FEATURE ARTICLE, DECEMBER 2004

FORECASTING A BRIGHT YEAR
Brokers across the Northeast predict continued improvement for 2005.
Interviews by Jaime Lackey

NREB: What markets (or submarkets) have grown in 2004 and which markets are poised for growth in 2005? Why?

Geanakos: With regard to the office market, the Manhattan market has experienced increases in sales activity and pricing this year.

Riguardi: The strongest market in the region by far is the Midtown Manhattan office submarket, where prime availabilities are limited and tenants in the market clearly outnumber the amount of available space. Whereas law firms led leasing activity in 2003, the commercial banking and financial service industries are once again driving leasing activity this year.

Schultz: [In New Jersey,] there is tremendous development and redevelopment activity in places like Harrison, Newark, Perth Amboy, Jersey City and Hoboken, as well as Morristown. Other areas along the Jersey shore are also undergoing an exciting renaissance.

Clements: [In the Philadelphia area,] all of the regional office markets (Southern New Jersey, Philadelphia’s western suburbs and Delaware) except Philadelphia’s CBD, added at least a few hundred thousand square feet of space in 2004. The CBD will be adding 730,000 square feet of space to its inventory in the fourth quarter of 2005, when the Cira Centre at 30th and Arch streets is completed. The regional industrial market will see some growth in 2005, especially in the Lehigh Valley and the Interstate 81 corridor. A partnership between Equilibrium Equities and Liberty Property Trust has shown confidence in the future success of the I-81 corridor by starting construction on a 750,000-square-foot speculative warehouse/distribution facility. The completion date is set for year-end 2005.

Robinson: [In terms of multifamily markets, Apartment Realty Advisors] thinks that there are two opportunities. Inside of Route 495 in Massachusetts, we are starting to see some job growth, especially in the biotech, medical devices and pharmaceutical sectors. In addition, we see a flight to quality of life also tied to seniors moving into New Hampshire.

NREB: What markets (or submarkets) are struggling? Why?

Riguardi: Relative to the success of the Midtown Manhattan office market, the downtown New York market is struggling. Although vacancy rates have increased in all building classes in downtown New York, rental rates have increased slightly. In the past month, however, we have seen increased leasing volume, and we expect to see a positive absorption in the Lower Manhattan office market in 2005.

Schotz: Due to the market fall off in Lower Manhattan, Jersey City has been way off.

Schultz: In New Jersey, the office market is clearly still languishing when compared to the industrial, retail and residential markets. However, the worst is definitely over and all signs point to a recovery in the office market as jobs, employment and growth in New Jersey are all leading the nation.

Clements: Philadelphia’s western suburbs are posting the highest office vacancy rates in the region at 22.4 percent, but are slowly taking back space. However, to slide back under 20 percent vacancy, 1.5 million square feet of space will have to be absorbed. The CBD’s vacancy has been increasing the last few years and is expected to increase into the high teens over the next few years before making its way back down. For industrial product, New Castle County, Delaware, has suffered the most this past year, vacating nearly 1 million square feet of space as of the third quarter of 2004 and rising to 15 percent vacancy.

NREB: What property types are hottest in the Northeast? Why?

Geanakos: There has been tremendous competition on all product offerings. While office, residential and retail product is being aggressively bid and acquired, acquisitions continue to be difficult and demand extremely low cap rates on average. Institutions utilizing lower leverage strategies continue to compete with entrepreneurs who aggressively employ low cost debt capital.

Clements: In the Philadelphia region, smaller office and flex properties ranging in size from 10,000 square feet to 20,000 square feet have been the hot product type for users to acquire over the last few years. Quality office buildings have been more attractive recently, as the rate differential between Class A and Class B spaces has grown smaller, especially in the CBD, where the differential is slightly under $3 per square foot. Big box warehouse distribution space has been the hot industrial product type over the last few years, and will continue to be because the Philadelphia metro area is well positioned between Washington, D.C., and New York, making it a tremendous location for distribution and third-party logistics companies.

Riguardi: The property type most in demand throughout the Northeast is well-located Class A office buildings in central business districts or downtown markets. Those properties are seeing the greatest interest from tenants in a wide variety of industries, fueling a drop in vacancy rates and an increase in rents.

Futterman: Between Boston and Washington, D.C., the biggest push we are seeing is the development of lifestyle retail centers. Originally conceived for warmer climates such as Florida and Alabama, they have been very well received in the Northeast. S.R. Weiner & Associates is developing three lifestyle projects from Boston to Hartford, Conn.; Stanbery Development is constructing three lifestyle centers in New Jersey; and Poag & McEwen is one of several companies building similar properties in the Allentown, Pennsylvania, area. Retailers that have located stores in lifestyle centers have seen impressive sales and greatly reduced costs. In many cases, retailers can save more than 20 percent in costs compared to operating out of a traditional mall.

Robinson: [Apartment Realty Advisors is] seeing an increased focus on age-restricted [multifamily] developments.

Schultz: In New Jersey, industrial and office properties [are hot]. With its central location between New York City and Philadelphia, a lot of companies in the warehouse/distribution business see New Jersey as a key location. In addition, office space is hot for companies seeking space close to New York City or as New York City back office space.

NREB: What property types are struggling in the Northeast? Why?

Schultz: The properties that are struggling are the Class B, older facilities that do not have modern amenities. There is clearly a flight to quality in the market so the best properties are getting all of the attention from prospective tenants. Many of these older, abandoned properties, however, are being targeted for conversions to residential and retail usages.

Clements: In the Philadelphia region, Class B office space has the highest vacancy in the region and should continue to struggle into 2005. Less demand for manufacturing space within the Philadelphia region has been a growing trend, as more and more manufacturing jobs are shipped overseas.

Robinson: Some of the Class A quality properties in markets where there has been overdevelopment of this type of product have been suffering.

NREB: What do you think needs to happen in order for the market to improve in 2005?

Schotz: Job, jobs and more jobs.

Phelan: An improving economy will lead to job creation, which leads to absorption of vacant space.

Riguardi: Job creation, corporate expansion and lack of development of new office properties are leading us to a market in 2005 that will enjoy positive absorption and a significant increase in rental rates.

Futterman: I’m not sure how the retail market can get any better in 2005. Consumer confidence is strong, the country is adding jobs, Wall Street is growing and the economy is doing very well.

French: Interest rates need to stay at their current levels and the unemployment rate needs to stay down so that consumer discretionary income is spent at the retailers’ stores, increasing their sales and allowing them to expand into these markets.

Geanakos: Ultimately, there needs to be a stabilization of fundamentals (equilibrium in supply and demand). There will need to be a strengthening in job growth as well as a positive shift in employer confidence so that users of office space will decide to implement expansion plans.

NREB: What trends do you think will emerge in 2005?

Geanakos: 2005 will bring about an improvement in real estate fundamentals, which will lead to potentially more aggressive underwriting, off-setting the continued increase in the interest rate environment. The number of entrepreneurs aggressively participating in the large-scale acquisition markets ($100 million+ properties) may begin to decrease, thereby allowing institutional investors to become more aggressive and prevail in bidding contests more frequently.

French: I think we are going to see an increase in inflation causing interest rates to go up, which in turn will cause the retail investment sales market to slow down as sellers will be unwilling to reduce their asking prices and buyers unprepared to pay those prices.

Futterman: Food-related retailers and restaurateurs have been very active throughout the Northeast in 2004. In 2005, that trend will continue and expand. Better restaurants and higher quality food retailers are opening their doors in many markets, and people are going out to eat more. In addition, companies are catering to the “nesting” trend that has developed over the past couple of years, with home furnishings retailers leading the pack. Smith & Hawken, Williams-Sonoma, Z Gallerie and many others are expanding throughout the Northeast based on the success of existing stores and the promise of continued growth.

Riguardi: In 2005, we are going to see vacancy rates drop significantly in Midtown Manhattan. As available space continues to tighten and rental rates increase steadily, we will see more significant movement of tenants from the midtown market to the downtown New York market than ever before.

Schultz: The major trend in 2005 will be the recovery of the office leasing market. With the uncertainty of the election over, companies will begin to focus on growing their businesses and start aggressively looking for expansion space. One area to be concerned with, however, is rising interest rates, which would dramatically chill the investment sales market and make doing business in general more expensive.

Clements: [Grubb & Ellis expects to see] few speculative office or industrial developments. Tenants will continue to be cautious, although many will want to renew their leases early, before demand picks up again and rents increase. Landlords will want to renew tenants for shorter terms, so they will be able to lock in higher rents when demand returns. Furthermore, with construction costs moving close to a 20 percent increase, look for rents on new product to increase significantly — perhaps giving existing product an edge.

Robinson: [Apartment Realty Advisors expects to see] more specialized housing. The baby boomers are renting in the city and there are some substantial renovations occurring at properties like Avalon Prudential and The Devonshire in downtown Boston, and also at suburban age-restricted for-sale product like the Pine Hills community in Plymouth, Massachusetts.

NREB: What are your predictions for northeastern real estate in 2005?

Schultz: My prediction is that you will see the office market continue to recover, the retail and industrial markets still strong and the investment sales market will continue to tighten with little new product hitting the market.

French: [Sperry Van Ness] expects retailer sales to decline in 2005 compared to 2004 due to two factors: the number of jobs that have not been replaced and the increase in transportation costs that are going to reduce discretionary income. This will cause some retailers to close stores, creating vacancies in centers, which will lower the value of the property. We predict a slowing of the retail investment markets by the third quarter of next year.

Geanakos: As job growth within New York City solidifies, office fundamentals will improve, leading to an increase in rental rates. More importantly, a compression in the disparity between midtown and downtown rents may occur as office users recognize the tremendous values in Class A product available downtown to accommodate medium and large size requirements.

NREB: How would you describe the lending environment?

Schotz: Very active with plenty of capital available for quality deals.

Riguardi: The amount of money looking to be placed in the commercial real estate market remains greater than available product.

Phelan: The Northeast continues to be quite active. Money is bountiful, rates are favorable, and lenders are being wise and not making mistakes.

Schultz: The lending market is highly competitive as there is so much capital chasing so few good deals.

French: Right now the lending environment is very active. The lenders can’t loan their money fast enough. Lenders have the highest levels of delinquencies that they have had in years, but these delinquencies are still relatively low.

Geanakos: The current lending environment is robust. Large amounts of debt capital have been provided to quality sponsors, while spreads have been compressed to unprecedented levels. Interestingly, lenders’ aggressive underwriting practices have not been limited to standard assets (i.e., office product) and now include hotel and development financing.

NREB: Interest rates are expected to rise in the coming year. How do you think this will affect real estate in the Northeast?

Phelan: Obviously, how high the rates go is going to affect the equity side real estate, which has been helped dramatically by the low price of leverage. I suspect it will have more of an impact on the sales market than it will on the development market, which will be driven by demand. I think borrowers have a higher threshold and tolerance for some margin in the rates versus sales deals.

Riguardi: As interest rates continue to increase, the profile of the typical buyers of real estate in the Northeast will evolve from the more highly leveraged entrepreneurial owners we see today to more institutional investors.

Clements: Interest rates will be a bit higher at the end of 2005, but this should not pose too much of a threat for buyers because they will also be factoring in an improving leasing market. The investment market hit a recent high-tide mark for dollars spent per square foot in 2004, but activity will be brisk in 2005. Sellers may not fetch the same fevered pricing or pool of buyers that they have in 2004, but they will continue to make comfortable returns in 2005.

Geanakos: The interest rate increase may prove beneficial to institutional investors as it may force private players to become less aggressive due to increased debt constant levels (i.e., spreads and/or amortization schedules). The possible offset to this phenomenon (which may allow private investors to remain competitive) is an improvement in property fundamentals, which should translate to increased property cash flows to offset increases in the debt capital markets.

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