A Familiar Recovery Pattern With a Twist

 Conventional wisdom in the real estate industry says that in recoveries, apartments and hotels come back first, followed by retail, industrial and finally office. The thinking is as follows: Apartments are first, since demand can expand quite rapidly once renters and potential renters feel that it is economically safe to unbundle (for young adults to leave their parents, or for roommates to separate). Hotels also recover quickly, due to the virtually non-existent lag time between a return in consumer and business confidence and the booking of rooms. Retail is next, due to the fact that retail sales generally lead a recovery, and retailers are notoriously nimble in responding to any change in consumer demand. There is some lag time with industrial, due to factors such as: growth during the recession of under-utilized space, and reluctance among industrial users that were hard-hit by the economy to commit to new space until it is clear that the recession is over. These dynamics also apply to office users, only amplified by the lag between an economic recovery and hiring, as well as the high transaction costs and lead time associated with an office move.

They are further intensified by the supply side: Office buildings generally take longer to build than apartments and industrial buildings, causing supply to come online long after a recession begins and vacancy rates to peak much later than they do for apartments or industrial.

 The question is: Does this conventional wisdom still apply in the recovery that is currently underway? The answer is yes.

 The apartment market is leading the way, once again. Tenant demand for apartments has exploded in 2010. Vacancy rates have dropped to 7.1% nationwide, down from 8% at the end of last year, and are sub-6% in a number of key markets, including New York, Washington D.C., and most of coastal California. Effective rents are growing in most markets, and in some markets rents appear to be on the cusp of acceleration. Investors have responded in kind, and prices are inching upward and cap rates have fallen substantially. A lack of product, however, has limited the amount of sales activity that can take place. Upward price pressure will likely occur when significant job growth occurs. Historical data indicates that job growth is a strong predictor of multifamily-price appreciation.

 Retail vacancies are also starting to fall having reached a peak of 10.3% nationwide in Q1 2010 (they currently stand at 10.2%). Effective rents are starting to firm, following year-over-year losses averaging 7.0% as recently as Q4 2009. If historical patterns repeat themselves, the drop in vacancy rates will accelerate over the next year and a half, and effective-rent growth will occur starting as soon as spring 2011, sooner than that in key markets.  Prices would follow a similar pattern.  One concern, however, is whether the retail recovery this time will be as rapid and prolonged as previous recoveries.  The lack of any significant job and income growth suggest that this time, it may be a slower recovery than we are used to.

The recovery in industrial is lagging the recovery in apartments and retail as expected. Vacancy rates have peaked: Nationwide, they have hovered in the high 12% range since Q4 2009. Effective rents, however, have continued to drop by an estimated 11% year-over-year. In key markets, the decline s is more in the -4% range. Prices continue to fall, although at a much slower pace than in 2008 and 2009. The outlook is for vacancy rates to start dropping and for effective rents to start firming soon. Conventional wisdom suggests that rent and sales-price growth may not take place until late 2011 or early 2012. This time around, however, the industrial recovery may be an exceptionally strong one, enhanced by increased globalization (requiring greater storage and movement of goods) and a relatively cheap dollar (increasing worldwide demand for US-made goods).

As in previous cycles, the recovery in office is last. The national office vacancy rate has continued to climb, albeit at a slower pace than in prior years. It currently stands at 17.6%. Effective rents are still shrinking, although at a slower pace than in 2008 and 2009. As of Q3 2010, they were down 5.6% year-over-year. Office sales activity is low, but prices and cap rates appear to have firmed. The outlook is for vacancies to peak and rents to stabilize soon, but significant declines in vacancy and increases in rents and prices are not expected until 2012. Job growth is particularly important in the health of the office market, and thus far it has been lackluster.  However, when it does kick in (2012?), the possibility of price spike exits. Sales prices in office are particularly volatile, and when they climb, they tend to climb precipitously.

As in previous cycles, Class A properties and segments have been the first to attract investor interest. This will likely be followed by increased interest in Class B and C assets as opportunities in the Class A market become more scarce and expensive and as investor confidence increases. This suggests that strong opportunities exist now in the Class B and C segment for the contrarian investor.

Hessam Nadji is managing director, research and advisory services at Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com.