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Wednesday, February 22, 2012
Feature: February 2007
Soft Landing
This year, the once sky-high commercial real estate market should come down to earth
Story by Bill Romanelli
There are several popular analogies to describe what’s going to happen in the region’s commercial real estate market next year. We’re going from the hot tub to the heated pool. We’re going from light speed to supersonic. We’re cutting down on the caffeine.
One thing they all have in common is a prediction for a market that’s going to be a little less exciting than it’s been in past years.
“We’re definitely starting to see the effects of a slowing market, but I think we’re in for a fairly soft landing,” says Dave Brennan, senior managing director with CB Richard Ellis. “Several of the signs of a healthy market are still there.”
That’s really the bottom line on the commercial real estate forecast for 2007. We’re in for a slowdown, but not a downturn. There are plenty of reasons for investors and developers to be more thoughtful in the coming year, but just as many reasons to believe our market is still very healthy, strong and stable. Some areas may get hit a little harder than the rest, but all the experts agree that even the worst-case scenario reveals a market that would be considered normal by almost any standard — and getting back to normal may even make the region more attractive.
As for what started this cooling trend, everyone has the same favorite whipping boy. It’s the slowdown in home construction.
There is so much housing inventory on the market and so much commercial activity tied to it that the end of the housing bubble was sure to be a drag on commercial real estate.
“Of course, the housing bubble here is actually more of a soufflé that’s out of the oven and gently settling,” says Sean Snaith, consultant to the Business Forecasting Center at the University of the Pacific and director of the Institute for Economic Competitiveness at the University of Central Florida. “We’ve hit the peak in terms of inventory level, but the long-term prognosis for Sacramento and the Central Valley in particular is good.”
There’s an old real estate adage that says “retail follows rooftops,” so a slowdown in home construction will invariably lead to a slowdown in retail construction. The good news is that there’s usually a time lag while retail catches up to the housing trend. That’s especially true in a housing market that’s been as white hot as ours has been for the past several years.
Where the pinch will be felt a little sooner is on the construction companies and financial services, such as mortgage lenders and title companies, that thrive on high volumes of home construction and low interest rates. That pinch might be felt most in Roseville and Rocklin, where, according to John Frisch, senior vice president with Cornish & Carey, 50 percent of all the office leasing in the past three years is attributable to the housing market.
“The long-term prognosis for Sacramento
and the Central Valley in
particular is good.”
— Sean Snaith, director, Institute for Economic Competitiveness
“I’m working with one company that was planning to expand to 55,000 square feet before the market started to cool,” Frisch says. “Now, they’ve decided to expand to only 15,000 square feet. That’s a very good snapshot of the South Placer office market.”
It’s also a clear picture that while things are slowing overall, they are not going backward. Frisch emphasizes that there’s no disaster looming and predicts the South Placer market will continue to grow steadily throughout 2007.
Other parts of the region are also expecting great things in the year ahead. In places like Yuba and Sutter counties, the commercial market actually has a long way to go to catch up with the housing market.
“We’re vastly underserved in commercial real estate,” says John Fleming, economic development coordinator for Yuba County. “If you look at the area between Marysville and Wheatland, there’s not a single bank on that map; not a single business park, office park or commercial center for a population that will reach upwards of 40,000 in 2007.”
Fleming says the presence of a Wal-Mart Supercenter may have frightened other would-be retailers away, but suggests no one can ignore a county that issued 4,300 building permits for single-family residences in the past two years, up from only a few hundred permits issued between 2000 and 2003.
Other counties seem to be focusing on specific commercial sectors. San Joaquin, for example, has been very successful in attracting large-scale industrial and office development, primarily component manufacturers. Sixteen new industrial parks are expected to come on line in the county within the next three years. That’s in addition to ongoing redevelopment in downtown Stockton; 550 acres of pending mixed-use development at the Stockton Airport; and Tracy Gateway, a 350-acre office project that will start construction in 2007.
That’s not all San Joaquin County has to feel confident about, either. “New office development continues to show strength in small to mid-size projects in Tracy, Manteca and Lathrop,” says Michael Locke, president and CEO of the San Joaquin Partnership. “We’ve also got promising large-scale office projects, like the expansion of Blue Shield in Lodi, which could bring anywhere from 600 to 1,100 jobs in the next few years.”
Sacramento County will have its challenges, especially if it tries to compete for industrial-sized tenants, but with a healthy downtown, a robust and growing healthcare sector, much-anticipated redevelopment in the railyards, and the ever-present government sector, there’s a distinct lack of furrowed brows in and around the River City.
Even more encouraging is the incoming tide of newcomers. “Our prospect list is up from last year,” says Bob Burris, deputy director of the Sacramento Area Commerce & Trade Organization. “The exciting news there is that nearly half of our prospects are coming from out of state.”
On that front, Sacramento is competing with other similar markets like Phoenix, Denver and Dallas, but our geography seems to be helping.
“Sacramento stacks up well against other cities on things like rents, land prices and a business-friendly environment,” says Stan Mullin, senior vice president with Grubb & Ellis in Newport Beach and president of the nationwide Society of Industrial and Office Realtors. “Sacramento stands to benefit as populations continue to migrate toward the coastlines and want to take advantage of the region’s weather, top universities and proximity to major cities in the Northwest.”
“Recent buyers are still going to make money,
but they’ll have to sit on their properties for a few years.”
— John Frisch, senior vice president, Cornish & Carey
Even though investors and developers are getting more conservative, they’re still seeing plenty of things to like about the Sacramento region.
For starters, job growth, one of the main gauges of the future health of the commercial real estate market, remains in the black. Snaith says the beginning of 2007 will definitely mark the low point in job growth — about 1.2 percent — but that it should start climbing and reach about 1.4 percent by year’s end.
In the meantime, we’re also enjoying historic lows in unemployment. “Virtually anyone who wants a job can get one, and from the latest information I’ve seen, about half the companies in Sacramento plan on hiring in the coming year. That’s very good news,” Frisch says.
One area of potential vulnerability is interest rates. Snaith says it doesn’t look like rates will rise very much in 2007, but if there’s inflation or other economic windstorms that cause interest rates to jump, the landscape could change.
“That would affect profitability of proposed projects and could influence a go-versus-no go decision towards the negative,” Snaith says.
The key to that go-no go decision is the expected capitalization or “cap” rate, basically the expected return on investment. In the past, lackluster performance by the stock market and low interest rates pushed savvy investors into commercial real estate, where they comfortably embraced very low cap rates — to the tune of 5 and 6 percent — as a viable alternative to Wall Street.
Now that the stock market has rebounded and interest rates are up about a point from a year ago, experts are expecting to see some upward pressure on cap rates to keep some investors in the market. That said, no one is predicting anything too dramatic. Most don’t expect to see cap rates climb more than a point, to somewhere around 7 percent, but that doesn’t exactly mean smooth sailing for new projects.
“We’re in an environment of high land prices, increasing costs for construction materials and high development fees,” Brennan says. “In that kind of environment, there has to be upward pressure on rents to ensure profitability.”
Charging more for rent is challenging enough when rents are fairly flat, but the wave of higher rents is already washing over the region. Whether the market will bear those increases remains a big question, but so far, aside from some initial sticker shock, there doesn’t appear to be a major upheaval pending. Rents here are still a bargain compared to other markets.
For new owners looking to sell, however, the news is definitely not as good as it was a few years ago, but it’s hardly bad either.
“Recent buyers are still going to make money, but they’re going to have to sit on their properties for a few years instead of flipping them right away,” Frisch says.
That may explain why, despite this foreseeable slowdown, new office and retail space is continuing to enter the market. What that creates is a very unusual dynamic for 2007, in that we’ll see a market with higher rents and higher vacancy.
“Low inflation, low employment and continued growth —
those factors contribute to what should be a very healthy market.”
— Greg Margetich, senior vice president, NAI BT Commercial
When looking at other outside factors that should help offset any potential vulnerabilities and allay any fears for the coming year, the impact of the November elections can’t be overlooked.
“Two major cornerstones of what is really critical to commercial real estate — local government financing and transportation funding — got some much-needed protection in November,” says Rex Hime, president and CEO of the California Business Properties Association. “We also passed more than $4 billion in flood and levy protection, which will be very important for encouraging commercial development in a region that currently ranks No. 1 in flood vulnerability.”
Investors want stability, and while more-thoughtful development in the face of potential interest rate hikes and a slowing market helps create that stability, it is the presence of state government in Sacramento that ultimately prevents us from having too many empty buildings.
“State government in California is really on a growth spurt,” Frisch says. “They have about 2.5 million square feet of office space requirements right now, and about 98 percent of that is in Sacramento County.”
Burris agrees, saying that as the market slows, we’ll start seeing the government reprising its traditional role in hedging our economy against any potential private-sector swings.
That said, the real possibility of any private-sector swing causing a serious economic slump in the region is becoming smaller as the local economy continues to diversify. The tech bust that nearly crippled so much of the state was never really felt here, and we’ve continued to grow stronger in education, healthcare, biotech, and more recently, clean-energy technology. It’s a very promising time.
“California is the fifth largest economy in the world, and we are in the capital of that economy,” says Greg Margetich, senior vice president with
NAI BT Commercial. “We’re in tremendous economic times; we have low inflation, very low unemployment and continued growth. Those factors all contribute to what should be a very healthy, but stable, commercial real estate market in the coming year. Any changes from 2006 are really just the market normalizing itself.”
Land, land everywhere — and hardly a speck for industrial use
A quick peek out the airplane window as you fly into and out of Sacramento International Airport would suggest we have all the industrial land we need. The view from the ground, however, tells a much different story.
“We have a definite scarcity of industrial land,” says Bob Burris, deputy director of the Sacramento Area Commerce & Trade Organization. “Companies are looking for bigger parcels — 50 acres or more — to provide a buffer from residential areas, and those have become very hard to find.”
Simple economics is partly to blame. The region’s housing boom has made it much more attractive for developers to rezone their land for residential use or office parks instead of making room for industrial tenants.
“Homebuilders have eaten up a lot of property,” says Skip Vanderbundt, senior vice president with Cornish & Carey. “Without some major amendments to our general plan, we’re looking at a scarcity of land here for the next five to 10 years.”
The other part of the problem is that most companies looking for industrial parcels are like sailors on shore leave: they want something cheap and easy.
There’s plenty of land around, but it either needs to be rezoned for industrial use, or it has no infrastructure or services. It takes significant time and money to overcome those obstacles (it took developers two decades to get approvals to build Metro Air Park). Thus, while Sacramento, Yolo, Sutter, Yuba and Placer counties are doing all they can to attract industrial tenants, they’re having a hard time competing with communities in San Joaquin and Solano counties that have parcels ready to go.
“We have about 3,000 acres of industrial space available among our 36 existing industrial parks,” says Michael Locke, president and CEO of the San Joaquin Partnership. “We’ve got 16 other parks expected to come on line in the next three years, with some offering lot sizes of 75 to 90 acres.”
Fairfield, in Solano County, offers tenants state-of-the art water and sewer systems, which, together with the city’s position as a crossroads between the Bay Area and Sacramento, has made it very attractive for manufacturers. Even so, Assistant Community Development Director Curt Johnston says large sites are getting scarcer.
The news is not all bad for Sacramento and its neighboring counties, however. Metro Air Park, while it will be mostly mixed-use, will have industrial-sized parcels available that will be a welcome addition to the local inventory. There are also a handful of existing structures that, while obsolete, could be retrofitted to conform to today’s industrial standards.
Then there’s the issue of job growth. One large industrial facility may only provide a few hundred jobs, thanks to automation, while a large-scale office park could provide 1,000 jobs or more. That’s the kind of thinking that keeps SACTO’s Burris in an upbeat mood when companies look elsewhere for big parcels.
“We’re targeting smaller industrial firms that can have a high economic impact and offer higher-than-average wages, particularly in clean energy, for which Sacramento is positioned to be a very hot market.”
Rex Hime, president and CEO of the California Business Properties Association, takes a similar view, but scoffs at the notion that land can’t easily be rezoned for industrial use.
“The land is everywhere,” he says. “I have to believe that if tomorrow a large industrial company with a promising clean-energy technology wanted to locate here, agencies would be falling all over themselves to zone the land.”
Higher rents and higher vacancy: the coming conundrum
It seems to defy the most basic law of economics. In an ordinary universe, the commercial real estate market is either defined as one with high rents and low vacancy, or high vacancy and low rents. It’s basic supply and demand.
Then there’s the Bizarro universe, where things that shouldn’t happen do. Welcome to Sacramento, where the coming year looks to offer the worst of both worlds: higher rents and higher vacancy.
“This never happens,” says John Frisch, senior vice president with Cornish & Carey. “Even though it’s more expensive to build, new inventory keeps coming on line. Every year we have more leased space than we started the year with, but we can’t keep pace with new construction.”
This strange brew in which the Sacramento region finds itself is comprised of three main ingredients. The first has been the nearly scandalous affair with low cap rates, brought on by a market that’s been somewhere in hyperspace for the past several years. Developers and investors have simply been willing to make less return on investment — 5 percent or lower in some cases — in exchange for having product in a hot market. That has created a large, albeit temporary, glut of new commercial space, particularly in the retail and office sectors, in all of the region’s hot spots.
The second ingredient is the region’s historically underpriced rent market. “Our rents have been too low for a long time,” Frisch says. “An overall increase in rents here should be considered a normalizing event. There’s a lot of sticker shock going on out there, but when you look realistically at value and compare rents here with places like San Francisco, this is not anything that should be viewed as trouble brewing.”
The third and most potent ingredient is the exorbitant rise in the cost of construction materials, as much as 50 percent in just the past five years. Two things get the blame for that: Hurricane Katrina and the People’s Republic of China.
“At one point, 75 percent of the world’s construction cranes were in China,” says Greg Margetich, senior vice president with NAI BT Commercial. “You also had a huge demand for materials after Katrina. With that much draw on materials and resources, you have to be willing to pay a high price to get them.”
The good news there is that higher costs for construction materials are a global problem. On that level at least, Sacramento is at no more of a competitive disadvantage than any other city.
“I think prices, while they do cut into profits, don’t prevent new projects from being profitable,” says Sean Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida. He may be right, but there’s no question that materials costs have been the bane of every builder and developer in the region since 2000.
Finally, sprinkle in a concern over rising interest rates, a dash of higher construction fees, and a layer of steadily increasing land prices, and landlords have very few options.
“In residential development, sellers can counter the effects of higher interest rates with a variety of creative gimmicks, like free pools or a year of yard maintenance,” Frisch says. “Those kinds of gimmicks just don’t exist in the commercial real estate world.”
As a result, landlords have to start raising rents even as new inventory comes on line faster than it can be leased. Voila: higher rents and higher vacancy.
The trend is destined to be short-lived, however, as this strange dynamic forces everyone to be a little more conservative about new development. In the long run, perhaps the one-two punch will end up being good for the market.
“This kind of thing really makes people sharpen their pencils on their projects and ask themselves some tough questions,” says Dave Brennan, senior managing director with CB Richard Ellis. “If you have to push rents up 10 or 20 percent, you don’t fully know how the market’s going to react to that. Is demand strong enough? It creates an environment of much smarter and more conservative new development, and that’s a good thing. It stops overgrowth.”
The other factor contributing to the short lifespan of higher rents and higher vacancy is the possibility that the higher vacancy rates are somewhat artificial.
“When you see a huge jump in vacancy that’s due to new projects, such as the situation we’re seeing now, that’s not necessarily indicative of what’s going on in the overall commercial real estate market,” says Bob Burris, deputy director for the Sacramento Area Commerce & Trade Organization. “What we’re seeing is a blip in vacancy that should get absorbed very quickly. The Central Valley remains one of the fastest-growing regions in the nation, and this is where the bulk of California’s growth will occur over the next 20 years.”
