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May 4, 2018

Commercial Real Estate Cycle: What Happens When the Music Stops?

The West Coast commercial real estate markets are among the best-performing in the country, a condition fueled by the current cycle’s sustained economic growth. That isn't expected to change anytime soon. That's because the U.S. economic recovery remains on solid footing, supported by historically low unemployment (4.1%,) job growth and consumer spending.

The bright economic news has certainly contributed to the extension of the current CRE cycle, which due to its length, has many in the industry wondering when the "music will stop." That's causing many real estate companies to implement strategies with their portfolios, to prepare for an economic downturn that consensus opinion holds will come at some point.

Economists note, just because a recovery continues on for an extended period, doesn't mean it will soon end. Given the strong fundamentals, economists say it just doesn’t add up to a problem now, especially since CRE markets aren't experiencing over-building, over-borrowing or overspending.

An overview of the West Coast markets reveals a number of intriguing findings. Let's examine four key property types – office, industrial, multifamily and retail – across the region to get a sense of how each sector is performing, which ones may have some runway left and where potential challenges may be on the horizon. The primary West Coast markets examined by Kidder Mathews include Seattle, Portland, San Francisco, San Francisco East Bay, Sacramento, Los Angeles, Orange County, Inland Empire, San Diego, Reno and Phoenix.

Office Market Overview

The West Coast office markets enjoyed a strong first quarter of 2018, as absorption began to catch up to the accelerating pace of new completions. That seems to indicate there's ample demand to fuel further growth. Office vacancies stood at 10.2% at the end of Q1 2018, just 40 basis points above their pre-recession point of 9.8% in 2007, and virtually unchanged over the past 12 months.

Meanwhile, construction completions during the first quarter increased to more than seven million square feet. The Silicon Valley has 2.2 million square feet of space that has already been claimed by technology giants, the lifeblood of the West Coast's primary office markets. Still, developers and investors are exercising caution, as the economic recovery continues. Construction starts were well short of what was launched a year ago, which brought the volume of active projects down by 17.2%. On the sales side, volume dropped 12.13% from 2017’s total, which was already off by 20.5% from the year before.

Premier markets, such as San Francisco and Los Angeles, maintained their strength, which pushed occupiers into overflow markets, where improved fundamentals were experienced. That was the case in Southern California's Inland Empire. Net absorption in the Inland Empire continues to improve as office tenants, priced out of Los Angeles and Orange County, sought more cost-effective space.

And in Northern California, Sacramento's office market is on a six-year run of 80 basis points or greater declines in vacancy, and this steady tightening has driven rental rate growth that is three times the national average.

Consistent with the nationwide pattern, suburban submarkets outperformed their CBDs in terms of absorption in Phoenix, San Francisco, and San Jose, while Los Angeles, San Diego, and Seattle bucked the trend, as major tenants, such as Amazon, expanded within growing downtowns.

While West Coast markets should continue to favor landlords in the coming year, Kidder Mathews anticipates a modest slowdown in rent growth, as long-awaited supply additions ease competition for space. The broadening of the technology sector into new frontiers, such as virtual reality and autonomous vehicles, offers a reason to believe the ongoing recovery on the West Coast could prove longer and more durable than the upswings in previous cycles.

Industrial Overview

The strong run displayed across the industrial sector continued into the second quarter of 2018, as the e-commerce industry expands into uncharted territories. Some perceive this asset type as cycle-proof due to a fundamental change in the way Americans consume products, which has driven construction higher than for all other property types.

While leasing has kept up with supply, it should be noted that much of the product delivered before 2016 was built-to-suit. In turn, rents have grown vigorously since the first quarter of 2015. Speculative projects account for a greater proportion of recent deliveries, as well as projects under construction, and impressive leasing velocity has been achieved. Still, Kidder Mathews believes the waters will be tested later this year when new supply enters the market at record-breaking levels.

Since peaking in 2016, sales volume has moderated recently, due to limited supply, while prices reached new highs. Robust industrial demand continues to put upward pressure on lease rates, with double-digit year-over-year gains (26.67%). While annual deliveries have grown every year since 2011, industrial demand continues to outpace the rate that new supply hits the market. At the end of the first quarter, industrial vacancies were near or at historical lows in most markets. Absorption for the quarter exceeded 10.6 million square feet, surpassing Q1 2017 absorption of 7.3 million square feet.

Reconfigurations of supply chains to accommodate e-commerce have driven this demand, which is forecast to decline slightly this year relative to the past two years. This, coupled with a robust development pipeline, may put upward pressure on vacancies going forward. Large spaces remain in demand, which tends to place super-regional distribution markets at the center of leasing.

One of the hottest industrial markets is the Inland Empire, which ranked at or near the top of national metros for absorption earlier in the cycle. It posted 5.8 million square feet of positive absorption in the first quarter of 2018, which led the pack on the West Coast. There was a staggering 19.8 million square feet of industrial product under construction in the Inland Empire, 6.1 million square feet was delivered year-to-date and total vacancy stood at 5.1%.

Multifamily Market Overview

The multifamily sector is experiencing a renaissance unparalleled in its history, with demand approaching the highest level on record. Even encumbered by a burdensome entitlement process and regulatory constraints, new development in 2017 did not decelerate from the previous year’s frenetic pace. In fact, new construction increased by nearly 13% year-over-year. By any measure, the multifamily sector is performing at the highest levels. Transaction volume remained strong, cap rates have stabilized, ranging between 4.7 and 4.9%, and average sales prices increased by nearly 30%.

On account of the record-setting pace of new construction, concerns of oversupply are often voiced regarding the sector. However, those fears are belied by certain demographic facts and the character of the current construction. A supply-demand imbalance largely offsets the overbuilding of the 2003–2006 period, and although this imbalance cannot persist indefinitely, in the near to mid-term, household formation is expected to exceed the supply of new multifamily and single-family housing units.

Further, developers have largely neglected single-family home construction in favor of high-end, urban rentals, creating an abundance of supply for affluent renters, while leaving middle-and lower-income renter households under-supplied and would-be homebuyers with few options. These underserved markets are thus ripe for enterprising developers to capitalize. Although premium, high-end, amenity-rich product faces upward vacancy pressure, demand for such multifamily units is still extremely strong. Vacancy, in fact, dropped 3.4% year over year in 2017. All of these signs portend continued growth in the sector for the near to mid-term.

Apartment markets that remain hot include Seattle, which continues to attract both foreign and domestic demand. That's being driven by job growth that continues to outperform the national average. Upward pressure on vacancies could transpire as a result of a heavy delivery schedule on the horizon, but if demand persists, vacancies may begin to level out.

In the Bay Area, structural factors, such as exorbitant rents and the East Bay’s more affordable housing options, have limited rent growth in San Francisco. However, San Francisco continues to benefit from a strong local market which has provided robust demand. Further south, demand in the San Jose market has achieved an exceptional growth pace over the past four years, credited to outstanding employment and population growth.

The San Diego apartment market remains lucrative for landlords, as rents continue to rise and vacancy decreases, despite record-high construction. Low vacancies have led to impressive rent gains over the last five years, fueling a sustained development wave that is predicted to last for the next couple of years. Projects continue to break ground in nearly every submarket across the metro, but these have put minimal downward pressure on rents, as developers have largely focused their attention on luxury units due to the high costs of construction.

Retail Market Overview

The retail sector continued to stabilize and recover throughout 2017, despite being vulnerable to competition from online outlets such as Amazon. Vacancy stood at roughly 4.7%, a decrease of 4% from a year ago. Even in the face of declining vacancy rates, and increases in occupancy, rent growth has slowed, with the increases over the past 12 months the slowest since 2012.

Investment performance for the retail sector is largely stratified by location, as retailers continue to target less-productive locations for closure, while demand for strong locations remains robust and unmet by new supply. The top 25% of the market is unlikely to be fazed by the upcoming round of store closures, and therefore represents the best opportunity to outperform the national benchmark over the coming year.

Similar to the multifamily sector, retail strategies tend to cater to the population's urban luxury segment. Urban centers are becoming denser, and land constraints make it difficult to build, which translates into urban cores being underserved, challenging developers to come up with creative strategies for these consumers.

An interesting trend being driven by tenants' willingness to pay to access this market, is the resurrection of the urban mall concept. To be sure, the modern version leans more toward a mixed-use, open layout concept than the enclosed fortress malls of the past. In particular, these new urban malls are focusing on the high end of the market, boasting tenants such as Neiman Marcus and Saks Fifth Avenue. Despite this recent surge in activity, there is enough demand in the urban luxury-retail segment to keep the fundamentals of the sector strong.

Looking Ahead

So far, as the current cycle continues unfolding, the future looks positive for CRE across the West Coast markets. Though it is always wise to keep a watchful eye for signs of potential challenges that may derail the expansion, there appears to be sufficient runway left. The market fundamentals remain stable, with demand drivers in place to sustain continued interest in office, multifamily, and industrial plays, while the headwinds facing the retail sector should produce some interesting new strategies. That is likely to include a blend of new experiential and mixed-use retail environments, as well as omnichannel approaches to meet the emergence of e-commerce.

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