MARKET HIGHLIGHT, OCTOBER 2007

PHOENIX
Jim Hayden, Vince Femiano, Pat Feeney, Bobby Bull and Matt Lockin

The Phoenix market has felt the economic slowdown, but, by and large, the area’s strong fundamentals keep it in very high demand.

Retail

If you’ve been following the nation’s retail market the past few weeks, you know that Phoenix was recently ranked number one for retail building in the country. This growth is a direct result of the housing boom that hit the Valley hard over the past few years, and is a perfect example of retail following behind rooftops.

According to CoStar Group’s Mid-year 2007 Phoenix Retail Market report, the Phoenix retail market currently consists of 3,993 properties totaling more than 157 million square feet of space. More than 10 million square feet of that is currently vacant, putting the vacancy rate at around 6.5 percent.

So far this year, there has been 251,900 square feet of retail space delivered in Scottsdale, 772,400 square feet delivered in the East Valley, 1.1 million square feet in west Phoenix and a stunning 1.6 million square feet of space was delivered so far in 2007 in northwest Phoenix.

Much of the Phoenix retail development currently underway is occurring around the Loop 101 and Loop 202 freeways, specifically near Tempe Marketplace, Vestar Development’s 1.3 million-square-foot center that is 98 percent pre-leased. San Tan Village is also a notable project with 1.2 million square feet that is 100 percent pre-leased. Of the top five retail projects currently under construction, three are in the East Valley: Tempe Marketplace, San Tan Village and Queen Creek Marketplace. The other two are The Promenade at Casa Grande (Pinal County) and Prasada (West Valley).

Another important focus of the Phoenix retail market is the entrance of what will be the first pre-certified LEED (The Leadership in Energy and Environmental Design) Platinum commercial developments in the state.

San Tan Commons, located at the southeast corner of Hunt Highway and Valley View Road in Pinal County, will feature 57,550 square feet of retail, restaurant and pads. The center will also offer 72,000 square feet of office condos. Groundbreaking is planned for September and the center is scheduled to open in summer 2008. M Square, at the southwest corner of Litchfield and Cactus Roads in Surprise, will have 56,750 square feet of retail space and pads. The center will also include 54,000 square feet of office condos. Groundbreaking will begin at M Square in November, with the grand opening slated for fall 2008.

Both developments are a product of c.i. Development Group. It is anticipated that within the next 5 years, all retail developments will be required to have a major green aspect.

In the next few quarters, watch for Tesco’s market entrance. Tesco’s plan is to open 50 stores throughout the Valley in El Mirage, Queen Creek, Gilbert, Mesa and Chandler. This could drive up the price of hard-corner pads and could potentially negatively affect chains like Walgreens, CVS and other C-store operations. Also, watch for Bloomingdale’s to enter the market and Nieman Marcus to expand current operations throughout the Valley.

— Jim Hayden is president of Scottsdale, Arizona-based Retail Brokers, Inc. (RBI).

Office

With the summer’s meltdown in the subprime mortgage market causing a ripple effect in the capital markets and further complicating the housing market, what looked like a slowdown in the rate of economic growth has the potential to turn into something more ominous. It will probably take a few months for enough smoke to clear to really have a better sense of the impact of the credit crunch, but all signs indicate that this crunch will not bleed into a national recession.

While Phoenix has followed the national economy’s slowdown in 2007, its economy remains among the strongest in the nation. Metropolitan Phoenix’s unemployment rate of 3.1 percent still indicates a tight labor market, while 73,500 new jobs were added in the 12 months ending in July 2007. While the housing market has slowed, tourism should remain strong, receiving a boost with Super Bowl XLII coming to town in February 2008.

Office market fundamentals in Phoenix are still strong and should generally remain unaffected, in terms of occupancy and rental rate trends, in the short to intermediate term by the credit crunch. The greater risk to the office market might be the amount of new construction in the Valley and how well that space can be filled. There is currently 7.3 million square feet of office space either under construction or set to be renovated at mid-year 2007. Thirty-eight percent of this space is already pre-leased.

Office vacancy in Phoenix edged up in the second quarter, however, due to increasing rental rates and the injection of new supply into the market. The overall vacancy rate at midyear in the greater Phoenix area was 12.5 percent, up from 10.6 percent a year ago. The net absorption of office space totaled 1.2 million square feet in second quarter 2007, after averaging 1 million square feet per quarter in 2006. Although the market had a slow start this year, it has been steadily improving.

Although office rents are rising, the pace of the rental increase is slowing. Class A rental rates increased at an annualized rate of 3.7 percent by mid-year, down from 4.8 percent (annualized) in the first quarter. However the market is still achieving much higher rents than just 3 years ago. The average rental rate for class A office buildings is $27.54 per square foot versus $22 at the end of 2004.

As stated earlier, we may need a few more months to get a better sense of how the credit crunch will impact the investment market. While leveraged buyers may be out of the market for now, there is room for buyers with patience and cash. Whatever the fallout, investors should remain interested in Phoenix assets due to solid market fundamentals and strong economic and job growth relative to the national economy. The decade-long cycle of cap rate decline is likely over, so price increases in real estate assets will be won the old-fashioned way — by improvement in cash flow performance.

— Vince Femiano is an associate vice president in Transwestern’s Phoenix office.

Industrial

Five years ago, investors and tenants would be hard-pressed to find an industrial building larger than 350,000 square feet in metropolitan Phoenix. Today, of the 10.7 million square feet of speculative product under construction, six buildings or 35 percent of the total are 330,000 square feet or greater.

What’s changed? The need for a better alternative to the California ports situation, for one thing, has driven a number of large distribution users to the southwest Valley, where developers are answering the cries for more space by building a new crop of roomy distribution buildings with large, truck-friendly turnarounds. There, truck drivers are able to off-load and warehouse their goods, restock their big rigs and be back to the coast in less than 11 hours. Phoenix’s lower cost of living, business-friendly laws and relatively inexpensive rents have worked in conjunction with the ports situation to secure the Valley’s growing reputation as a major distribution hub.

Case in point: in the second quarter, Ulta Cosmetics set up operations at 43rd Avenue and Lower Buckeye Road by leasing 328,995 square feet of Lauth Property Group’s barely completed 603,910-square-foot distribution center. Earlier this year, Duke Realty purchased a 604,500-square-foot warehouse/distribution facility at 67th Avenue and Buckeye Road from The Alter Group before the building was even completed. Within 2 weeks of Duke closing on the sale, Amazon.com swooped in and inked a 10-year lease agreement on the entire building.

Jonathan Tratt and KTR are underway with construction of a 1.15 million-square-foot facility at 51st Avenue and Buckeye Road — commonplace for other, more established distribution hubs like the Inland Empire in Ontario, California, but a first for Phoenix. Although the building won’t be completed until year’s end, developers have been entertaining serious inquiries from tenants seeking to take up to three quarters of the structure.

The need for greater swaths of land to accommodate the demand for larger industrial buildings is expanding the boundaries of Phoenix’s traditional southwest distribution market. Developers are being forced to jump from West Phoenix and Tolleson over the city of Avondale, which lacks the proper zoning for distribution land uses, and into the municipalities of Goodyear and Buckeye. SunCor and Duke Realty both have spec distribution projects under construction in Goodyear that are scheduled for year-end completions.

Industry watchers wonder what effect all this new construction will have on the market. The answer remains to be seen. The metro area absorbed 6.1 million square feet in 2006, and second quarter 2007’s 3.1 million square feet of absorption indicates the market is on pace to do the same this year. Although the vacancy rate has ticked upward to 7.63 percent from the 6.65 percent recorded at the end of 2006, the extra vacancy at this point only means more product availability for previously space-starved large users. In addition to the 10.7 million square feet of space presently under construction, 8 million square feet are in the planning stages.

Rent hikes across the board, driven by increasing land and construction costs, as well as higher municipal impact fees to bring infrastructure to undeveloped areas, will do little to put the brakes on activity. Look for the Phoenix industrial market to remain under landlord control through the rest of the year and into 2008.

— Pat Feeney is a senior vice president for CB Richard Ellis in Phoenix.

Multifamily

The soaring single-family real estate market leading up to 2005 and 2006 significantly changed the dynamics for the Phoenix multifamily housing market. Due to quickly appreciating home values, many would-be home buyers were priced out of the market and forced to rent apartments. This fact, along with a low supply of new rental development, helped drive apartment rents up 16 percent during the last 5 years and force vacancy rates below 5 percent.

Currently, due to struggling single-family home sales and serious turmoil in the credit market, many homes originally purchased by investors are now being offered as rentals. Additionally, a significant number of apartments that were converted into condominiums are now being rented. This increase in Phoenix’s existing supply, along with new ground-up apartment construction, has pushed vacancy to almost 10 percent and has nearly halted rent growth.

A total of 106 multifamily properties have traded ownership so far in 2007, totaling more than $2.5 billion in market value. As would be expected following the overheated condominium craze, the majority of properties now being traded are Class B or C assets. Strong rent growth coupled with compression in capitalization rates since 2002 has caused average sales price to soar. In fourth quarter 2002, the average price was $53,556 per unit and $62.45 per square foot. The average sales price for the most recent quarter was $92,865 per unit and $119.23 per square foot, representing a 5-year increase of 73 percent and 90 percent, respectively.

The recent deterioration in the CMBS credit market fueled by poor underwriting and cheap debt has caused many deals to fall apart or be significantly re-traded. Many past and potential buyers in the Phoenix market have placed new acquisitions on hold all together. The remainder of the year will likely see some cap rate expansion as the market adjusts to the rising cost of new debt. Given this “flight-to-quality” mentality in the debt and equity market, look for increased activity in the more supply-constrained submarkets of Phoenix including downtown, South Scottsdale, Tempe and the Biltmore/Arcadia area. These submarkets are not as likely to be as afflicted by the single-family housing fallout and also have significant barriers to entry for new construction.

The vacancy rate has steadily increased in recent months due to languishing home sales and a glut of reverted condominium product. The metropolitan Phoenix average vacancy rate stands at 9.33 percent. This is a significant increase of 2.6 percent from 1 year ago and represents a 1 percent increase during the last 4 months.

Average rents for multifamily housing have remained flat for most of 2007. The trailing 12-month average rent growth is currently $26 or 3.4 percent, down from $47 or 6.3 percent at year-end 2006. Since June 2005, average rents have increased 10.5 percent.

The remainder of the year will likely see continued stagnation in the market fundamentals. No significant change in average vacancy or rental rate is expected to occur before second quarter 2008.

— Bobby Bull is managing director and Matt Lockin is an associate for Transwestern in Phoenix.

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