Back On Level Ground

Now that the US economic recovery is well under way, improvements are being seen across most individual property sectors as well. Whereas some segments—such as multifamily—were doing remarkably well over the past few years while others—like office space—were still suffering, these days industry insiders are reporting upswings across the board.

The reasons behind the trends vary, though the primary drivers involve a combination of job growth, restrained development activity and a wave of optimism among consumers and businesses alike. Of course, each asset class has its own nuances, and potential hurdles to overcome. As part of this year's Annual Review and Forecast, Real Estate Forum examined the conditions in the core property sectors—office, industrial, retail multifamily and hotels—and what we can expect to see this year.

Job Growth Pushing Office Recovery

Even though the US economy started to pick up speed several years ago, the office sector seemed to drag its heels. Tenants of all sizes were shrinking their footprints in attempts to use space more efficiently. That trend has certainly not disappeared, but experts say that at some point during 2014, job growth in the office sector took over, and once again tenants began adding more space. And 2015 promises more of the same. In fact, the revival of the office sector should encompass not only the core CBD markets, but many suburban areas that during the recession suffered an even steeper decline.

“We're very optimistic,” says Kevin Thorpe, DTZ's chief economist, Americas. “We see office emerging as the darling of commercial real estate this year.” The US office sector was quite robust in the latter half of 2014, absorbing about 44 million square feet, which would roughly equal on an annual rate the amount absorbed in 2005. In 2015, DTZ forecasts that users will continue at the same pace and absorb about 89 million square feet.

Furthermore, the overall vacancy rate fell from 14.8% in the third quarter to 14.5% in the fourth. And more than three-fourths of the 80 metro areas tracked by DTZ saw fourth quarter occupancy gains.

Still, certain regions did see a much greater increase in activity. Net absorption in the West increased 89% over the previous year; the South was up 36%; but the Midwest and Northeast only saw a 1.2% boost. And even though average asking rents in the US rose just 2% over the past year, San Francisco saw a 17.2% increase and Houston rents were up 9.0%. 

Thorpe says the plunge in oil prices could bring somewhat more balance in the coming year. Much of the growth in 2014 happened in Texas and other energy-driven metros like Denver. “We anticipate a cooling in these markets. But every other city that isn't an energy market, which is 97% of them, will benefit.” If oil continues to hover around $50 per barrel, “most markets will see 10% more demand than they otherwise would have.”

“This is not going to be a recovery just for the global gateway cities,” Thorpe adds. “This could be the year of the secondary markets.” Outside the gateways, many in the office sector have been “licking the wounds caused by the recession,” which kept rent growth low. But with a booming jobs market, not merely rent growth but “a rent pop could be coming to those secondary markets.”

The suburbs showed improvement in 2014, but at a more moderate pace than CBDs, according to Paula Munger, Americas research director for Cushman & Wakefield. The CBD vacancy hit 12%, a drop of 150 bps, and the suburbs saw a decline of 70 bps to 16.3%. Rents in the nation's CBDs grew 4.2%, double the rate seen in the suburbs. But positive absorption in the latter was 26.9 million square feet, the most since 2006.

[IMGCAP(1)]

Still, even though the suburbs have performed better, many occupiers will continue to prefer the urban core as they attempt to attract the many Millennial workers that now reject the suburban lifestyle. “I don't see an end to this downtown trend,” Munger says. “That's what we're hearing from our clients.” However, transit-oriented suburban areas, such as Tysons Corner in Northern Virginia, which can provide solid live/work/play environments at a lower cost than urban cores “will do well in the coming years. It's got to be the right mix of amenities and competitively-priced housing,” the lack of which in some markets “is shutting out Millennials.”

The construction of new office space should also accelerate in 2015. Last year, developers finished 21.75-million-square-feet of new construction, roughly equal to what was done in 2013, but this year C&W forecasts that 36-million-square-feet will come on-line. However, Munger points out that this represents only 1.1% of total inventory and due to a strong jobs forecast even this increased growth of new construction will not equal the accelerating demand for new product.

“We see that as a good thing,” she says, since it means a vicious cycle that eventually spirals out of control won't get started. “We're not going to have an oversupply situation.” Instead, over the next year increasing tightness in the markets should lead to a rental rate increase of between 4% and 6%.

 “We're seeing the fastest job creation since the late 1990s and most geographic areas are starting to see substantial upticks in hiring,” says John Sikaitis, JLL's managing director for local markets and office research. Job openings are up about 20% year-over-year, the data show, and more employees quit their jobs these days, a sign of confidence that other jobs are available. And in 2015 and 2016, “our forecast calls for even heightened growth.”

“That is going to have a big impact on occupancy in the next 12 to 18 months,” he adds. JLL tracks leases of more than 20,000 square feet and in the fourth quarter 46% of these involved an expansion. In other quarters during the recovery this number was typically between 15% and 20%. “Demand has definitely increased at a much more frenzied pace,” Sikaitis concludes. 

Industrial Gets Shot of Adrenaline

The tremendous improvement in the US economy has given a lift to most sectors, but industrial real estate has gotten an additional shot of adrenaline from the transformation of the nation's logistics network. Experts say a profound change has occurred in just the past six or seven years, as logistics providers shifted from a focus on store replenishment to speedy customer delivery.

“Throughout this cycle, we've had the growth of e-commerce and the continual perfection of the supply chain,” says Craig Meyer, president of JLL's industrial brokerage group. “E-commerce has become a core competency for many retailers.” Customers once content to wait five or six business days to receive a purchase will now seek out retailers who can deliver it in a fraction of the time.

These widely held expectations have fueled the demand for even larger, technologically advanced fulfillment centers and should keep industrial developers busy throughout 2015 and beyond. In fact, according to JLL market data, sixty tenants from across the nation are currently looking for big box warehouses of one-million-square-feet or more, a level of demand that outstrips available sites by a nearly three-to-one margin.

Further, demand may continue through several business cycles, even if other sectors experience downturns. “A lot of retailers are still figuring out their e-commerce strategy,” Meyer says, and are not yet ready to announce plans for million-square-foot buildings.

[IMGCAP(1)]

David Egan, head of industrial research, CBRE Americas, believes landlords will also see healthy rent growth in 2015, which in turn should help fuel development. In the aftermath of the economic collapse in 2008 and 2009, “rents fell faster and further than they ever did.” But since the recovery began, about half of that roughly 20% drop has been made up, “and in the coming year alone we will make up about half” of the remaining gap. In 2016 similar rent growth should finally make up the losses from the recession. “Developers will be able to comfortably underwrite development,” and kickstart “a strong renaissance in the industrial market.”

Still, “development has been quite disciplined,” Meyer says, another trend he thinks will endure. Large institutional owners working in multiple regions now handle much of the nation's big box development and seem reluctant to overbuild. “We have not gotten ahead of ourselves in any market and it doesn't feel like new development will get out of control.”

In 2014, developers completed about 135 million square feet of new distribution center space, JLL found, and in 2015 they should quicken the pace to about 171 million square feet. Although that would be the most completed in seven years, it would also remain slightly below the 40-year historical average of 178 million feet.

And with all of the economic indicators looking moderately positive, Meyer says “we don't see any major changes in 2015 or even 2016 that will upset the apple cart.”

This bodes well for investors, who have already responded to the increased trade, production, employment and consumption in the US. In 2014, according to the latest research from CBRE Group, Inc., the “investment volume in US industrial properties totaled $54 billion in 2014, a 13% climb over the prior year. If industrial investment continues to rise at the pace set in 2014, the 2015 volume will reach the prior peak of $61 billion, set in 2007.”

The nation's industrial revival should also start to encompass not just modern big box distribution, but light industrial product as well, Egan says. Demand for this sector has been solid, but rents have not grown very much. He expects rents will improve this year, partially because retailers have started to realize they also need smaller facilities in urban cores to quickly complete many customer deliveries. And light industrial buildings tend to be in older, infill markets that can service this niche. “These facilities will be absolutely critical,” making class B properties well positioned to see a spike in demand.

“The light industrial space saw the greatest gain in investment activity, largely as a result of stronger market fundamentals,” CBRE research showed. The sector “saw a 24% increase in sales volume in 2014, while investment in warehouse space rose 9%.”

And the economic recovery has also spread out far beyond top markets such as the Inland Empire. In 2014, industrial leasing activity in the US reached 340.3 million square feet, a 3.6% boost over 2013 and the most since 2005, according to John Morris, Cushman & Wakefield's leader of industrial services. “Nineteen of the 38 markets Cushman & Wakefield tracks posted increased activity year-over-year, and 14 markets recorded double-digit gains.” Atlanta saw a 51.5% increase, the most of the top performers, and a surprise to “just about everyone. It was simply the last major market to recover.”

“The industrial market is well-positioned to gain further momentum in 2015,” Morris says, but he agrees with other experts that in some ways this recovery is different. According to C&W research, at the end of last year developers had 105.1-million-square-feet of industrial inventory under construction, and speculative projects accounted for 66.8% of the space. That is near the historic low, but for several reasons, Morris does not expect it to change much.

The relatively low number partly reflects the greater discipline among developers and the desire to avoid overbuilding, he says. But the growing need of distributors to secure custom-designed high-tech facilities that can handle the intensifying demand also means that speculative buildings, which typically have a more standard design, will be less appealing. Furthermore, many of the development world's big players “have gotten better at interfacing with clients” and designing product that suits their needs. “They are much better at it than they were ten years ago.” Therefore, the declining importance of speculative development “feels to us like the new norm.” 

Retail Consumers Are Back

Belying the fact that e-commerce continues to erode the market share of brick-and-mortar operations, and that a few of the most venerable names in the sector have either filed for bankruptcy or are rumored to be next in line for doing so, retail is a growth business in 2015. Occupancy levels are up, as are investment sales, and the year is likely to see a number of major entity-level consolidations, whether among owners or occupiers.

During 2014, “resilient absorption rates and receding vacancy” characterized the retail sector, according to Avison Young's 2015 forecast. Cushman & Wakefield data put the overall vacancy rate at 6.1% for the fourth quarter, with vacancies for individual market segments ranging from 4.2% for general retail to a high of 9.4% for the neighborhood/community/strip center segment. Reis Inc. has projected that national rent growth would accelerate from 1.4% in 2014 to 2.5% in 2015 and 3.2% in 2016.

Behind these numbers, of course, is increasing consumer confidence and, therefore, an increase in retail sales. C&W notes that holiday sales for 2014 reached their best levels since 2005 with $617 billion, and propelled a 4.1% year-over-year increase to $5.3 trillion for the year.

[IMGCAP(1)]

Looking at the current year, C&W says, “The outlook for 2015 remains very positive. The US economy is poised to record its best year of growth in at least a decade, with conservative projections of GDP growth in the 3.0% to 3.5% range. Consumers are optimistic, given rising incomes and healthy job growth, which will drive increased consumer spending.”

C&W expects supply-side characteristics to continue improving as well, “thanks in part to the still-restrained construction pipeline. As market fundamentals strengthen, retail real estate will benefit. Available space will continue to be absorbed as retailers, both traditional and online-only, reassess their bricks and mortar strategies in the context of an increasingly complex omni-channel marketplace.”

Not only decisions made by retailers are determining vacancy rates in the face of e-commerce. “In recent years, online retail sales increased exponentially, while some traditional shopping malls and retail centers suffered from decreased sales, increased vacancy and postponed capital projects,” according to the 2015 Expectations & Market Realities in Real Estate report from Deloitte, the National Association of Realtors and Situs/RERC. “However, the balance may be shifting back in favor of the traditional store for several reasons.”

While the avoidance of sales tax was once a big attraction for many online shoppers, “due to changes in internet sale tax laws by some taxing authorities, many companies are now collecting tax on any order shipped to a state where that company has a presence,” the report states. It notes that Amazon, the 800-lb. gorilla of online retailers, is now collecting taxes on purchases shipped to 23 states.

“With respect to shipping costs, the idea of free shipping is slowly fading,” according to the Expectations & Market Realities report. “Many online retailers are increasing the prices of goods to maintain the illusion of free shipping or are requiring larger minimum purchases to qualify for this benefit. In addition, the idea of price steering or targeted marketing gives some consumers reason to pause. The combination of these and other practices may be enough to get consumers back in the stores to regain their sense of connection with sellers and the products they are shopping for.”

Given these encouraging market trends, it stands to reason that investment sales in the sector have increased. In fact, with $82.6 billion in transactions during 2014, retail sales volume exceeded the 2007 peak and rose 31% Y-O-Y, the highest annual increase of any property type, according to Real Capital Analytics.

Dollar volume may have exceeded 2007 levels, but pricing is another story. The Moody's/RCA Commercial Property Price Index rose 5.3% Y-O-Y, the smallest gain of any sector and still 13.7% behind the peak set in 2007.

The biggest Y-O-Y gains were in sales of urban/high street retail properties, where the $13.1 billion of volume represented growth of 60% from a year earlier. RCA notes that the tally for urban/high street was slightly skewed due to a few trades of $200 million-plus in Manhattan last year, “but excluding these, this segment still saw 45% growth from 2013.” The major weakness in volume came from the mall segment where sales fell 6% Y-O-Y to $9.9 billion.

The perception has been that retail has lagged the recovery as consumers have kept a tight hold on their wallets, but the 2015 Emerging Trends report from PricewaterhouseCoopers and the Urban Land Institute suggests that this will be subject to change. For retail since the 2008 financial crisis, “Optimism has seemed premature—or even unrealistic,” according to the PwC/ULI forecast. “It is time to question that. The trend for retail for the second half of this decade should be a story of expectations exceeded—expectations that continue to be set too low by those wounded in the last battle.”

Multifamily Growth Outside the Core

The ongoing debate surrounding multifamily is whether the sector can sustain the momentum over the next few years, with concerns about overbuilding and declines in rent growth, along with a worry that maybe Millennials aren't quite as predisposed toward the idea of renting as they advance in their careers and start families.

As a measure of how much construction is taking place in the apartment sector, Phoenix-based Rider Levett Bucknall recently counted tower cranes in nine major US cities and found that multifamily development was responsible for the majority of projects in seven of those cities: Boston, Chicago, Denver, Honolulu, Los Angeles, New York and Seattle. The findings of the inaugural North American RLB Crane Index indicate that “residential developments are driving growth across the US,” Julian Anderson, president of Rider Levett Bucknall North America, said in January. “We expect that this growth will continue to increase throughout 2015.”

[IMGCAP(1)]

Even so, Pierce-Eislen, a Yardi Systems company headquartered in Scottsdale, noted that the nationwide tally will come in below the long-term average of 300,000 units per year. With 296,848 units expected to come on line during 2015, it's not that far below the norm, though. The increase in supply will lead to an uptick in vacancy, says Dallas-based Axiometrics, with the current 5.3% vacancy increasing to 5.7% by the end of this year. Simultaneously, annual effective rent growth is expected to reach 4.1% for the first quarter of 2015 before dropping to 3% by year's end.

Yet a USC Lusk Center for Real Estate study found that household formation has rebounded to pre-recession levels, a demographic finding that favors apartments while the single-family housing market is still recovering by fits and starts. Meanwhile, Real Capital Analytics reported that sales of apartment properties priced at $2.5 million and greater reached $112.4 billion in 2014, a 9% increase year over year and 7% above the previous peak reached in 2007. That number is coupled with an even bigger Y-O-Y increase in pricing: 14% overall, with prices on mid- and high-rise properties growing faster than those for garden apartments.

Further, a survey from Capital One Multifamily Finance shows that 29% of respondents expect to be net sellers in 2015, up from 18% a year earlier, along with 47% who said they'll be net buyers. Taken together, these figures point to a more active year than we saw in 2014, says Grace Huebscher, the firm's president.

And while the urban core is hardly losing its appeal, recent reports suggest growth opportunities outside the CBD. For instance, Pierce-Eislen predicts that in 2015, the apartment rent-growth story seen in the first few years of the recovery will invert itself. That is, the faster growth shown by class A properties will instead go to class B and C assets this year. The reason, according to Pierce-Eislen, is the advent of new supply. Although the tally for this year is still projected to come in below the long-term average, it will affect a handful of submarkets more deeply, and the upper end of the market in particular. Accordingly, class A's projected rent growth of 4.5% comes in below the predicted 5.1% for B and C properties.

The best performers in terms of rent growth among class A “lifestyle” properties are predicted to be “technology-heavy Western markets with restrained supply growth,” such as Denver, San Francisco and Seattle, all of which are projected to top 7% year-over-year rent growth in class A, Pierce-Eislen says. The firm notes that Atlanta, where rent growth started later than in other cities, is poised for “another strong year.”

However, the multifamily sector appears to have gotten the memo that being in the suburbs has its advantages. AvalonBay Communities said recently that it would shift its new-development emphasis toward suburban markets, a decision driven largely by trends in rent growth and occupancy. During the fourth quarter of 2014, the Arlington, VA-based apartment REIT began construction on three new projects at a total cost of $168.3 million. All were in suburban markets.

At the National Multifamily Housing Council 2015 Apartment Strategies Outlook Conference in January, a panel of experts affirmed that development outside the urban core is thriving, contrary to widespread perceptions. Two of the panelists came from multifamily analytics firm MPF Research, which recently published a study of “good” suburbs and how they compare to CBDs. “'Good' suburbs perform in line with CBDs because they share many of the same characteristics: more jobs, higher incomes, higher home prices, more amenities and proximity to major highways or rail stations,” according to Carrollton, TX-based MPF.

The company's study of the nation's top 50 metros defines “good” suburbs as submarkets outside a CBD that had two factors in common: “They're within economically healthier metro areas (those with net employment growth of at least 3% over the past six years) and have average monthly rents that top their parent metro's norm. It's a fairly simple line of demarcation, but it tells a compelling story.”

Good Times Keep Rolling for Hotels

“Many hotel investors are expressing strong interest in hotels due to improving property-level metrics and low supply additions,” reports the 2015 Expectations & Market Realities in Real Estate from Deloitte, the National Association of Realtors and Situs-RERC. The metrics will continue to improve over the next few years, although new supply will begin to tick upward during that time, as well.

“No matter what hotel performance indicator you look at for any type of hotel, we foresee extremely favorable movements the next few years,” R. Mark Woodworth, president of PKF-Hospitality Research, said in December. “Our firm is projecting demand growth to outpace changes in supply in the US through 2016. That will result in industry wide occupancy levels at, or above, all-time record levels through 2017.” RevPAR growth, for instance, is expected to exceed long-term averages across all chain scales through 2017, while ADR is forecast to increase by an annual

average of 5.4% for the next three years. That will drive an average 11.8% annual rise in unit-level NOI during the same period, including a 13.2% year-over-year increase projected for 2015.

[IMGCAP(1)]

Illustrating the appeal that the lodging sector has for investors, Real Capital Analytics reported in January that hotel investment volume came in at $34.6 billion in 2014, up 27% from a year earlier. The research firm notes that making broad-based comparisons to the previous cycle represents “a bit of a stretch, given the impact of the Hilton and Station Casinos entity-level deals in 2007.” Those two deals—Blackstone's $26.1-billion buyout of Hilton and Station Casinos' $3.1-billion sale to a partnership of the Fertitta family and Colony Capital—come close to equaling the 2014 total, thus making a comparison between the two years one of apples and oranges. RCA suggests that when individual sales for 2014 are considered apart from portfolio deals, volume comes in at $22.3 billion, “very close to the $22.9-billion high water mark set in 2006.”

Lodging Econometrics reports that for the $30.8 billion of 2014 transactions it tracked, the average selling price per room was $156,002, representing a “dramatic” 20.6% year-over-year increase. It's also up about 270% from the trough of 2009, when 427 reported transactions carried an average per-key price of $57,434. The Portsmouth, NH-based company attributes the Y-O-Y increase to “record-setting hotel revenues and profits, low interest rates and the availability of attractive financing terms.”

Longer term, LE foresees selling prices continuing to accelerate for the next several years, “as hotel performance continues to shine in the absence of any significant new supply. A critical part of the equation is that interest rates, although expected to rise, still remain attractive, causing competition to intensify for prized single assets and portfolios.”

In 2014, LE says, there were 799 single-asset transactions and another 481 hotels that changed ownership in the context of portfolio sales. “A mere 12 hotels were recorded as part of merger activity,” according to LE. “It is thought that any significant industry-wide consolidation of companies and brands may still be at least two years away, after the expansion phase of the current real estate cycle concludes and the maturity phase begins in 2017.”

As for development, LE says the pipeline is now fuller than it's been in six years. However, the firm notes that a six-year high doesn't match the previous cycle's peak, and pipeline totals are still a long way from the peak of 5,438 projects and 718,387 keys set in 2007.

As it is, however, the total construction pipeline in the hotel space currently stands at 3,645 projects totaling 460,551 keys. “After a three-year bottoming formation, the pipeline has now posted five consecutive quarters of double-digit year-over-year growth,” according to LE. “In both the third and fourth quarters increases were particularly impressive, exceeding 20%.”

By category, projects under construction, the most important predictor of near-term supply growth, has zoomed ahead 37% by projects and 34% by rooms YOY. In terms of numbers, that translates to 1,086 projects and 136,442 keys, the highest level in more than five years. The numbers of projects scheduled to start construction in the next 12 months have risen strongly to 1,351 projects and 160,061 rooms. Those figures are up 17% and 13% YOY, respectively.

Even with these figures, yearly supply growth is expected to remain modest. After 557 openings in 2014, LE projects 726 properties to go on line this year and 797 in 2016. The firm says that new hotel openings aren't expected to peak until 2018-2019. That's because the typical hotel project takes an average of 22 months to migrate through the pipeline “before eventually opening as an addition to new supply.”