MARKET HIGHLIGHT, MAY 2008

PHOENIX
Craig Coppola, Andrew Cheney, Patrick Dempsey, Jan Fincham, Tyler Anderson and Mark Krison

Concerns about temporary economic hurdles or delays in the Phoenix market are more than offset by the city’s long-term track record of growth.

Office

The 60 million-square-foot Phoenix office market is heading south — not into a crisis but rather a cycle. There is no question a cleansing of unrealistic expectations and trends is taking place in the market, yet all must remember that Phoenix earned its name for a reason. Yes, the scary lease comps are coming, there is an extra 3 percent in vacancy due to subleases and there is a large amount of uncertainty. However, it is a special market with great fundamentals (i.e., sunshine, jobs and opportunity) that has absorbed at least 1 million net square feet every year for the past 20 years. Phoenix remains a growth market and a smart place to hold real estate in the long term. The following is a look at market conditions since the first of the year.

January and February were clearly the two slowest months since second quarter 2002. Final first-quarter absorption numbers will definitely be off the 230,000-square-foot first quarter pace from 2007. These 2 months are great indicators of the sidelines packed with business leaders perfectly able to make real estate decisions, but holding out for better deals. The beginning of March, however, signaled the return of significant activity as tenant tours increased, while many companies simply realized business must go on. These events have created a challenge for area brokers: managing expectations of media-tainted tenants and spoiled owners while making deals in a volatile market.

Metropolitan Phoenix’s direct vacancy stands at 14.5 percent, up from an 8-year low of 11.95 percent achieved in fourth quarter 2006. Add on sublease figures and a true vacancy of 17.5 percent reflects the current state of the market. Characteristic of downtimes, numerous credit tenants are coming to the market early (with 18 months or more left on their existing term) to flex their muscles. Keen to potential consequences, wise landlords in overbuilt submarkets are making the painful but necessary concessions to ultimately close deals at sub-pro-forma levels. One 70,000-square-foot anchor tenant achieved 12 months of free rent outside a 10-year lease (with a very generous “fit up” period), while another 12,000-square-foot golden-credit tenant was handed 10 months free inside a 10-year term. Both deals were done at $2.50 per square foot less than asking rates.

The capital markets have deterred, but not completely eliminated, investment sales activity. The average cap rate among the 10 office sales since January 1st averaged 6.98 percent. Anticipate cap rates to rise well into the 7 to 8 percent range during the course of 2008. The best buys will be small- or medium-user sales as several office condominiums have begun to hit the market with existing owners hungry to get out of mortgage payments they can no longer afford. The challenge may not be the cap rates but rather financing in the debt market. This market, unfortunately, is in complete disarray. Concession-heavy transactions will continue to permeate the sector as companies take advantage of the first tenant’s market in 4 years.

— Craig Coppola is founding principal and Andrew Cheney is an agent in Lee & Associates’ Phoenix office.

Retail

Both retail owners and investors are uncertain today, eyeing the first real setback in retail real estate, and commercial real estate in general, since the savings-and-loan crisis of the late 1980s and early 1990s. Regarding greater Phoenix retail, the issues begin with the subprime mortgage market and the metro’s over-built residential market causing home values to decline. Everyone is being cautious about spending money in this market, and there is uncertainty about when the current financial situation will get better.

Through fourth quarter 2007, the retail market vacancy was a strong 6.3 percent according to Costar research. This statistic is healthy by any measure but there is 9.9 million square feet in new construction in greater Phoenix on the horizon. In addition to the economic issues stated above, that vacancy rate could rise precipitously. Developers and retailers have taken positions at strategic intervals around the new sections of greater Phoenix’s freeway system to cut off competition and in anticipation of future residential growth. This added retail inventory is primarily in large power or lifestyle center formats.

This increased retail competition puts pressure on existing properties and their tenants. The new projects and low vacancy rates have pushed lease rates to new highs. The trend in 2005 through 2007 was for landlords to push rental rates due to a low market vacancy, but in 2008, vacancy rates are up due to expansive new construction and smaller shop tenants failing due to slower sales. Many of these distressed smaller tenants are the same people who are suffering from declining home values. A poll of current retail property owners indicates that many local tenants are struggling and often closing their doors due to today’s economic environment.

The greater Phoenix retail investment market is stalled as buyers and sellers adjust from a seller’s to a buyer’s market. Again, this is not a real estate problem but a credit and liquidity crisis in the financial markets. The fundamentals of the investment sector have adjusted to a post-July 2007 market whereby CMBS financing is gone. Cap rates have adjusted to the corresponding leveraged returns that investors expect to achieve based upon life insurance or bank financing. There are fewer buyers and sellers in this environment, as sellers lack the motivation from profits. In addition, 1031-exchange buyers, who were plentiful in 2005 and 2006, are considering paying capital gains versus overpaying for property in 2008. Realistic buyers and sellers are still transacting but sales volume is down by more than 50 percent in first quarter 2008.

— Patrick Dempsey and Jan Fincham are principals in Lee & Associates’ Phoenix office.

Multifamily

No one can deny that after several years of record-breaking sales activity and pricing growth Phoenix’s multifamily market is experiencing a relative slowdown. But in true Phoenix style, the area continues to attract keen interest from developers and investors anticipating the valley’s historic ability to rise above momentary market lulls.

This notion is particularly evident in the number of investors trolling for perceived values in the wake of the valley’s well-publicized single-family housing slump. While the credit crunch caused by turmoil in the capital markets has undeniably put a dent in sales activity — $300 million as of first quarter this year compared to $1.2 billion in first quarter 2007 — abundant capital exists if the price is right.

A well-priced, well-located property will easily garner upwards of a dozen offers when put up for sale. Well-capitalized investors are increasingly utilizing Fannie Mae and Freddie Mac as sources of financing in the multifamily market.

Construction of new units in 2007 totaled 5,221, up from the 3,433 units built in 2006; this was modest by historical standards, but nonetheless, an indication of developers’ overall confidence in the area. The Hanover Company recently secured city permission to build Ashton Scottsdale, a 255-unit luxury community targeted for Fifth Avenue, the heart of the Scottsdale’s downtown arts and entertainment district. The project is scheduled for delivery in early 2010.

Other new development is primarily concentrated within a mile of the Loop 101 and Loop 202 freeways, with additional growth along Interstate 17 north of the Loop 101 and close to the Loop 303 Freeway on the valley’s west side.

Overall, occupancy is down, due to the large number of single-family rentals available in the market and the recent enactment of undocumented worker legislation, which has specifically hit Class C properties in heavily Hispanic-populated submarkets. The valley’s occupancy averaged 90.7 percent in 2007, down from 93.1 percent in 2006.

At the same time, occupancy and rental rates remain healthy in the Scottsdale, northeast Phoenix and central Phoenix submarkets. In fact, 14 of the valley’s top 20 high-rent communities are located on a two-mile stretch of Scottsdale Road reaching from north Scottsdale to Tempe, where rates still average $1.15 to $1.60 per square foot.

Looking ahead, renters will control the market, except in the luxury submarkets. New construction will be limited and overall sales will lag until rents rebound. However, continued population and job growth, coupled with stabilizing factors in the shadow rental market, should pave the way for recovery in 2009.

— Tyler Anderson is vice chairman in CB Richard Ellis’ Phoenix office.

Industrial

After years of dangerously skinny vacancy rates, the Phoenix industrial market finally has some meat on its bones. Heading into 2008, the overall vacancy rate clocked in at a respectable 8.4 percent, compared to rates that hovered in the 6 and 7 percent ranges in 2007 and 2006. The most notable outcome of this extra elbow room is that users looking for high-cube distribution space in metro Phoenix no longer are being forced into competing markets simply because their needs could not be satisfied here.

The addition of 5.96 million square feet of large warehouse/distribution space during the last year has provided more than enough user options for tenants looking to relocate or expand their operations. Despite the addition of all this space, the valley’s 68 million-square-foot inventory of warehouse/distribution space remained only 10 percent vacant at year’s end. In fact, vacancy rates in every industrial product category remained at or below 10 percent, with the exception of back office, which had a 13 percent vacancy at the end of 2007 for its 13 million-square-foot segment. It is expected that the vacancy rate for most product types will have increased in first quarter 2008 due to the scheduled delivery of new product and the slowing economy.

While user demand remains active, last year’s building boom, followed by the continued turmoil of the capital markets, is prompting many developers to take a wait-and-see approach to new projects. Some are waiting for current inventory to burn off, while others are proceeding at a more cautious pace.

The same holds true for users. The desire is still strong, even if the sense of urgency has cooled. Deals that may have taken 3 months to complete in previous years are taking 4 to 5 months under current market conditions.

Active industrial developers include:

• Liberty Property Trust, with new buildings comprising 66,000 and 54,000 square feet under construction at Liberty Cotton Center in Phoenix.

 • EastGroup, with a five-building, 261,000-square-foot general industrial project, which is expected to deliver second quarter 2008 in the Sky Harbor Airport submarket.

• Lauth, which has a 400,000-square-foot bulk distribution building under construction in Goodyear and a 600,000-square-foot industrial building in the West Valley that is complete and already 50 percent leased.

• Lincoln Property, which recently added six general industrial buildings, totaling 387,000 square feet, to its newly recently renovated 10 Chandler project, creating a nine-building, 554,600-square-foot industrial development along Interstate 10.

Heading into summer, look for continued user activity by tenants while investors will be keeping a close eye on metro Phoenix. Overall absorption will be modest, due to the effects of the cooling national and local economies, but a rebound is anticipated by early next year.

— Mark Krison is a senior vice president for CB Richard Ellis in Phoenix.

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