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Thursday, May 17, 2012
Feature: August 2006
Steady As She Goes
The cooling commercial real estate market is far from tepid
Story by Bill Romanelli
For the past couple of years, we’ve simply been spoiled.
Most commercial real estate experts believe we’ve had it so good in recent years that a mild regional slowdown may seem worse than it is.
“We’ve been cruising at 90 miles an hour, and suddenly we’re slowing to 65, so it seems like we’re crawling,” says Bob Dean, executive vice president and managing director for the Grubb & Ellis Co.’s Northwest region. “In truth, we’re still moving forward and still healthy.”
There’s no doubt that creeping interest rates and higher construction costs are taking a slight toll in 2006. But even as the region’s commercial real estate market cools, local experts remain upbeat.
There are several ways to gauge the overall state of the market. Most common among them are vacancy, absorption (usually defined as the net amount of new space that becomes occupied, not including office moves), construction and capitalization rates, all of which are influenced to some degree by interest rates.
Then there’s the biggest variable of all: job growth. When job growth is positive, the commercial real estate market is good, as every employee needs a place to work.
At the end of 2005, the Sacramento Forecast Project at Sacramento State predicted a 2.4 percent increase in job growth in 2006. As of March, that number was increased to 2.5 percent, which so far looks to hold true.
According to the latest data from Grubb & Ellis, virtually all of the region’s employment sectors have posted increases in paid positions this year. Likewise, Sacramento’s unemployment rate remains below the state and national averages.
In other areas, the news is not so rosy, but it’s hard to describe as bad. Vacancy overall is up, but it’s by such a small fraction — 0.08 percent, according to Cornish & Carey Commercial — that it’s hardly worth noting. That may be due more to the fact that construction remains very active, with nearly 3 million square feet planned or under construction for 2006.
“We’ve been cruising at 90 miles an hour; suddenly we’re slowing to 65,
so it seems like we’re crawling.”
— Bob Dean, executive VP and managing director, Grubb & Ellis
New construction seems almost in defiance of rising interest rates. “When you look at the construction figures, Roseville’s leading with about 1.14 million square feet in development,” says Craig Brinitzer, senior vice president with Cornish & Carey Commercial. “Northgate-Natomas has 400,000 square feet under construction, and Elk Grove has 390,000. That’s a lot of construction.”
That said, the impact of higher interest rates isn’t being ignored. Higher interest rates make new development that much less attractive, as they necessitate higher rents to make the project meet the expected return — or capitalization rate — on the property.
At the end of 2005, cap rates could be found at the sub-6-percent level. So far this year, cap rates seem to have leveled off or been bumped slightly higher, but again, not enough to create great concern.
Rents are also creeping up almost everywhere — the Highway 50 corridor being a notable exception — and may be affecting absorption, which appears to be where the first signs of the slowdown are starting to materialize.
Importantly, the news on absorption is dependent on who’s providing it, as no two companies measure it quite the same way. Cornish & Carey, for example, only looks at buildings larger than 5,000 square feet and does not include owner-occupied space, government-owned buildings or medical buildings. Their latest numbers show net absorption for the year in the black (although significantly lower than the last quarter of 2005), at 142,000 square feet.
Grubb & Ellis, on the other hand, which uses different criteria and focuses on different areas within the region, reports net absorption in the red, at negative 46,609 square feet. The numbers may be different, but where there’s agreement is that the region is nowhere near where it was at the end of 2005.
“The current market is forcing people to closely assess whether they should renew or redo their current space, or, if they relocate, whether they would be better off outside this market,” says Kevin Sheehan, senior vice president with CB Richard Ellis. “Sacramento isn’t as inexpensive as it used to be. Unless they have an absolute need to relocate, a lot of companies are just trying to make it work where they are.”
"The current market is forcing people to closely assess whether they would be better off outside this market. Sacramento isn’t as inexpensive as it used to be.”
— Kevin Sheehan, senior VP, CB Richard Ellis
While mildly sobering, that reality is not enough to start anyone’s hands wringing. All the experts agree it just means we’ve gone from a hot market to a good one.
While the region’s numbers on absorption, construction and job growth tell the bigger story, there are some smaller trends just under the surface. One of the more noticeable this year has been the continuing decrease in office leases. Instead, many would-be tenants are choosing to purchase their buildings, particularly smaller buildings of between 5,000 and 10,000 square feet.
“The small building is the new deal in our marketplace,” Sheehan says. “As long as interest rates stay somewhere below 8.5 percent, you’re better off buying than leasing.”
It is precisely because of the current upward trend in interest rates, however, that Dean of Grubb & Ellis predicts that the dip in office leases can be expected to reverse. “As money gets more expensive to borrow, we’ll probably see slowing down of owner-user sales, meaning there’ll be a shifting over from purchases back to leases,” he says.
Another small but noticeable trend has been the invasion of new condominium projects. Concurrent with the small-building trend, there’s a market of buyers who don’t need and can’t afford a 5,000-square-foot space. They need something more in the range of 1,500 to 2,000 square feet, and condos are fitting the niche.
“The condo trend is allowing more people to get into the game by enabling them to buy just what they need,” Sheehan says. “Even if they need to grow later, they have the opportunity to go to other condo owners in the building and buy those additional units.”
“The long-term view for Sacramento and the entire Central Valley is that
this is where the bulk of California’s growth will occur over the next 20 years.”
— Bob Burris, deputy director,
Sacramento Area Commerce & Trade Organization
A third emerging trend has been the interest and arrival of higher-quality companies to the region. According to the Sacramento Area Commerce & Trade Organization, there’s been a rapid increase in the number of life-sciences companies giving Sacramento a look.
“We’ve seen a doubling of interest and activity in all categories of prospective businesses looking at Sacramento,” says Bob Burris, SACTO’s deputy director. “What’s exciting is the quality of those companies; these are high-quality companies looking to bring in highly skilled workers and to pay higher-than-average wages. That’s exactly what we want.”
So what’s the bad news? For starters, there’s Sacramento’s title of most flood-vulnerable city in the nation to contend with. Air quality and congestion could also become issues of great concern if not addressed. Hence, our future depends in part on this November’s election.
“The future value of all our investments is tied to the bond measures,” says Rex Hime, president and chief executive officer of the California Business Properties Association, based in Sacramento. “If California decides to provide the infrastructure and flood-control investments our area needs, that will be a very strong sign for the future.”
Our heightened vulnerability in commercial real estate is also, unfortunately, connected to oil supplies. Increasing oil prices represent a drag on the overall economy that, when coupled with higher interest rates, higher rents and so on, can put a sudden chill on the market.
To make matters worse, the Associated Press recently reported that just two Arab nations, Saudi Arabia and Iraq, have provided nearly half of the state’s oil supplies in recent years. As the one state that uses more gas than any other in the nation, California is significantly at risk from a crisis in the oil supply chain.
Still, these clouds on the horizon are far from casting a shadow on the region, at least for now, and with California being the attractive state it is, SACTO’s Burris maintains a very positive outlook.
“The long-term view for Sacramento and the entire Central Valley is that this is where the bulk of California’s growth will occur over the next 20 years,” he says.
