Commercial real estate fundamentals improved for the third straight year in 2007, as both office and industrial space saw positive absorption (net change in occupied space). Industrial availability was 9.4 percent in the fourth quarter, unchanged from a year before, while office vacancy dropped 10 basis points to 12.5 percent. Concomitant with economic growth, commercial real estate markets, which displayed solid fundamentals through much of 2007, are poised to slow in 2008. Office and industrial properties, tied to the business side of the economy, are subject to cyclical movements in employment, trade and industrial production, while retail properties are closely tied to the consumer.
Unlike their business-driven counterparts, retail properties saw demand wane in 2007, as availability rates rose 110 basis points on the year. The same issues that held back the economy through 2007 were obstacles for retail properties as well – declining home prices and historically high oil prices cut into households’ bottom lines, reducing their discretionary income.
While the retail sector has been negatively affected by more conservative consumer spending, a business-driven economy emerged during the second half of 2007, helping to steady demand for office space. The shift in demand drivers is a departure from the norm; where gross domestic product growth once was dominated by consumer expenditures, it is growing on strong business investment. The results are seen in stronger job growth in high-tech and service-related industries. The timing of this could not have been better, coinciding with layoffs in the financial services, which shed 34,330 jobs nationally in the fourth quarter of 2007.
Hardest hit by the downturn in financial services were credit intermediation (mortgage brokers, loan officers, etc.) and real estate broker positions, which shed jobs steadily throughout 2007. In contrast, hiring in the tech sectors continued unabated. The trend will probably continue into 2008 and markets with more software- and technology-focused economies are expected to outperform finance-oriented ones.
Office Fundamentals
While office vacancy rates declined nationally and remained fundamentally healthy, the wealth was not shared evenly. Markets in which financial employment was overexposed to subprime mortgage lending were the hardest hit. Orange County, Calif., for instance, the home to mortgage lenders New Century Financial Corp. and Ameriquest Mortgage Co., saw its vacancy rate rise from 8.3 percent to 14.5 percent over the course of the year as both companies pared down their payrolls. Through 2007, Phoenix’s vacancy rate rose to 15.9 percent from 11.9 percent, and Las Vegas’ vacancy rate is up to 15.5 percent, from 9.4 percent at the end of 2006. Exacerbating the woes of those two markets was a bloated construction pipeline that delivered more new space than demand could keep pace with.
Increasing supply was an issue across the board, with 2007 seeing the most new completed projects since 2002, which added more than 61 million square feet of office space nationally. While new supply is not a problem in itself, slowing absorption trends challenged many markets. Suburban areas were the hardest hit, as new projects totaled 52.6 million square feet – a direct result of more land availability compared to downtown areas. Space-constrained downtown markets performed better than their suburban counterparts, with vacancy rates dropping to 9.6 percent from 10.2 percent, whereas suburban vacancy rates rose from 13.9 percent to 14.2 percent.
Retail, in its dependency on consumer spending, was struck hardest by the economic turbulence of 2007. Consumers were hit from both sides as their spending power was eroded by near-record oil prices and declining home values. Further deterioration of credit quality and tougher underwriting standards also made it difficult for consumers to spend at their pre-2007 levels. In recent times household balance sheets have not been flush with cash, as many consumers have relied on low interest rates, lax lending standards and strong personal income growth to fuel their spending. Those three things came to an end in 2007.
Nationally, availability rates for retail space rose by 1.1 percent for the year, to sit at 9.8 percent. The news from the final month of holiday shopping (the day after Thanksgiving to midnight on Christmas Eve), was less than stellar, resulting in the worst holiday season since 2002. Estimations showed that core retail sales during this time were only up 2.4 percent, compared to one year ago. This is far below the expected worst case scenario forecasts of around 3.5 percent. Availability rates rose in all but four of the retail markets tracked by Torto Wheaton Research, an independent commercial real estate research firm owned by CB Richard Ellis. Those negative effects on consumer spending persist, with signs that the labor market continues to weaken and that consumers remain pensive, signaling that the problems that plagued retail space toward the end of 2007 will persist into 2008.
Up and Down
2007 gave a mixed performance for various reasons; sure, it outpaced retail, but what didn’t? It was a good news/bad news kind of year for industrial space. The good news was the revival of U.S. export activity in 2007, thanks to a weakening dollar that allowed exporters a modest advantage. Where national warehouse availability remained the same compared to year-ago levels, availability of manufacturing space fell by 40 basis points to 6.7 percent. Because we still maintain such a large trade deficit, however, lower import activity is increasing availability rates for industrial space. Warehouse demand has consequently weakened in port markets. The housing slump had already brought lower housing-related imports since 2006, and the trend continued through 2007.
As a result, import-dependent markets, particularly those on the West Coast, experienced rising availability throughout the year. As import port traffic has declined, warehouse availability rates have started to increase in the nation’s largest port markets on both coasts. Los Angeles and Riverside, Calif., the second- and fifth-largest warehouse markets nationally, are worse off as a result of the decline in trade flows. Los Angeles accounts for roughly 40 percent of all container traffic into this country. The Inland Empire started to exhibit rising availability in the second quarter of 2007, which has since risen from 6.8 percent to 9.1 percent. The warehouse availability rate has not been as high in the Inland Empire since the first quarter of 2003. Among East Coast import-dependent port markets, Newark, N.J., and Miami both had higher warehouse availability rates by the end of the year, increasing by 80 basis points and a whopping 240 basis points, respectively.
Though the economy has slowed and there are signs that may give us cause for concern, the commercial real estate market is in a good position to withstand what may lie ahead. Signs of a slowdown may abound, but we are not likely to see a repeat of the 1990 downturn. Real estate markets are reaching peak at the right time and are far from what one would consider speculative bubbles. A slowing into 2008 is not a surprise; it is what distinguishes a mild correction from a downturn.
