MARKET HIGHLIGHT, NOVEMBER 2008

PHOENIX
Greg Abbott, Erik Marsh, Chris Keenan and Alon Shnitzer

The Phoenix market may be adjusting to new economic realities, but with its impressive fundamentals it’s a sure bet to rise again like its mythical, winged namesake.

Retail

Although 2008 has been a soft year for the Phoenix retail market, Phoenix has had an extremely impressive run in this current expansion period. Given the tremendous growth, a pullback is not unexpected nor should it be a surprise. A combination of factors including the credit crunch, housing bubble, rising gas prices and falling consumer confidence have all contributed to Phoenix’s softening retail sector. So how long will this period last? An important event this month in our nation’s capital will hopefully eliminate some of the uncertainty that exists in the market.

Increased supply is putting pressure on occupancy in Phoenix’s retail market. The vacancy rate has increased to approximately 8 percent, a 0.75 percentage-point increase from the prior quarter. Vacancy has been trending upward since fourth quarter 2007, and this trend is expected to continue for the next 6 to 12 months with an anticipated vacancy rate of 9.5 percent by mid-year 2009. As the credit markets free up, tenant expansion should resume, helping the vacancy rate trend to stabilize.

As the construction pipeline continues to flow, bringing new space to the market, recent absorption has had a difficult time keeping pace. Approximately 7.5 million square feet of new retail space was completed in the past year with another 7.2 million square feet currently under construction. Net absorption has been positive year to date at approximately 700,000 square feet. However, absorption in second quarter 2008 was negative 550,000 square feet. As the pipeline begins to slow, many new projects that were scheduled to break ground this year have been postponed. As a result, completions will be down in 2009, allowing the market to balance itself out.

Rental rates have remained remarkably strong in recent quarters despite the increase in supply. According to CoStar, average quoted rates were $20.68 per square foot after second quarter, unchanged from the year prior. Meanwhile, concessions have increased by about 40 percent. Rental rates are forecast to go down slightly in 2009, at which time leasing activity will again outpace new construction and a base is expected to form.

Transaction volume in both multi- and single-tenant retail categories has decreased in 2008, with the multi-tenant category experiencing the biggest decrease. In both categories, a separation still remains between bid and ask pricing, which has resulted in lower transaction volume. However, sellers have begun to digest the market conditions, and, as a result, cap rates have adjusted upwards by 50 to 75 basis points on average.

— Greg Abbott is a principal at Scottsdale, Arizona-based Arizona Retail Advisors LLC.

Industrial

Even as the local economy slows, the Phoenix industrial market continues to emerge as an attractive regional distribution and warehouse hub for the Southwest. Industrial developers remain active in the metro, most notably in the Southwest Valley, as logistics firms are capitalizing on the cost benefits from storing bulk inventory in the area.

Amazon.com, for instance, which already occupies 600,000 square feet of warehouse space in Phoenix, announced plans to open a 500,000-square-foot order-fulfillment center in Goodyear, Arizona, this year. This announcement came shortly after Macy’s Inc. opened up a similar operation in the city.

As for market fundamentals, vacancy rates have pushed 440 basis points higher year over year to end the second quarter at 13 percent, as builders continued to deliver large blocks of space and the deteriorating effects of the housing slowdown eased demand. In the second quarter alone, the city’s industrial market reported nearly 2 million square feet of total negative net absorption. Despite some near-term weakness, the area’s extended outlook remains favorable, and steady population growth will drive demand.

Additionally, the widening of Interstate 10 will provide some relief from congested roadways and bolster the appeal of the west valley as a growing warehouse hub. With an abundance of available land and a strategic location less than a day’s drive from Southern California, the Southwest Valley submarket will continue to receive much of the market’s new construction activity this year, which will likely keep vacancy in the area above the metro average. The southeast submarket, meanwhile, should continue to benefit from still-healthy demand for flex space, supported by business derived from the Phoenix-Mesa Gateway Airport, keeping vacancy rates in the mid- to high-7 percent range this year.

In 2007, transaction velocity jumped 25 percent, while the median price increased 9 percent. In that time, investor demand compressed cap rates to the low-7 percent range, as buyers from higher-priced markets had been willing to accept lower first-year returns for well-located assets in the path of growth. The trend is reversing in 2008, however, as investors now require higher yields to cover greater financing costs and lower loan-to-value ratios. Moreover, year-to-date sales have slowed more than 40 percent, compared with the same period 1 year earlier, as tightened lending requirements have diminished the pool of active buyers and the owner/user segment has delayed expansion plans.

One of the more active areas in the metro for investment thus far in 2008 has been the southeast submarket, due largely to strong tenant demand derived from increased air freight through the Phoenix-Mesa Gateway Airport.

— Erik Marsh is a senior associate in the Phoenix office of Marcus & Millichap Real Estate Investment Services.

Office

Office fundamentals in the Phoenix metro will continue to soften this year due to the slow economy and the area’s heavy dependence on the residential real estate market. In the past year, the metro’s turbulent housing market has prompted many local employers to streamline staff levels and space requirements in the near term, as the metro is highly influenced by real estate-related job sectors. Subsequently, vacancy pushed 270 basis points higher in the last 12 months to reach 15.8 percent in the second quarter.

Long-term projections, however, point to underlying market strength. Although job losses will be recorded in 2008, the metro’s anticipated healthy population growth is forecast to drive employment gains during the next 5 years. On the supply side, rising office stock and slowing demand in the past several months have resulted in an oversupply that will likely persist until the local economy regains traction. This saturation is heaviest in the outlying areas, like the Mesa/Chandler and west side submarkets, but also affects submarkets previously with low vacancy like North Scottsdale. As such, development activity is expected to return to the core office-using districts in the coming years, and the lack of available financing for construction loans should keep new product from coming to market. For the year, approximately 2 million square feet of new office space is slated for delivery, down from the 2.8 million square feet delivered in 2007. One project slated for the downtown area, CityScape, is scheduled to add 575,000 square feet of office space to the market upon completion in 2011.

Investment activity in Phoenix has remained relatively brisk in the past 2 years, driven by the metro’s long-term employment prospects; however, things changed in late 2007 to early 2008 with velocity down nearly 30 percent year over year through the second quarter. Out-of-state buyers have played a large role in deal flow in previous years, but local buyers have dramatically increased their presence in recent quarters, encouraged by cap rates in the mid-7 percent to low-8 percent range.

Local investors are also reacting to realigned pricing strategies from sellers who have begun to adjust their expectations. Both out-of-state and local buyers have exercised flight-to-stability strategies in an effort to minimize downside risk. As a result, infill locations, like the downtown, uptown and Camelback submarkets, are recording increased interest from investors. Despite projections for market-wide rent decreases this year and perhaps next year, buyers with local knowledge may find long-term upside potential in assets currently with below-market rents, as occupancy in these properties will likely remain strong and rent increases can be enacted when leases expire. The recent financing crisis has not yet played out and this will be a key factor in transaction velocity.

-— Chris Keenan is a senior associate at Marcus & Millichap Real Estate Investment Services.

Multifamily

Phoenix’s extended growth prospects continue to provide a favorable outlook, despite near-term uncertainty regarding the metro’s economic climate. The area’s traditionally robust job market has recorded a net loss during the past year due to payroll cuts in housing-related fields. This trend, combined with the metro’s vast shadow inventory, has pushed vacancy levels 150 basis points higher to 8.9 percent in the past year. With single-family housing permit issuance down substantially, layoffs in the construction sector have been steep, easing tenant demand for Class B/C units. In addition, new legislation on illegal immigration has placed additional pressure on Class B/C rents.

Space demand in the top-tier segment, meanwhile, has receded as operators face stiff competition from the large oversupply of single-family homes and unsold condos entering the rental market. Slower permit activity for single-family homes, however, will help to reduce the number of properties for-sale on the market, which should help hasten a housing recovery. Despite these near-term challenges, overall demand is buoyed by declining home values and stricter lending criteria, which has relegated many prospective homebuyers to the rental market, a trend that could carry over well into 2009. Supply growth, meanwhile, is expected to slow modestly this year and drop off significantly in 2009. Still, deliveries in 2008 will remain 24 percent above the metro’s 5-year annual average. Owners will continue to compete with the area’s shadow inventory through year’s end, especially in outlying areas where homebuilding efforts and speculative buying activity were concentrated during the boom.

Decelerated sales activity will persist in the Phoenix apartment market as out-of-state buyers take a diminished role and tightened lending requirements limit the pool of qualified investors. Savvy local buyers remain in the area, however, targeting stabilized, quality infill assets. The bulk of this year’s apartment transactions have been on higher quality, well-located properties. Class B and C properties will suffer the greatest decrease in value on a year-over-year basis. Owners who are not prepared to hold their assets may want to consider divesting them if the properties no longer align with their investment strategies. Sellers may be able to reduce marketing times by attaching assumable financing when possible, while cash buyers could capitalize on assets that need to be closed in a short period of time.

— Alon Shnitzer is a senior associate and director of the National Multi Housing Group of Marcus & Millichap Real Estate Investment Services.

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