some semblance of order, although some “cash-for-clunker” transactions will still be taking place.

— Brian Raczynski is a senior vice president of the Landlord Advisory Group in Colliers International’s Phoenix office.

Retail

In first quarter 2010, the retail market continues to experience significant economic pressure. According to CoStar Group’s statistical reports at the close of 2009, retail vacancy rates climbed to more than 12.4 percent versus 11.9 percent the prior quarter. Vacancies are projected to trend downward slightly to 11.8 percent by year-end 2010. As retail vacancy rates increased, the average asking rental rate declined to $17.52 per square foot, compared to third quarter’s asking rate of $17.94 per square foot.

Commercial foreclosures continue to occur, with one of the most high profile being the CityNorth mixed-use development located at 56th Street and Loop 101 in Phoenix. In early January, the lender filed to foreclose on the first phase of the project, according to documents filed with the Maricopa County Recorder’s Office. The auction has been set for March 31. The first phase of CityNorth, which opened in 2008, is known as High Street and includes retail, apartments and office space. High Street is expected to remain open after the foreclosure action takes place.

Although commercial foreclosures have continued to increase, so has retail leasing activity. Many smaller tenants are beginning to realize that this is an excellent time to expand due to their ability to negotiate reduced rental rates with landlords. Tenants are starting to trickle back into the market, as these lower rental rates improve their profitability. Even more encouraging are the number of anchor tenants actively looking to take advantage of the current market conditions to expand their businesses.

In January, Dealmakers.net announced that the regional grocery store chains, Sprouts Farmers Market and Safeway, are seeking expansion opportunities in the Arizona market. Sprouts Farmers Market operates 43 locations throughout Arizona, California, Colorado and Texas. Their typical store ranges in size from 23,000 to 27,000 square feet. Safeway operates 116 locations throughout Arizona and New Mexico, with a typical store ranging in size from 55,000 to 58,000 square feet.

Indicators are that there will still be a lot of pain in the retail market in first quarter 2010, with very slow growth for the remainder of the year. Commercial foreclosures will increase throughout the year and continue to push down rental rates. Even with lower rental rates, however, the restricted economy and reduced consumer spending will keep pressure on retail expansions and profits.

— James Hood and Adam Hood are vice president and senior associate, respectively, in Colliers International’s Phoenix office.

Multifamily

The multifamily market in metro Phoenix is starting to show signs of life, but at sales volumes and prices far below those of 3 years ago. Lenders, particularly special servicers of securitized debt, have recently become much more aggressive about foreclosing and selling defaulted assets. Banks, especially community and mid-sized, have been slower to react.

Lower-quality assets have been the first through the foreclosure pipeline, as their operations have been the most stressed by blue-collar job losses and 2008’s employer sanctions law. Surprisingly, buyers have lined up to acquire these properties, sometimes at trustee’s sales with little or no due diligence, at prices up to 70 percent less than previous sales prices. These properties may be anywhere from 50 to 100 percent vacant. At prices from $12,000 to $19,000 per unit, however, experienced owner-operators figure they cannot lose in the long run.

The recent $2.15 million purchase of Lincoln Village Apartments, a 115-unit, 1980s property on Phoenix’s west side, is a good example. The process that determined this asset’s value was “pricing per pound.” Because these assets generate little, zero, or sometimes even negative net operating incomes, cap-rate analysis is meaningless.

At the other end of the quality spectrum, there were approximately 10 Class A assets traded in 2009, generally at prices 40 percent less than their previous sale prices. While some speak of rising cap rates, these are largely illusory because of significantly deteriorated operations. Even in so-called stabilized properties with occupancy rates approaching 90 percent, when factoring in concessions and general rent declines, the revenue streams from these properties are off 40 percent from a couple years ago. When properties of this quality hit the market, there is no shortage of qualified buyers prepared to step up with high levels of equity (35 to 50 percent) to take advantage of reduced prices.

There has been a big hole in sales for what were classified as B assets — properties built in the 1980s. As these properties slip into the 25-year-old range, this B classification becomes questionable. This large group of properties will see more activity in 2010. One notable example in this category was the $18.5 million sale on the last day of 2009 of the 428-unit Morgan Park Apartments, which was built in 1987.

2010 is expected to present opportunities for lenders to dispose of troubled assets on their books and for well-capitalized buyers to acquire multifamily assets at deeply discounted prices.

— William Hahn and Jeffrey Sherman are senior vice president and senior associate, respectively, at Colliers International’s Phoenix office.

Industrial

Most in the metro Phoenix industrial real estate market say good riddance to 2009, as it appears last year’s “pretend and extend” trend is now passé. There are a number of reasons for optimism as the market returns to real estate fundamentals in 2010.

The metro industrial vacancy rate appears to be finding a ceiling in the 17 percent range. New supply is constrained, as financing of any new speculative projects is not anticipated until the vacancy rate decreases and rental rates bounce upwards. Any new construction will be design/build for specialized or difficult-to-purchase property types. Historic absorption rates will steadily chew through the oversupply of industrial premises as the economy recovers.

It appears the industrial market may be plumbing bottom. Rental rates are down 25 to 50 percent from their 2007 peak, depending on product type and location. Opportunistic tenants need to take advantage of the closing window of low rental rates and abundant concessions that are being offered by competitive landlords. This will be a big deal-making year for both tenants and buyers of industrial real estate.

The view here is that sales transaction volume should triple that of last year as buyers take advantage of the increased supply of properties at historically attractive prices. Sellers and lenders alike are going to be forced to make tough decisions in a buyer’s market that is coupled with an economy slowly coming out of this deep recession.

All hope of a quick rebound in both the economy and credit markets is giving way to the harsh reality that cash is once again king. Allred Development’s all-cash purchase of the 187,000-square-foot Hewson Chandler Airport Center for $37.98 per square foot is a key indicator of what vacant shell industrial buildings are worth when factoring in tenant improvements, interest carry, brokerage fees and rental rates necessary to fill vacant space in today’s market.

Liquidity is returning to the mortgage market. Potential buyers of commercial properties, who were priced out of the market in 2007, are now taking advantage of low interest rates and increased availability of both buildings and financing. Most properties are being purchased for less than replacement value, so there is minimal risk for financial institutions on many of these new deals, particularly those with SBA loan guarantees.

The industrial land market will not be a factor until both vacancy rates and rental rates rebound to historical norms.

— Mike Parker is a senior vice president in Colliers International’s Scottsdale, Ariz., office.

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