Update: a more recent post on this topic is available at Commercial Real Estate Forecast 2014-2015
Commercial real estate continues to improve at a moderate pace, much in line with our previous forecast update from six months ago.
The office market enjoyed “11 consecutive quarters of occupancy growth and eight straight quarters of rent increases,” according to the Jones Lang LaSalle firm. The length of the expansion is more noticeable than the strength of the expansion. REIS Inc. reported national figures for office vacancy that are only slightly lower than a year ago. Jones Lang LaSalle also reported that most of the improvement is in Class A space, which confirms the anecdotes I’ve been hearing as I travel around the country: the only challenge for tenants is finding large contiguous Class A spaces in downtown areas. DeLoitte’s annual commercial real estate survey notes low construction levels in office space, which should bode well for landlords’ future occupancy and rent rates.
Before we get too overjoyed, note the limiting factors on the office rebound. First, the pace of economic growth is subdued, with a risk of recession large enough to demand concern. Second, high tech is a growing element of office occupancy. The software industry’s preference for putting many programmers in one large room cuts the square footage per worker. It may not be justified on productivity grounds, but the open workspace concept is so established in the software industry that it’s not going away any time soon.
Industrial space is starting to expand, with more new deliveries than in recent years. Industrial typically has the shortest development and construction periods and thus is the first sector to complete new projects when the market improves. This trait means that vacancy rates will not fall too far, nor will rents rise too fast. Still, increased volume of rented space will help the large landlords improve their efficiency, though it does little for owners of one or two properties who must compete in a market with growing supply.
Retail space is seeing more absorption than construction, but there’s plenty to worry about. Retail spending has only increased 4.4 percent in the past 12 months; a year ago we saw a 6.2 percent gain, and a year before that a 7.8 percent increase. Our recent figure is certainly an increase, but not terribly fast, especially in light of two percent inflation. Looking forward, the end of the temporary payroll tax cut will pinch a number of wallets.
On the positive side for property owners is the extremely low interest rate for commercial mortgages. Those owners who qualify pay so little interest that it’s almost free. Others, however, still have some difficulty obtaining cheap financing.
Investor interest has been strong, but the recent stock market surge may shift some money away from real estate into stocks. It’s certainly foolish to invest for the future based on recent gains or losses, but that is what many investors seem to do. In the coming year it’s unlikely that prices of commercial properties who show a strong upward trend. Light to moderate gains are likely, but price risk is greater on the downside than the upside.
For contractors itching to erect some buildings, the best opportunities last year were in multi-family residential. This year single family residential and industrial offer the best gains. Next year and in 2014, look for retail then office construction at the top of the leaderboard.
The greatest economic risk for commercial property owners is recession. The Wall Street Journal’s most recent survey of economic forecasters shows a 17 percent risk of recession. I am at 20 percent, but what’s a few percentage points among friends? The most likely trigger for a recession this year would be a worsening of Europe’s financial crisis. The Continent had been in a mild recession, then last quarter it turned decidedly ugly. If bond defaults or bank failures begin, the Europe’s economy would turn down, with ripple effects triggering an American recession. Most likely that will not happen, but nobody can be sure.
Given this risk, it may be better to sign a long-term lease at a low rental rate than to hold out for a premium rent in a year or two. Holding out for a better rent will probably work out—but probably is not the same as certainly.
