Dynamic Market Presents Opportunities for Buyers and Sellers

Positive economic indicators, especially healthy employment growth, will support improving property fundamentals and sustain the strong investor appetite of the past few years. While appreciation is likely to slow over the next year as rental-market fundamentals catch up to prices, favorable demographic trends and job creation will translate into strong long-term NOI growth, supporting buyer demand and valuations.

While the heavy capital flows of the past few years have significantly compressed cap rates, long-term investors can benefit from the stability and rent growth offered by markets experiencing strengthening numbers. And while increasing interest rates may siphon off some pent-up investor demand and slow appreciation, transaction volume will remain strong as the need for low-risk cash flow dominates the investment strategy of investors, who range from aging baby boomers to institutional investors and REITs.

Office: Higher Returns Attract Investors. The good news is that the office market is on its way back after hitting its cyclical bottom in 2004. While it will take several years for the market to return to equilibrium, employment growth, positive absorption and declining vacancies are a welcome change. We expect absorption to register 60 million sf this year and the national vacancy rate to improve by 110 basis points to 15.6% by year end.

The investment market should gain momentum as more investors seek to ride the sector's recovery and capture higher returns. While the divergence in prices and fundamentals has produced significant cap-rate compression, office properties still possess rates that are 100 basis points to 250 basis points over apartment and core retail assets.

Depending on their strategy, investors should find appropriate opportunities. Markets such as Fort Lauderdale, FL and Riverside-San Bernardino, CA have moderate price-to-rent ratios, but strong job and rent growth make them solid candidates for appreciation and short-term investment plays. Conversely, markets such as New York City, San Francisco and San Jose have relatively high prices given current rents; however, they have positive long-term outlooks due to factors such as high barriers to development and strong foundations in financial and/or new-economy industries.

Retail: Stability Attracts Broad Investor Pool. Retail is the only property sector with growth in net income over the past three years based on national averages. Limited construction and strong consumer spending have fueled strong market fundamentals. Not surprisingly, retail investments have attracted a flood of capital, producing elevated prices and compressed cap rates. The average cap rate for multi-tenant properties fell 70 basis points to 8.1% in 2004. The national vacancy rate will dip below 10% this year, with stable rent growth of approximately 2.5%.

Grocery-anchored centers remain at the top of many investors' lists. However, challenges facing the grocery industry are producing more investor caution. Investors are investigating an anchor tenant's staying power as well as the likelihood of a Wal-Mart moving into the area. As the retail giant continues to expand across the nation, it is estimated that for every new Wal-Mart Supercenter, two grocery stores will close.

Single-tenant investments have become increasingly popular over the past few years. With demand exceeding available supply, prices of single-tenant net-lease properties jumped approximately 12% in 2004, to around $200 per sf, while cap rates declined to an average of 7.6%. Properties differ significantly by tenant and location, but quality properties with a credit tenant in a prime market can sell at sub-6% cap rates. Baby boomers and retirees comprise a large share of the buyer pool, and many of these investors are willing to trade in strong returns for safety and minimal upkeep.

Apartment: Stage Set for Improving Fundamentals. Healthy employment growth combined with a slowdown in home buying will fuel increased tenant demand in the apartment market and sustain the strong investor appetite of the past few years.

National vacancy registered a 20 basis point decline in 2004 to 6.8%. Further improvement to 6.4% is forecast for 2005. Concessions will begin to burn off in most markets, which will help effective rents climb 3.5%, outstripping asking-rent growth by 150 basis points. On a national basis, the median price per unit is up more than 50% since 2000, to more than $93,000. Cap rates have compressed more than 200 basis points over the past three years and are expected to remain low over the coming year.

Long-term investors who can afford to pay a lower cap rate in a market with higher rent growth—players with longer horizons such as REITs, institutional players or multi-generational investors—are buying in markets such as Washington, D.C. ; Boston ; and Los Angeles. They're betting on the long-term stability of those markets because of better-than-average rent increases. Investors looking to capture some upside in rents may consider some of the nation's high-tech markets, which are starting to show signs of revival after several years of economic malaise. With increasing business investment in equipment and software, markets such as Seattle, Austin and San Jose will realize employment gains that will translate into strengthening tenant demand for apartments.

Think Tank member Hessam Nadji is a managing director of Encino, CA-based Marcus & Millichap Real Estate Investment Brokerage Co. Nadji, who is located in the Walnut Creek office, oversees the firm's research services division.