MARKET HIGHLIGHT, OCTOBER 2006

PHOENIX FORECAST: CONTINUED HOT REAL ESTATE
Ron Finkel, Brad Goff, Rich Sica and Laura Becker

What’s hotter than summer in the Valley of the Sun? Perhaps Phoenix’s commercial real estate market. But unlike Arizona temperatures, the sector will remain hot as the winter months approach.

Retail

Although the housing market in the metro Phoenix area seems to be gradually leveling off from its unprecedented recent growth, the retail sector continues to thrive as it has for the past few years. For the most part, the commercial real estate market seems to follow the overall performance of the economy, but is always a bit behind. The retail market has not yet — and most likely will not — hit the extreme highs that the Phoenix residential market hit last year, so it seems to be a relatively safe prediction that it will not hit any major low points either.

Phoenix continues to be a hub for retail development, especially with the revitalization of downtown Phoenix and the Copper Square district, and with the massive expansion efforts and new growth in the West Valley. Copper Square will soon house some of the most high-end retail in the state, combining a wide mixture of entertainment, restaurants, shopping and more. As these new retailers join the established downtown area, most will have to adapt their traditional store layouts to the smaller spaces available downtown, which could have an effect on leasing.

Scottsdale’s downtown area is also being revamped with a $1 billion facelift. The area continues to be one of the Valley’s strongest retail markets with more than 220,000 square feet of new shops at the Scottsdale Waterfront, most of which have already opened for business or will open before the end of 2006.

Additional retail growth has been sustained due to the ongoing and aggressive freeway expansions around the Valley. Retail is popping up everywhere alongside freeways and freeway exits, specifically in the West Valley. This is evidenced through projects such as Westcor’s Prasada and Estrella Falls. Located near the intersection of the Loop 303 and US 60, Prasada is a 4,200-acre, master-planned community with an 800-acre commercial core and more than 3 million square feet of retail space. Estrella Falls is a 300-acre mixed-use development off the Loop 303. These projects join the new Westgate City Center, The Ellman Companies’ urban village in Glendale, which will add a whole new submarket of retail development to the West Valley.

Rental rates for retail space will continue to rise, ranging from single-digit lows of $5 per square-foot to highs of $40 per square-foot in select submarkets, as more high-end retailers continue to enter the market. Vacancy rates are currently just below 5 percent.

Lifestyle, open-air centers and mixed-use and transit-oriented developments still continue to be the focus of developers. Transit-oriented development is playing an integral role in the retail redevelopment of downtown Phoenix, as the Central Phoenix/East Valley light-rail transit corridor heads toward a December 2008 opening.

Smaller-anchored retail centers are thriving as well. Lesser-known groceries, fitness centers and hardware stores have become key players in neighborhood centers. Ace Hardware, for instance, has leased 120,000 square feet of space year-to-date throughout Phoenix, and has plans to expand further in the near future.

The massive increase in the Valley’s population combined with a strong economic forecast in 2007 indicates that retail development will continue to be a driving force throughout the year.

— Ron Finkel is senior managing director at Retail Brokers Inc. (RBI) in Scottsdale, Arizona.

Multifamily

The Phoenix multifamily rental and investment markets are continuing their upward momentum. Population growth in the Valley of the Sun is creating a robust rental market, sellers are taking advantage of low cap rates and cashing in on the skyrocketing values, and buyers are banking on continued growth of the market. The market is also normalizing from abrupt peaks and valleys in the condo-conversion market.

Phoenix leads the nation in new jobs and net in-migration. The affordable single-family real estate market hasn’t been able to keep up with the influx of buyers, so the rental apartment has become the dwelling choice for many valley residents. With very little apartment construction, strong job growth and increasing interest rates, apartment vacancies are at their lowest level in years. Currently, vacancy in the valley is less than 7 percent, the lowest rate in 6 years. As occupancy continues to rise, concessions have been virtually eliminated from the market, and the average rent has grown significantly. In the past 12 months, Phoenix apartments have experienced rental growth in excess of 10 percent. The city should expect similar growth for the next calendar year as well.

The investment market is as active as ever, too — both for buyers and sellers, but for different reasons. The sellers are obviously energized due to the relatively low cap rates and significant run-up in values in the past 2 years. The buyers are active not necessarily for the initial return or cap rate, but for the future appreciation. The active buyers in the market today are betting on continued rental growth and further value gain. Most buyers today are pricing significant rental appreciation into their investment models to achieve the desired internal rate of return.

The most significant change to occur in Phoenix was the sudden condo-conversion acceleration and decline. A little over 12 months ago, single-family housing prices increased 55 percent in 1 year to a current average of $267,000, pricing many would-be homebuyers out of the market. The jump gave birth to Phoenix’s very own conversion craze. Condo conversions were selling out in a single weekend, as homebuyers looking for an alternative to apartment living flocked to the sales offices.

The craze subsided as quickly as it began due to a glut of units on the market. Early this year, there were around 13,000 units in some stage of the condo-conversion pipeline. There were, and are still, too many choices for the target buyer. As sales absorption slowed, many of the amateur converters fled the market, leading to a sharp decline in the number of conversions underway today; only a few of the long-standing converters remain.

These market changes have been positive in two ways — first, that the apartment dweller that could afford more but could not make the jump to a house has his own residence and gained some stability with a mortgage payment; and second, the removal of these units from the rental pool, in combination with increasing demand, has reduced apartment vacancy considerably and raised rents as a component of a healthier apartment market.

With the conversion market significantly slowed, expect a more normal investment market in the next year. The rental market will continue to tighten as job growth predictions — and therefore population growth — remain strong for the foreseeable future. The only potential stress point in the tightening rental market will be residents’ ability to absorb significant rent gains in the future.

— Brad Goff is a principal at Apartment Realty Advisors (ARA) in Phoenix.

Industrial

Following an extended period of “white-hot” growth, the Phoenix industrial market remains poised for continued expansion. The region’s record-setting for-sale market has given way to a revitalized leasing market, characterized by low vacancy rates, rising rents and a healthy infusion of new product.

The upward progression of construction and land costs, bolstered by higher lending rates, is continuing to place upward pressure on sales prices. With many deep-pocketed developers opting to retain 40- to 120-acre land parcels as inventory rather than price them competitively, land prices will remain high even during market fluctuations. Additionally, the high cost of construction has placed many new projects well beyond the reach of potential buyers.

With new for-sale product now demanding between $90 and $120 per square foot, many small business are now finding the leasing market a much more viable option. This has, in turn, driven rents up an estimated 11.3 percent in the past year and placed the vacancy rate at a very strong 9 percent throughout the greater Phoenix area. Fortunately for lessees, the delivery of 2.2 million square feet of new inventory in second quarter 2006 has provided some relief, and a number of new projects are under development.

Santan Development is currently constructing a 120,000-square-foot medical office and flex industrial complex on a 10-acre site directly across from Iases Hospital in Mesa, Arizona. Industrial units are expected to be available for lease in second quarter 2007.

While the majority of new industrial development is occurring on the west side of the valley in submarkets such as Peoria and Glendale, The Williams Gateway region to the east is positioned to be the growth area of the future. Despite booming housing and retail markets, significant industrial construction has yet to occur, and a number of developers are now positioning themselves to take advantage of this growth. As the valley’s economy continues to expand and residents begin to demand jobs closer to home, Williams Gateway will be the area to watch in the next 5 to 15 years.

The forecast for the remainder of 2006 remains very healthy, with a number of new projects coming online and approximately 100,000 new jobs predicted for the local economy. Phoenix has always enjoyed a positive migration to the area from both residents and businesses searching for a favorable climate and reasonable prices. However, those joining late in the game may find that even though the market is falling off its record-setting pace, sales prices and lease rates will likely continue their ascent.

— Rich Sica is executive vice president and principal at GVA DAUM.

Office

Landlords in the Phoenix office market are firming up their control in the negotiation process as the vacancy rate remains relatively unchanged and the tenant demand remains strong. The valley’s vacancy rate has dropped 3.2 percent from 1 year ago when the vacancy rate was 14.5 percent. Both Class A and Class B rental rates have risen to new records. Since the first quarter, the overall average Phoenix rental rate increased 98 cents to $24.15 per square foot. This is the highest overall average rental rate Phoenix has ever experienced. With some current lease deals starting in the mid-$30-per-square-foot range, Class A average rates have increased 15 percent since mid-year 2005 to $26.90.

Net absorption for the metropolitan Phoenix office market at mid-year was more than 2 million square feet, as compared to 1.36 million square feet at the same time last year. In the second quarter, the market absorbed 556,378 square feet of space and is looking to exceed last year’s net absorption of 3.5 million square feet. Gross activity at mid-year is 3.5 million square feet compared to 3.1 million square feet 1 year ago.

Despite rising construction costs, 4.1 million square feet of new space was under construction at the end of second quarter. Although the northeastern submarket leads the way with 1.8 million square feet of new product, the western submarket is starting to gain momentum with 957,882 square feet currently under construction.

Office completions are down, as most current construction is slated for a late 2006 or early 2007 delivery. As of press time, third quarter completions totaled 576,521 square feet. The vast majority of completions — 404,921 square feet — occurred in the northeast market.

While Arizona and California companies are still active participants in the tenant market, a new trend includes companies from the Gulf Coast/Southeast and the East Coast. The hurricanes’ effect on the former has companies evaluating the cost of doing business in Florida and other Gulf Coast states and looking at Arizona as a more cost-effective alternative.

In one of the highest price-per-square-foot transactions in Arizona history, the Schonbraun McCann Group purchased Westwind Capital Partners’ 302,209-square-foot Class A office building at 24th and Camelback for $113 million or $373.91 per square foot. Private investor Thomas McCarthy purchased the Class A Viad Corporate Tower from F. Johnathan Dracos for $105.6 million. This is the third time Viad, located on Central Avenue and Phoenix, has changed hands in the past 9 years.

The Arizona economy remains strong with unemployment down to 4.2 percent in May compared to 4.7 percent a year ago, according to the Arizona Department of Economic Security. The Phoenix market should continue to see less available space, higher construction levels and increasing rental rates. High demand submarkets, such as the Camelback Corridor, offer a limited selection of availability. Along with limited availability come steep rental rates, which are rising for Class A and Class B office space.  There is currently not enough space under construction to meet the demand, and overall vacancy rates are not projected to rise until possibly late next year.

— Laura Becker is an associate vice president for GVA DAUM.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.