Commercial Outlook: Ready for Cloudy Weather

Rising oil prices and failing dot-coms will pack limited punch for commercial practitioners.

December 1, 2000

In the event of an economic downturn in 2001, industry developments are working in your favor. Market forces and regulatory changes have converged in a way that’ll ensure a soft landing for commercial real estate.

In fact, at no time in recent memory has the balance between supply and demand in the commercial sector been more finely tuned than it is today, according to a half dozen analysts REALTOR® Magazine interviewed about the state of commercial markets today.

That balance is commercial practitioners’ ace in the hole should the economy slow in 2001, as many predict, or even slip into a shallow recession.

“The fact is, we have good equilibrium between supply and demand,” says Duncan Patterson, president of the Commercial Investment Real Estate Institute. “In most metro areas, even in secondary and tertiary markets, vacancies are still in single digits.”

Increased discipline in capital markets chastened by the overbuilding of the 1980s and the growth of high-scrutiny, publicly traded Wall Street conduit lenders played key roles in dampening the aggressive spec building that in the past has thrown commercial markets out of sync, analysts say.

But key tax law changes in the mid-1980s in response to the overbuilding and the growing concern over sprawl have also played roles. Much of past overbuilding was driven by investors looking for income tax shelters. Those shelters are gone now, so projects are driven more by market needs, analysts say.

Development is also kept in check by the regulatory hurdles localities are erecting to preserve open space and channel growth back into central city areas.

But the good overall market balance doesn’t mean commercial practitioners won’t feel any pain if the economy slows significantly in 2001, say analysts.

Already there are growing signs of overbuilding in some markets, particularly of offices. Atlanta, Dallas, Las Vegas, and Phoenix are among the areas with creeping office supply excess, as are some emerging high-tech centers such as Charlotte, N.C., Portland, Ore., and Seattle, according to federal bank regulators. These and some other big metro areas are also seeing early signs of supply and demand changes in other commercial market sectors.

Here’s a brief look at each sector:

Retail— With equity markets stuck in the doldrums, retail properties could see the beginnings of a shakeout, especially among the big box facilities that have become ubiquitous around the country. Consumer prices, too, will have an impact if they continue rising. That prospect remains likely as long as oil prices continue their upward swing.

“If people start feeling less wealthy, the retail sector will definitely be the first to feel it,” says Glenn Mueller, a specialist in market analysis at Johns Hopkins University.

Hotel— Continuing high oil prices will also put hotels at risk, because airlines will pass their higher fuel prices on to travelers, putting a crimp in room occupancy if people and companies start paring back on travel, says Mueller.

The crimp could be especially severe in the major metro areas, where supply shortages over the past few years have enabled hotels to boost their room rental rates significantly. As long as travelers were feeling prosperous, they were willing to pay the higher room rates. But that will stop quickly enough if prices throughout the economy start following oil up.

“Right now, the traveling public is able to pay,” says Hasmukh Rama, chairman and CEO of JHM Hotels, an owner of Marriott and Hilton hotels in the Southwest. But “it cannot go on.”

“We’re watching oil prices very closely,” says Jason Ader, senior managing director of Bear Stearns & Co., the Wall Street analyst firm. Rama and Ader made their remarks in late September at a roundtable discussion hosted and reported on by Real Estate Forum.

Office— For offices, more fundamental than oil price hikes is the flattening in the equity markets and the capital crunch faced by the fledgling dot-coms, which have helped drive office occupancy rates to some of the tightest levels ever seen. After developing new properties and retooling existing properties to meet the demands of these high-tech tenants, owners are bracing for occupancy flux as investment capital for many of these start-ups evaporates.

“When these start-ups get their financial reality check, there’s a strong likelihood there will be an adjustment,” says Stephen Blau, president-elect of the Society of Industrial and Office REALTORS®.

On the other hand, there’s a long-term trend that’s working to the advantage of office owners--the shifting balance in office tenant costs.

For many companies, operating in an increasingly high-tech environment has meant higher expenditures on telecom systems than on space, historically businesses’ biggest cost center. This cost shift means there will be less pressure on owners and landlords should tenants start feeling crunched.

“Occupancy costs are no longer seen as a major expense,” says Patterson. “In the past, if you had to cut costs, you looked at occupancy first. That’s changing now, especially since many companies already have their people squeezed into cubicles to maximize space. In a lot of cases, if cuts need to be made, space is the last thing they can cut.”

Industrial— The market for warehouse and distribution centers could also get caught in a dot-com downturn, because it’s been dot-com giants like Amazon.com that have fueled much of the development of new regional distribution centers.

Multifamily— Probably best positioned to weather a slump is the multifamily sector, which is being powered by massive demographic shifts at a time of continued supply constraint. Even with homebuying at a peak, the demand curve for rental housing stretches out well beyond whatever short-term bumps are on the economic horizon.

That demand is driven by big growth in household formation as the children of baby boomers enter their adult years, and by continued strong immigration.

“Multifamily housing operates on a long time horizon and is well positioned going into 2001,” says David Lereah, NAR chief economist.

Occupancy stays tight

Vacancy rates, 1999–2001

  Office ($/sq.ft.) Warehouse
($/sq.ft.)
Retail
($/sq.ft.)
Hotel
($/unit)
Multifamily
($/unit)
1999 10.7% 8.0% 7.5% 32.1% 7.0%
2000 10.7 8.3 8.0 32.2 7.0
2001 11.5 8.6 8.3 32.9 7.1

Source: F.W. Dodge

Rents push upward

Rental rates, 1999–2001

  Office ($/sq.ft.) Warehouse
($/sq.ft.)
Retail
($/sq.ft.)
Hotel
($/sq.ft.)
Multifamily
($/unit)
1999 $25.59 $4.62 $17.31 $93.39 $704
2000 27.11 4.91 -- 96.98 731
2001 28.24 5.13 -- 100.31 762

Source: National Real Estate Index

Robert Freedman

Robert Freedman is the former director of multimedia communications at NAR.

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