A hopeful (yet sobering) commerical real estate outlook.

Author:Riggs, Kenneth P., Jr.
Position:Commercial - Industry Overview

The outlook is somber for commercial real estate in 2003. This forecast, for example, expects no full-fledged office market recovery until 2004. And it could be the end of 2006 before the office vacancy rate falls to the 10 percent range. Yet on the bright side, apartment rent concessions are expected to be gone by the end of 2003.

AS 2003 GETS UNDER WAY, WE ARE HOPEFUL THIS WILL BE THE YEAR OUR ECONOMY TAKES OFF, businesses begin hiring again and the investment climate begins to demonstrate clear and sustainable levels of growth.

Indeed, recent indicators show economic growth is occurring (with the revised third-quarter growth in gross domestic product [GDP] snowing an annual rate of 4.0 percent versus 3.1 percent), layoffs are slowing, consumer confidence is creeping up and even the stock market is sorting through its weakness.

Yet, as Real Estate Research Corporation (RERC), Chicago, has forecast throughout this recession, it will take six to 12 more months after the economic recovery kicks in before we see solid improvement in the commercial real estate markets.

The good news is real estate, for the most part, has learned from its somewhat checkered past. Although investment capital--both debt and equity--has been plentiful, investors have been looking more closely at the fundamentals before building another office complex or retail center.

Developers also have been disciplined, with the result being decreased construction in many markets and many projects being put on the shelf until the oven is warm. RERC's detailed look at investment conditions and analysis of the major property types follows.

OFFICE: A challenged asset class

The impact of a weak economic environment is being felt the most within the office market. Considered the weakest among the core property types, excluding hotel investments, office has been plagued with downward adjustments to expectations and an inability to deliver predictable returns from both a cash-flow and value basis.

Rents have slipped in almost all markets, with some rents being off more than 20 percent from several years ago. RERC expects rents will continue to be weak throughout 2003, with no discernable signs of strength until mid-2004.

Supply-constrained markets--especially central business districts (CBDs)--hold the most promise for maintaining current rent levels. In the long run, rents will gravitate back to a fair return on replacement costs. Watch for markets that have rents significantly below sustainable levels, as they offer the best investment opportunities late into 2003.

Given that rents are just starting to show serious signs of stress and that supply will outstrip demand throughout 2003, rents will be under pressure and concessions will become more common in the office market. RERC does not foresee a full-fledged office market recovery before 2004. Office rents will struggle on average for the next three years to get back to levels experienced several years ago. Some markets will never get back to the dot-com-mania levels.

Based on published statistics and RERC's estimates, projections call for the national office vacancy rate to climb to 18 percent by the end of 2002, and then hover in the 17 percent to 18 percent range during 2003. On a positive note, the development pipelines for the top 40 U.s. markets are now below what they were at year-end 2000.

RERC hates to be a pessimist, but given the current supply imbalance and future demand factors, it could be the end of 2006 before the market vacancy rate falls to the 10 percent range.

Expenses are expected to increase at a rate greater than inflation as real estate taxes rise to meet city budget deficits and insurance costs continue to soar. With rents projected to be flat to down, net operating income (NOI) levels will be down. Cash flow-NOI less capital expenditures--will suffer more than NOI weakness, as tenant-retrofitting costs outpace inflationary levels. Cash flows for office remain subject to significant downward pressure in 2003.

Overall capitalization rates will rise to reflect the slower growth prospects, and discount rates will increase to reflect higher risk. Expected or required going-in capitalization rates will average 9 percent to 10 percent (see Figure 1); a total yield of 11 percent to 12 percent will be needed to attract investment capital, and that applies to only the best of projects.

As is characteristic of a weak property class, a broad deviation from quoted averages will occur. Well-leased, class-A properties with stable cash flows located in stronger markets will garner yields up to 150 basis points below the average. Specific exceptions are evident in New York City and Washington, D.C., where going-in cap rates for class-A properties are below 8 percent and 8.5 percent, respectively.

Values will decline throughout 2003 as the...

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