Plenty of Capital and Good Economic News

   Buoy Spirits, But the Basics Are Still Irksome

A continuum of leadership is shown here, with past and current chairmen of the board. From left to right: Dana Rowan, Exeter Realty Capital Partners; David Jellison, Liberty Property Trust; Jack O’Neill, Southgate Corporation; Brian Hogg, Portman Management Company; Anne Evans Estabrook, Elberon Development Company; James “Marty” Irving, Cassidy & Pinkard; Ronald Rayevich, RayMar Associates; Paul Novak, Bedrock Properties; Terry Stiles, Stiles Corporation; Daniel DeMarco, Campanelli Companies.

It may have been chilly and windy on the streets of downtown Boston as attendees gathered for NAIOP’s Annual Conference in October, but inside there was – dare we say it? – a palpable sense of a coming economic thaw.

First, there was good news about the economy. At the Conference’s opening session, Stephen Fuller, Professor of Public Policy and Regional Development at George Mason University (and a NAIOP Distinguished Fellow) and Susan Hudson-Wilson, CEO of Property and Portfolio Research, drew a positive picture of accelerating GDP growth, continuing consumer spending and confidence and encouraging labor market indicators.

“The job market is better than what is being reported,” said Dr. Fuller, stressing that total jobs – including entrepreneurs, consultants, freelancers and part-timers – are typically not covered by government employment statistics. “The churn that’s going on is generally favorable for the economy.”

Dr. Fuller observed that while the unemployment rate could go higher as more people come into the work force as the economy rebounds, “it won’t go below six percent this year.” In forecasting GDP and job growth over the next five years, he said that 2004 would be the best year of the decade – more like 1999 than 2000. After that, 2005 will be the second best year of the decade.

If this sounds like the makings of opportunity, Dr. Fuller cautioned that local public policy has a significant impact on economic growth.

“Local governments are the problem,” he said. “Developers know what to do; it’s a question of whether they will be allowed to do it.” He also pointed out that while growth is blamed for local problems, fiscal impact studies done for Loudoun County in Virginia, as an example, show that new development “pays the bill.” With a backdrop of failure of local leadership and foresight, he said, momentum for economic growth can be lost.

“Recovery from lost momentum is difficult,” he said.

Passing the Gavel: Daniel DeMarco, Campanelli Companies (right) welcomes Stephen Crosby, CSX Real Property as 2004 Chairman.

Wayne Resisenauer of Northwest Building, Dan DeMarco of Campanelli Companies and Kevin Cantley, Cooper Carry take a moment to check the Yankees/Red Sox score.

Demographics, Demographics, Demographics

Her prime reason for economic optimism stemmed from one word: demographics. It all has to do with the impact of the Baby Boomers, the Baby Bust generation and the “Echo” Boomers (children of the Baby Boomers).

“We are headed toward the moral equivalent of zero in the growth rate of the working age population,” she said. Office absorption is going to “hit a wall if there aren’t enough bodies to fill the space.” But that won’t happen for some time. In the meantime, she said, “Look for a fabulous recovery.” (In response to a question about when that wall might be hit, Hudson-Wilson responded that when the unemployment rate crosses the 3.9 percent level, it would be time to become concerned about office absorption.)

Job growth varies widely from one metro area to another, she observed, and “there are many opportunities to get in the path of where growth and therefore absorption are happening.” In 2007, for example, she expects the greatest growth in office-using jobs to take place in Atlanta, Chicago, Dallas-Ft. Worth, Los Angeles, Phoenix and Washington, DC.

She also sees a “legitimate recovery scenario” for industrial space. When inventories are restocked, there will be a rush of demand for space, she said. She cautioned, however, that technology – such as the RFID radio transmitter, which will track goods anywhere they go, that Wal-Mart will require of its 100 largest suppliers by 2005 – will reduce demand for warehouse space by 10 percent.

“It’s not the worst thing that ever happened, but it’s a risk to the market,” she said.

Pension funds continue to be avid real estate investors because real estate is a debt/equity hybrid and “just what the doctor ordered now. There’s no mattress available in Pension Land,” she explained, noting that pension advisors’ key concern about making particular investments is ‘Do I look like a dope or a hero?’ Consequently, price support for real estate is phenomenal and growing like a weed. Conservatively, we think that $100 billion in new equity will be coming to real estate over the next three to five years.” As for current cap rate levels, she said, “relative to historic norms, is it scary? No. Real estate is connected to the capital markets. It is very fairly valued, maybe even cheap.”

Hudson-Wilson predicted, though, that the office industry would be at risk of overbuilding between 2006 and 2020. “It won’t look like overbuilding and it will be preceded by nice absorption.”

Susan Hudson-Wilson of Property and Portfolio Research told Conference attendees to “look for a fabulous economic recovery.”

Stephen Fuller, PhD, George Mason University and a NAIOP Distinguished Fellow, predicted that 2004 and 2005 would be the best years of this decade.

It isn’t that the economic picture is entirely rosy. When asked by a conference attendee what the worst thing that could happen to the economy might be, both Dr. Fuller and Hudson-Wilson were ready with different scenarios. For Dr. Fuller, it would be the collapse of the royal family in Saudi Arabia, leading to an energy-based crisis. For Hudson-Wilson, it was the prospect of five Stinger missiles deployed against three airplanes in the U.S. and two planes at European airports. Whether or not they hit their targets, she said, “then the global economy is dead.”

But if the economy is rebounding, with job growth sure to follow at some point, why don’t more developers, owners and real estate services professionals feel better than they do? Probably because so many markets have experienced negative absorption, flattened or declining effective rents and little evidence of the job growth that would revive what continues to be anemic demand. And there’s still all that shadow space lurking behind all the stats.

In his Office Market Overview session, Glenn Mueller, managing director of Legg Mason Wood Walker, predicted that the national average rent rate would decline by six percent in 2003. Occupancy rates, he said, “don’t come back until ’04-‘05. We’ll return to a growth phase in 2005.”

Is Industrial Space Market
Near Bottom?

Garry Weiss, senior vice president and national director, First Industrial Realty Trust, offered these key points:

• The industrial market downturn started in 2001 and has not yet bottomed. In contrast to the early 1990s, this downturn was demand-driven. Since the first quarter of 2001, tenants returned 186 million square feet of space—the size of Portland or Miami. Developers delivered 414 million square feet of space—almost the size of Detroit. Vacancies rose 440 basis points.

• The general economic recession and prolonged slowdown from 2001 to present has resulted in 2.6 million jobs lost (1.9 percent); 2.5 million manufacturing jobs lost (1.5 percent); 80,000 trucking jobs lost (5.6 percent); 7,000 warehousing and storage jobs lost (1.3 percent); business inventories have been cut by $240 billion; business investment has fallen by $118 billion.

• Tenants have responded by focusing on cost cutting, which has meant a geographical reconfiguration and a change in the type and amount of space used.

• Contrary to popular belief, there is not one general trend regarding supply-chain reconfiguration. The type of reconfiguration depends on the industry as well as product and corporate strategy. For example, with commodity products (price sensitive with many substitutes) the focus is on economy of scale in which many smaller operations are consolidated into a few very large facilities to reduce costs. With service-related products, the focus is on speed to the end customer, i.e., closing a few large warehouses to open many smaller facilities located closer to the end customer, such as the automotive industry.

• With supply chain reconfiguration, industrial building design is being affected, as warehouses become distribution facilities, i.e., buildings are getting larger, clear heights are getting higher, ratio of square feet per dock is getting smaller.

• The biggest trend in industrial development today is the centralization of distribution. Companies are looking to consolidate their distribution centers to perhaps five, rather than 10 to 12 facilities. They want fewer and larger facilities strategically located. There are now more 24/7 operations rather than facilities running an eight-hour shift.

• Site features: Unlike retail, which has changed dramatically, industrial is pretty basic with typical heights at 32 to 36 feet. The trucks are 65 feet and parking has doubled to 130 feet.

• Railroads: As a mode of transportation, rail has picked up substantially. It is less expensive than other modes of transportation, especially for bigger items.

• On lease renewals, tenants with two to three years left on their leases want to renew at today’s rates and lock in savings. Landlords, on the other hand, are looking forward to a better market in two to three years and are thus less inclined to “give away the store” than they have been recently.

The Honorable George Mitchell, former U.S. Senator and Nobel Peace Prize nominee, spoke at the Developer of the Year luncheon, asserting that “There is no such thing as a conflict that can’t be ended.”

Sharing insights from industry leaders were: Jeffrey Johnson, Equity Office Properties Trust; Luis Belmonte, AMB Property Corporation; and Charles Reiss, The Trump Organization

Other Industrial Trends

• The L-shape building is growing in popularity. Target now wants only L-shape industrial space, for example, and Home Depot is moving toward the same design.
• RFPs are reportedly now listing future expansion clauses.
• Build-to-suit properties are outpacing standard-builds by a nearly two-to-one ratio.
• Turning non-investment grade real estate into investment grade real estate is a big trend.
• Environmental hurdles seem to be most challenging when it comes to redevelopment, especially run-off issues.

New Buzzwords   Join the Lexicon It isn’t enough to talk about properties as Class A or Class B anymore. Now properties can be designated as “core,” “core-plus” and “value-add.” As defined by the panelists at the “Leading Capital Providers” session, “core” means Class A properties with long-term leases in great locations. “Core-plus” could be Class “A”, “A-“ or “B+”, with some risk, requiring some re-leasing or repositioning. A “value-add” property, in old real estate parlance, is a deal with a lot of hair: in other words, a high-risk. Investors in each of these property types expect commensurate returns. Charles Leitner, principal of RREEF, said that he expected nine to 10 percent returns, typically unleveraged, on “core” properties, while “core-plus” should provide 10 to 111/2 percent IRRs. “Value-add” properties should be in the 12 to 15 percent range.

Ellen Rand and Ron Derven are co-editors of Development magazine.