Pent-Up Demand, Liquidity Feed Southeast

Real Estate Southeast Markets is part of the Forum LOCAL series of features in Real Estate Forum magazine. This is an HTML version of an article that ran in Real Estate Forum. To see the story in its original format, click here.

From population growth to economic strength, the Southeast is giving commercial real estate developers, investors and advisors something to write home about. Economists predict expansion in Southeast metros as the post-housing bust markets post sold growth and boost overall commercial real estate demand.

The Southeast is bucking the national population growth trend. While growth is slowing overall, US Census data released in March reveals the Southeast is leading the nation's population growth, with Orlando topping the list at 5.4%.

“The Southeast is growing and will continue to grow from a population perspective, and that creates opportunities for the real estate industry,” says Bob Peterson, chairman and CEO of real estate investment, development and advisory firm Carter in Atlanta. “When you've got solid growth in the population, you're going to have solid growth in construction business.”

THE GREAT BIG TRENDS

Commercial real estate industry watchers see plenty of emerging and growing trends in Southeast markets, from collaborative officing to affordable multifamily to live-work projects. Mixed-use remains a hot trend but another “M” word—Millennials—is demanding even more attention from developers across diverse property types.

“There is a lot of talk in the industry about creative office and collaborative environments, but what that means to each company is different,” says Marc DeLuca, eastern regional president of KBS Realty Advisors, a buyer of commercial real estate and structured debt investments headquartered in Newport Beach, CA. “In some office markets we are seeing fully open floor plans and in other markets we are seeing traditional offices but with a design that gives a feeling of openness that still allows a confined work space to provide an area free of distractions.”

One consistent Southeast trend DeLuca sees: Companies want to be more productive with happy, healthy employees that like where they work. One solution is to incorporate collaborative workspaces in the mix and locate in areas with abundant amenities, such as restaurants, athletic activities, mass transit, retail and nearby residential.

“The obvious ongoing trend is the continuing movement of Millennials to the urban core,” says Peterson. “They want to live in a place where they don't spend half their life in a car. Now as Millennials age a little bit and start having children, the desires may change. Many folks in the South have not really grasped the long-term benefits an urban life completely. There are still a lot of people that want their yard and space, so that's going to factor in at some point.”

The Southeast is one of the most affordable regions in the US for Millennials, according to RealtyTrac. Fayetteville, NC, Atlanta-Sandy Springs, Jacksonville, FL, Nashville-Davidson and Greenville, NC were listed among the most affordable housing markets for Millennials. Of course, this demographic is not the only one that needs affordable housing.

“There's also no question that the affordability of housing is a real barrier for folks,” Peterson says. “That's why the multifamily apartment market has seen tremendous growth and a tremendous amount of construction. We're seeing rising rents and very strong occupancy rates.”

WILL OFFICE GET WHITE HOT?

Everybody needs somewhere to live, and with the population in the Southeast growing faster than the rest of the nation it's no surprise that multifamily would ride that tide. Despite some talk about a bubble forming, most industry watchers don't anticipate multifamily will cool down any time soon.

“Interest rates are still at historical lows and with Europe holding on to negative rates, we don't see a rise in the near future as it puts more pressure on the US bond market,” says Judd Bobilin, CEO of Chance Partners, an Atlanta-based fully integrated real estate firm specializing in the development and management of residential and mixed-use assets. “Equity capital is plentiful and needs a home, debt markets have expanded and are at pre-recession levels with the strong comeback of commercial mortgage-backed security.”

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Carter's Peterson acknowledges the multifamily trend but says the office sector is also growing fast—and predicts we will likely see even more office building starts in the Southeast in the near future. That's partly because the Southeast office market has always had relatively limited barriers to entry, which has created an oversupply situation for a long time in the major cities.

“You're now starting to see a lot of pent up demand in office, and most of it is driven by a desire to change the way companies work, versus just needing more space,” Peterson says. “Companies want less space per employee, because employees are out and about and working remotely. They're looking at the total cost of occupancy, which includes travel time and that type of thing. Instead of more space, they're looking for better and smarter ways to have office space.”

KBS' DeLuca is also pointing to the office sector. KBS partnered with Kane to develop a spec office building in Raleigh, for example, and reports strong leasing activity from professional services and biotech firms. Recently-acquired KBS office product in Nashville and Atlanta has leased into the upper 90% level and continues to see rental rate increases with each new transaction.

“Private office work is benefitting from the movement towards mixed-use, live-work projects which often combine high-rise living with work spaces, entertainment sites and rapid transit,” says Alex Carrick, chief economist at Norcross, GA-based CMD Construction Data. “They appeal to both senior-aged empty-nesters and 20-something young workers who are coping with student loan debt. They're also less inclined to buy cars these days, preferring the latest electronic gadgetry instead. Both the elderly and the young like the convenience of 'clustered', often downtown, living.”

Peter Muoio, chief economist at Irvine, CA-headquartered Auction.com, an online marketplace for buying and selling real estate, is pointing to the hospitality industry as white hot. He reports personal and business travel is increasing strongly, lifting all the Southeast markets. “We will have to watch for any impact of the strong dollar and weaker European economy on international travel to Florida cities like Miami and Orlando,” he says, “but otherwise this sector is really in good shape in the southeast.”

In 2015, Ernst & Young (EY) predicts the Millennial generation will continue to wield profound influence on how the industry looks and what services hoteliers are developing for guests. Mark Lunt, EY's Southeast US, Latin America and Caribbean Hospitality Leader, says: “Today's emerging traveler—Millennials and millennial-minded guests—is not looking for their parents' hotels and experiences and they are more cost-conscious and experience-focused than ever before, whether traveling for business or leisure.”

CITIES TO WATCH

If you ask industry watchers the cities that interest them most, you get a laundry list—and a lot of agreement. South Florida as a region is high on the list, along with Nashville, Charlotte, Raleigh-Durham, Charlotte, Atlanta and Jacksonville, Tampa and Orlando, FL. The basics of job growth, population growth and income growth are key drivers.

“Nashville is in a tremendous boom, as is Charlotte,” Peterson says. “We're also seeing a large amount of activity in Florida. Miami has always been an area where you have incredible amounts of wealth that drive up the pricing and popularity of the residential and retail sectors. There's also Tampa, Orlando and Jacksonville—all of these markets are experiencing positive absorption. Of course, Atlanta is still an enormous market as well.”

Auction.com's Muoio spotlights Nashville and Raleigh as hot areas for investors. The common denominator between those two cities: strong downtowns that are turning the heads of Millennials, as well as strong education and healthcare drivers and burgeoning professional and business services. For its part, Raleigh-Durham is benefitting from the tech and biotech boom. Muoio says an attractive lifestyle, low cost of living and job growth are attracting people to move in, boosting population and helping drive residential and retail demand.

“We also recommend that investors pay attention to the 'post-housing bust' markets,” Muoio says. “Atlanta and the various Florida markets went through a severe and prolonged downturn and now have sullied reputations. But now, with housing no longer exerting a drag, their economies are growing strongly and population growth is picking up. Meanwhile, development is uncharacteristically quiet for the most part, providing a setting for solid gains in commercial real estate fundamentals.”

LIMPING CAUTIOUSLY ALONG

That doesn't mean that the Southeast from end to end is hitting on all cylinders. The Southeast is marked by rural areas—secondary and tertiary markets—that are still struggling even while metro markets boom. Some industry watchers expect true suburban office and multifamily to continue struggling with lack of rental growth as concessions continue.

“Tertiary markets are suffering some,” says Bobilin. “It really is a function of where investor demand is willing to go to acquire deals. Most investment committees are going to look at only what and where they have been before and not where a new emerging market might be.”

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Some of the strugglers and stragglers in the Southeast include Montgomery, AL and Memphis. Memphis, in particular, stands out in light of nearby Nashville's revival. Muoio notes that Memphis' economy is struggling and poor demographics are holding back its commercial real estate segments. The only bright spot in Memphis, he says, is multifamily.

Beyond the strugglers and stragglers are the overlooked. Chance's Bobilin argues that one of the most overlooked commercial real estate markets, especially from a risk-adjusted standpoint, are college towns. As he sees it, college towns, on all fundamental levels, have performed strongly in the recession and in the subsequent recovery.

“Our tendency and research has shown that the primary schools are significant drivers of economic growth in these markets,” Bobilin says. “Although many state budgets have cut funding by 30% for state schools, the universities have adapted and those markets have performed extremely well. It's not just the student housing market;  retail and hospitality also have benefited.”

THIS IS NOT GOOD NEWS

Capital markets are still strong but some are predicting Fannie and Freddie will have to push many deals back to 2016 because of lending limits. Construction industry labor markets are still facing challenges, forcing labor costs to rise. That means deals are being stretched to make the cap rates work.

“Because of the activity in the marketplace and the amount of construction around the country, we're seeing a shortage of labor, particularly with skilled positions,” Peterson confirms. “The best subcontractors are spread more thinly right now, which is causing costs to rise. Of course, that's great for the construction companies, so it just depends on your perspective.”

From a Southeast investor standpoint, Kevin White, acquisitions director at Austin-based real estate investment firm Virtus Real Estate Capital, believes interest rates are going to increase and the best hedge is finding deals that materially increase the NOI at the property. He's also keeping an eye on could-be bubbles in the fast-growth Southeast.

“It seems like a lot of investors have forgotten about 2008 and 2009,” White says. “I like to look back at each market to see how it performed during the last recession. For example, there are many markets in Florida that got pretty beat up during the recent economic downturn, which have since made impressive recoveries. The key is figuring out the drivers behind those recoveries and finding the markets that are poised for sustainable growth.”

WHAT'S COMING DOWN THE PIKE?

Despite the strugglers, stragglers and bites of bad news, the future looks bright for Southeast markets. Again, economic strength and population growth are driving investment and development in metros—and even promising secondary and tertiary markets here. And, so far, talk of overbuilding is still at a whisper—and few are listening.

“This region benefits from low oil and that will boost growth and commercial real estate demand,” says Muoio. “Improved population inflows will also boost growth. While some segments in some markets—particularly apartments—are seeing increased development, those are mostly high demand, low vacancy markets where new supply does not look out of whack. Otherwise supply does not look threatening, enabling improving demand to pull vacancies down in coming quarters and years.”

When Carter's Peterson looks ahead, he sees some changes on the Southeast commercial real estate horizon. From his perspective, we'll soon have adequate multifamily supply in the region's major cities. Although statistics continue to support construction volume in the multifamily sector today, he predicts it will slow down at some point and rent growth will level. The big question is, how soon will the staple of Southeast's commercial real estate markets slow?

“The market is strong now, but I expect it will be slower this time next year,” Peterson says. “Overall, I think this active real estate market has good room to run. We're dealing, in many cases, with pent-up demand after six or seven years of almost no activity. There's a lot of liquidity in the marketplace. We're seeing mostly responsible financing, and a large percentage of equity going into these properties. I don't see an upcoming crash anywhere on the horizon.”