Location, location, location
Although the gloom in the US housing sector is attracting the big headlines, the real news may be the buoyancy of the office sector. Many industry participants agree that the office sector looks set to be the strongest performing sector over the short term.
This strong performance will have a significant impact on institutional portfolios, as institutional investment in the sector has averaged around 37% of the total NACREIF property index since its inception in 1978.
"Overall, when it comes to the office market, we are pretty enthusiastic over the next two or three years," says Kate Giordano, research associate at ING Clarion. And investors share the analysts' positive outlook. "Most funds are weighting more heavily in the near term," she continues.
Absorption rates, which indicates the occupation of available space, was high in 2006, coming in at 95mft2, and this is projected to be sustainable for 2007, according to Colliers International. This compares favourably with 2005, which came in at 105mft2 total absorption, and 2004's 80.3mft2.
Job growth statistics are on the side of the office market for the time being - this is extremely significant, as employment is obviously the main driver of the office market; its dependence on this indicator is largely why the sector tends towards volatility. Nationally, the US is seeing strong and sustainable job growth. Most metropolitan areas are expecting to add jobs over the next five years, and some cities - particularly Los Angeles, San Francisco and New York - expect accelerating job growth above their historical averages.
Even though projections are somewhat muted for the beginning of this year, the real estate market still holds on to good news. Much of the recent job gains have been in service industries, including professional and business services, according to the US Bureau of Labor Statistics, and these are just the types of jobs that raise demand for office space - more than 40% of new jobs created have been in financial, technical, or professional services.
Paul Curbo, portfolio manager at Invesco Real Estate in Dallas, notes that this job growth is very focused in certain locations. It is taking place where companies are expanding, in places like southern California or Seattle, but not necessarily in areas that had been booming in past cycles, such as the south eastern US. Although the region is experiencing some office-related job growth, it is not as significant as in other areas, and this means that the low-cost benefits of those markets are probably not as meaningful in the current climate as they once were.
"For us the supply indicator is even more interesting," Giordano notes. The firm projects that vacancy rates will dip below the natural rate of 12% by the middle of 2007. Locally some markets are even tighter.
Interestingly, Washington DC, Honolulu and San Diego register low vacancy rates both in their central business districts and in their suburbs (suburbs: DC: 13%; Honolulu: 10%; San Diego: 10.4%), while Dallas-Fort Worth (suburbs 21.9%) and Atlanta (suburbs 20.7%) rank among the 10 highest for both. While San Francisco's downtown ranks among the lowest vacancy rates, its suburbs rank among the highest vacancy rates, at 18.7%.
In addition to tight vacancy rates, particularly in key markets, there has not been the normal response in terms of new construction. Normally, falling vacancy rates would be a spur to new construction, but that is not borne out in the current cycle.
There are a number of possible explanations for this. "Construction costs are rising, with increases in oil prices and other inputs," suggests Andrew Warren, head of research at Principal Global Investors. Construction costs do not look set to come down any time soon. In addition, he states that many of the projects under construction are around 45-50% pre-leased.
Giordano points out that tougher zoning laws and growing ‘nimbyism' (not in my back yard) are also keeping new construction in check.
Warren also notes that, until recently, rents were not increasing that much, and there was significant surplus space on the market, "a hangover from the 2001 tech bubble. During the construction boom of that period, many pre-leased premises were built, which then had to be sublet after the contraction in the marketplace. This supply of pre-leased and build-to-suit property has kept construction activity down. This property has now cycled on, yet there is still not a dramatic response in terms of new construction."
This is going to have an interesting effect on this real estate cycle. Industry observers agree that the trough was in 2004 and we have been seeing gradual recovery since then. That the recovery is gradual is one key to the nature of the current cycle: construction has not boomed, and rents, until now, have not increased that much.
"The cycle is definitely flatter," Warren says. "We have not seen any tremendous drop in vacancy rates - there are only a few below 10%. When it gets down to 5%, rents usually take off, but we will not see that."
That said, rents are forecast to rise throughout 2007, almost across the board, and above the long-term average rates. Low vacancy levels in the California and the Pacific Northwest will encourage higher rent increases; similar conditions exist in Denver, Las Vegas, and Phoenix.
In Principal's internal forecast, 2006 was the peak of the cycle, and unless the economy has some surprises up its sleeve, the firm does not expect to see any great spike. "If I had to characterise things, I would say that now we are at the tail end of the expansionary cycle, yet we are not to the point where it is rushing down," Warren says.
There are advantages to a flatter cycle, in Warren's view. "If the cycle is a little flatter, you can manage the upturn with less pain, riding the cash yield."
"The story of this market cycle is that it is concentrated on individual markets," says Curbo. "Although there has been a national recovery in fundamentals, office-related job growth is more pronounced in a few select areas." Cities experiencing strong office demand include Austin, Texas; and Phoenix, Arizona. New York City is a very exciting place these days, expensive perhaps but exciting. The recent residential boom in the city took a lot of supply out of the market, and even what is currently under construction may not meet demand. "I believe that between now and 2008, office conditions should continue to tighten, absent an economic shock. There are three buildings in Midtown set to deliver in this time period and they are all already spoken for," Curbo says. "In terms of new supply, New York City appears underserved."
Because of this, the entire metropolitan area looks set to benefit. "The pricing is so out of control that most investors are limited in what they can get their arms around," maintains Giordano, noting that New York City vacancy rates are already very low. "The dynamics will ripple out beyond Manhattan." Cities that are likely to benefit include Greenwich, Connecticut, already home to many financial services firms, and Edison, New Jersey. In fact, ING Clarion forecasts returns for Edison, New Jersey, of 9.8%, well above its historical required return of 8.46%.
Curbo agrees that prices in the New York office sector are high. "We can understand the underwriting buyers are using in New York City. In some other markets, the underwriting is not as strong, and the returns buyers are looking for will require a level of rental growth that may not be achievable."
At this point in the cycle, markets are fully priced, and investors are unlikely to find any bargains out there. Giordano points out that the best bets are those markets that combine job growth with supply constraints, such as New York City, Washington DC, and Seattle.
ING Clarion has found that investors are looking to properties with a strong value-added component, such as a significant lease roll that provides the chance to get in a new tenant at market rates. "We saw triple the expected interest in one particular property in Silicon Valley for which this was the case," Giordano says.
Investors are also looking at properties that have been undermanaged or are in physical dis-repair. ‘Green' building, such as energy efficiency, is not yet prized enough to count as value-added in today's market, although there is some demand in certain markets.
"There is less of an interest in core assets, because investors are unlikely to get the pricing they need to get," Giordano adds.
Seattle looks set to be a strong performer, according to many analysts and portfolio managers.
"Seattle continues to see good fundamentals," notes Curbo. "There is strong job growth and limited new construction. As long as the economic drivers do well, Seattle should outperform."
Austin, Texas, is another city that benefits from a combination of limited supply and high job growth. Although its vacancy rates are high at the moment, current office space is not forecast to keep pace with job creation rates. Curbo also points out that, like Seattle, there are some natural constraints to continued expansion.
Some secondary markets look likely to offer good returns. Giordano is positive about cities such as Baltimore, Maryland; Portland, Oregon; and Denver, Colorado.
"The three-year forecast returns exceed the required return based on historical volume," she notes. For example, ING Clarion's three-year forecast for Portland is 9.41%, over a required return of 7.66% - giving an alpha of 1.75%. Similarly, Baltimore gives an alpha of 1.65%. This compares very favourably with most large markets.
Park and ride
irroring the increasing demand for office space nationwide, as well as rising rents, parking costs are also on the rise, reports a recent survey by Colliers International. Responding to the same indicators as the office sector, parking rates increased by 4.4% over the last year. Manhattan is by far the most expensive parking district in the US, with median monthly unreserved rates between $574 (€437) for midtown and $500 downtown. This compares with second ranking Boston, at $420 per month.
Supply will be increasing to meet demand, according to Colliers. In the 49 US markets surveyed, 63 new parking garages are in the pipeline over the next two years, with more than one-quarter of these planned for Washington DC.
US parking rates, although high, compare favourably with the cost of parking in other major cities internationally, according to the Colliers survey. In London, for example, the median cost for monthly parking in the West End is $898 and in the City, $896, higher even than second-ranking Tokyo, where monthly parking costs around $702.