Real Estate Poised for Next Growth Cycle

Although the US recession of 2001 was among the mildest on record, the lingering effects of the downturn are still being felt as the economic engines have sputtered and recovery has been painfully slow. The good news is that listless real estate fundamentals–rising vacancies and declining rents–have bottomed and a gradual upturn will start in 2003, gaining momentum in 2004, assuming we don’t encounter any economic or political shocks.

Relatively healthy GDP growth of 2.5% to 3% is currently expected for 2003. This is in line with the long-term growth rate for the US economy but well below the historical 5% in the four quarters coming out of a recession. Strength in retail sales and housing throughout the recession, spurred by historically low interest rates and availability of capital, has left little pent-up demand to boost the recovery. At the same time, the business sector is still struggling to recover from the late ’90s investment and stock-market bubbles.

Just as important, the shadow of uncertainty is making corporate CEOs cautious. The possibility of war, further terrorism, global tensions and corporate scandals are the main culprits. As a result, employment growth will likely remain weak through mid-2003, particularly since companies need to post sustainable profit improvement before investment and hiring can resume.

Record refinancing in the third quarter of 2002, relatively low unemployment and income growth should work to avoid a double-dip recession, but the recovery will remain muted and the risk of recession will be heightened for the next several months.

The counter-cyclical behavior of the real estate investment market during this recession will continue in 2003; albeit at a slower general pace. Volatility in the equity markets combined with low interest rates and willing lenders have fueled an unprecedented level of investor demand for commercial real estate. As rents have fallen or flattened out in virtually all property sectors, prices have climbed, lowering cap rates and returns. However, the spread between real estate yields and other investment vehicles has been attractive enough to justify investment conditions in most markets and property types. In the popular investment categories such as apartments and grocery-anchored retail centers, the shift of capital from the stock market to real estate has produced a sellers’ market where strong properties can receive top dollar. Sellers, however, are faced with the dilemma of where to reinvest the proceeds. The combination of increased capital flows to the sector and a limited supply of for-sale properties has also supported price increases in these sectors.

The prospect of higher interest rates down the line is worrisome to investors, but it is offset by the expectations of improving fundamentals and a coming economic recovery.

Still, more caution is justified in underwriting today’s transactions, primarily since the economic picture is not yet as clear as desired. Such issues as job-growth expectations, the short-term risk of additional layoffs and over-building potential should be carefully examined, especially in harder-hit markets.

Economic momentum in 2003, even with the expectations of moderate growth, will go a long way toward supporting another strong year of real estate investment as employment growth picks up and fundamentals show improvement. Although interest rates may be heading up in 2003, they will still be low enough to make real estate investment attractive.

As the economy and financial markets rebound, supply and demand will start migrating toward a healthy balance, but since most real estate sectors lag economic activity, it will take patience. In the next few years, real estate investment will be fueled by the prospect of current income and not so much by the potential for value appreciation. The focus will be preservation of capital via low-risk investments.

Office Turmoil. The lack of job creation does not bode well. On the leasing side, because the business recovery has been sluggish, demand for office space remains weak, although it will improve slightly in 2003. There is also the prospect of excess corporate owned space and shadow lease space, where companies own or lease space that they are not utilizing or not trying to market for sale or sublease. As the business environment improves and new space demand is created, companies will first utilize this excess space before going into the market to take on new space. While lower-risk investments are still generating heavy interest, projects with “hair”–credit, rollover or vacancy issues–are finding less demand. It will probably take until 2005 before we see a significant office recovery in the market.

Apartments Wanted. Demand for apartments by private and institutional investors continues to outpace inventory, pushing up prices and lowering cap rates. However, the yields at 7% to 8% are still attractive on a risk-adjusted return basis.

Tenant demand has already bottomed out; although absorption will remain relatively flat in early 2003, it should pick up starting in Q2. The sector will still feel the effects of low interest rates and increasing homeownership. Construction starts will contract for the next two years, setting the stage for a recovery in vacancy, which is expected to reach 6.5% by year-end 2002, up from a recent low of 3.8% in 2000. The new year should be strong for investments; however, prices will rise at a slower pace than in 2002.

Mixed Retail Bag. The effects of the economic malaise have produced uneven effects on various retail formats; some have proven more resilient while others have languished. The hot tickets include well-located, strong grocery-anchored centers with solid national and regional tenants and single-tenant net-lease properties with high-quality credit tenants.

A large number of investors are focused on a small selection of properties, which has pushed up prices and compressed cap rates. A lack of product also has contributed to the pricing/cap rate pressure, and many property owners have taken a wait-and-see attitude, preferring to hold investments until the economy perks and fundamentals improve. Strong consumer spending has kept the retail sector generally healthy, and this should continue into 2003.

Think Tank member Hessam Nadji is managing director and chief marketing officer for Marcus & Millichap Real Estate Investment Brokerage Co.