Rising rates, declining investment could slow real estate

March 2, 2005

'Forward buying' may dampen housing

Inman News

A continuing stream of capital is expected to flow into the real estate sector this year, though rising interest rates could slow down the raging single-family housing market, according to an annual real estate outlook by PNC Real Estate Finance, a member of The PNC Financial Services Group Inc.

The 2005 Real Estate Industry Outlook, titled, "Where Do We Go From Here?" also notes that the real estate industry should be cautious of the potential for investors to dart from the sector if something better comes along.

"We saw in 1998 that capital can quickly flee a sector, even if that sector is performing well. Although considered to be an unlikely event yet in 2005, real estate must be cautious about potentially finding itself vulnerable if fickle investors chase better returns in another sector," said Nicholas Buss of PNC Real Estate Finance.

Improving property market fundamentals, such as accelerated leasing traffic, backfill of under-occupied office space and growing business confidence, could be overshadowed by the direction of real estate capital flows in 2005, Buss also noted.

"Real estate today is more liquid than ever before, and by a wide margin. This weight of capital, and the competition it has created, pushed prices up and yields down," said Buss. Sales of institutional real estate jumped nearly 50 percent to $180 billion in 2004 and the commercial real estate debt market grew by 10 percent to $2.2 trillion, as yield-oriented investors (both debt and equity) continued to flock to real estate in record numbers, PNC reported.

While Buss predicts the strong flow of capital will remain a critical driver of the health of real estate in 2005, he also notes that the influence of rising interest rates and decreasing real estate interest yields on investor behavior – overall cap rates currently hover in the 7.5 percent range, down almost 100 basis points over the past year.

PNC sector forecasts for 2005:

While 2005 is predicted to be another good year for the housing sector, Buss does not expect another record-setting year. And, for the first time in the last three years, retail may have to be satisfied being back in the pack rather than leading the race. Predicted by Buss to be the most challenged sector in 2004, the office sector has steadily improved and is viewed with "cautious optimism" this year. Other highlights from the 2005 Real Estate Industry Outlook highlights include by sector:

  • Office: More predictable and stable job growth translates into increased demand for office space and will spur new leasing activity at a measured, not rapid, pace. Net improvement should move national office vacancy rates below 15 percent by year-end, but will not be enough to transfer pricing leverage back to the landlords. Core office markets will again see the bulk of investor interest in 2005. This may leave the door open for some relative "bargains" in smaller, non-core markets – but tread carefully; like a mousetrap, these markets are easier to enter than exit.
  • Apartment: Strap in, it could be a bumpy ride for apartments in 2005. Demand should start to stabilize as job growth continues and mortgage rates move higher – both trends that should boost renter household formation. But continued construction will likely overshadow these gains, keeping the national vacancy rate in the 7 percent range (or higher). Adding more confusion to this outlook is the condo market. If the condo market slows, some of the pricing pressure will be removed from the apartment sector – possibly impacting the capital-driven construction that is currently occurring and creating additional stress in the sector.
  • Retail: Although the retail sector will face many challenges in 2005, it is tough to bet against it. Consumers may be more selective in their spending, but they will continue to spend. As a result, retailers will have a more mixed year, with clear winners and losers. Overall it will be an okay year for the sector, just not a great year.
  • Hotel: The economy should continue to support respectable growth in room-night demand and supply will not be a near-term issue. As a result, we expect occupancy for the year to be in the 62.5 percent to 63 percent range. Landlords will continue to be able to push rates. As always, there are numerous risks to this outlook including rising oil prices, airline bankruptcies and terror threat – but on balance, it should be another good year for the hotel sector.
  • Industrial: Demand, which picked up nicely in 2004, should strengthen slightly in 2005 as the national economy settles into its expansionary mode and the goods producing sector continues its measured expansion. Although Buss expects the national vacancy rate to fall below 11 percent, improvement may be slowed by increased construction activity. While this is warranted in some markets, it could create problems and delay recovery in others – developers must be careful not to get ahead of the market.
  • Single-Family: After two years of hard labor, the housing sector will take a much-deserved breather in 2005. Mortgage rates will rise to the mid-6 percent range, taking some of the wind out of the sector's sails and likely reducing both sales activity and starts by 5 percent to 10 percent. The one downside-risk is that all of the "forward buying" of the past two years may result in a more significant slowdown as rates rise. A variety of macro-economic challenges in 2005 could also impact the rate of improvement, according to Buss, including uncertainty over energy prices, the weakening U.S. dollar and the possibility of terrorist attacks at home and abroad.

PNC's Real Estate Market Research division publishes periodic reports on the state of the industry and the economy's impact on the property markets. For the complete version of the 2005 Annual Real Estate Outlook, call 412-762-1841 or visit http://www.pncrealestatefinance.com/.

PNC Real Estate Finance is a member of The PNC Financial Services Group Inc., a diversified financial services organizations providing consumer and business banking; specialized services for corporations and government entities, including corporate banking, real estate finance and asset-based lending; wealth management; asset management and global fund services.

Copyright 2005 Inman News

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