Development ’06: Sunny Days Seen Continuing in ’07
[ By Ellen Rand and Ron Derven ]
Several walking workshops, with tours of outstanding commercial properties, were a popular option at development ’06.
Is the future so bright we have to wear shades? The prevailing mood at NAIOP’s development ’06: the annual meeting for commercial real estate, held at the Hyatt Regency in San Francisco, was overwhelmingly upbeat and the perspective increasingly global, though of course there was an undertone of concern about interest rates, the economy, distribution logistics challenges and construction costs.
If there had been an award for most optimistic view of the future, keynote speaker Newt Gingrich would have won hands down. Extolling a future filled with unprecedented scientific and technological breakthroughs and business opportunities, he asserted that “winning the future,” as he called it, will take the energy, creativity and innovation of a generation dedicated to creating an America that is stronger and more prosperous, capable of competing and winning in a global economy. But winning the future cannot be done in an “overlitigated, overlawyered economy,” he said. “What you want is a very strong government with a very lean bureaucracy.”
On the other hand, he said, “I believe we are in the early stages of an emerging third world war.” But barring major war, he commented, with America’s stable system of property rights and rule of law, it is no surprise that “you have capital running after opportunities; we’re not going back to opportunities running after capital.”
Speakers and attendees agreed about the good news in equity and debt capital: still abundant, with the spigot not likely to be turned off any time soon. But, as Bentall Capital CEO Gary Whitelaw asserted, “the cap rate compression game is just about done.” To him, this implied a back-to-development-basics approach. He said that the ability to “expertly manage properties, creating value, is what will make the difference.” He also asserted that “it’s folly to think of management and leasing as a commodity. Tenants’ decisions have every bit to do with the quality of service as they do with the economics of the leasing proposal.”
Investor Interest in Office Sector: Strong in ‘07
The dramatic atrium of the Hyatt Regency was the backdrop for Welcome and Forum receptions, with exhibitors mingling with development ’06 attendees.
Marcus & Millichap Real Estate Investment Brokerage Company’s Alan Pontius, national director of the firm’s office and industrial properties group, told a forum of office principals attending the conference that investor interest in the office market will hold strong in 2007.
The market continues to post improvement and the cap rate spread compared to other core property types remains favorable. Overall, cap rates have posted a mild decline this year, but into 2007, they will remain relatively stable, even if interest rates rise moderately, he said.
“Job creation is expected to be sufficient to support absorption of new space in 2007,” said Pontius. “Expansion requests are primarily being made from tenants within or organically. They are taking what they believe they will need rather than asking for more space in anticipation or larger future needs.”
Rents have increased considerably since the office recovery began but remain below levels achieved prior to the downturn. Effective rents are forecast to post growth in excess of five percent next year.
Despite a gradual rise in interest rates, office property prices continue to increase. This price growth is due to a variety of factors, including improving fundamentals, high development costs and land prices and strong investor demand for office assets. However, price appreciation will not be spread evenly across markets or property classes.
Institutional-grade, Class A properties in top-tier markets are experiencing some of the most significant price appreciation. High-quality assets, even those outside major coastal markets, are selling at cap rates of less than 6.5 percent. Investors are increasingly willing to pay premiums for Class A assets. Rising land and replacement costs lend further support to prices for top-tier properties, particularly assts in high-demand locations.
“Pension funds are putting up capital in office investments where they never did before,” Pontius noted.
A combination of improving fundamentals, strong capital flows into real estate and a relatively favorable lending environment will continue to support office property values during the next year.
Some key predictions:
In general, improving net operating income growth is forecast in virtually all office markets around the country – the Midwest will clearly lag, with Chicago and Minneapolis running modestly ahead of the overall Midwest trend – coastal markets will perform more favorably.
A slowing economy will reduce the rate of improvement in 2007, but there will be improvement nonetheless.
Cap rate compression will be very modest to not at all – limited only to “best in class” offerings in major metros while cap rates will inch up modestly in Class B or C assets (“commodity space”).
Mixed-Use for the Office Developer
Perhaps it was a measure of how ubiquitous mixed-use developments have become that of the attendees at a session on “Mixed-Use for the Office Developer,” a show of hands revealed that the mixed-use newbies were in the minority.
Jill Bensley, prinicipal of JB Research, outlined the “Top 10 Reasons Why Mixed Use is Making a Comeback, or Why American Cities are Reviving.” They are:
Changing demographics, baby boomers, generation Y and smaller households.
Consumer trends and lifestyle preferences: the search for meaning.
Payoff from 20 years of public investment and planning.
Immigration: resettling of undesirable urban areas by industrious, hard-working new arrivals.
Smart growth initiatives, sustainable development movement.
Innovative financing (TIFs, market-based financing solutions, special assessement districts, business improvement districts).
Lack of investment in infrastructure (transportation, power, oil and gas, education, utilities) and congestion.
Regulations/approvals at the fringe: NIMBYs
Land price escalation: changing economics of residential versus office development.
The urbanization trend worldwide.
Of these reasons, she said, the first two are most important. “People are searching for meaning in their lives,” she said. “They are looking for it in their retail experience. And I daresay, in their office space too. Give your clients or customers a way to connect and find meaning and you’ll be ahead of the game.” She suggested that a streetscape and retail component should “makes you feel better and different from when you came out of the office building. It should be an exciting place and space to be in.”
Eric Hohmann, vice president, acquisitions and development, Madison Marquette, a retail developer, said that “Government jurisdictions like to see retail because of the sales tax component. We’ve been driven to do [mixed use], whether we liked it or not.”
Luis Belmonte, principal, Seven Hills Properties, predicted that the widespread use of radio frequency identification devices could result in less of a need for warehouse space.
Like many other companies, Madison Marquette has grappled with the issue of how to structure mixed-use developments when venturing with other companies with different expertise. Do you add in-house capability? Do you spell out precisely who will do what, and how rights and responsibilities are split? Currently, he explained, the company’s stance is that “You have to control the environment and the uses. For a new project, we control all design and environment up front; we need to be the master developer.”
Bensley and Hohmann agreed that retail demand cannot rely on on-site consumers alone. “Regional demand has to be measured separately from on-site demand,” said Bensley. “Usually retail is the frosting for other uses, but there has to be regional demand.” She noted that retail anchors have changed -- a museum or a movie theater or an Apple store could serve as retail anchors.
Hohmann pointed out that the company has discovered that there is a premium that residential purchasers are willing to pay to live in a safe, well-designed mixed-use development. He estimated that premium at 10 percent for the mixed-use component and an additional 10 percent for views.
Ideas Heard ‘Round the Roundtables
Facilitated by real estate industry experts, Roundtable sessions at NAIOP’s annual conferences have become a staple in recent years. Here’s a potpourri on industry intelligence and good ideas heard at the sessions.
On reinventing the railroads—at a roundtable on railroads and their future, facilitated by Steve A. Crosby, president, CSX Real Property Inc., the view was that railroads will only grow in importance for the commercial real estate business. There will be: dramatic change, due to highway congestion; ports with better rail service; major distribution-oriented companies such as Wal-Mart locating closer to rail as rail takes on more transportation; new models emerging for inland “Integrated Logistics Centers”; movement toward presorted containers at the origination; railroads making huge investments in infrastructure and technology to continue to reduce costs and time.
On construction costs—Don Trainor, vice president, Howard S. Wright Construction Co., offered these insights: With prices rising and the threat of shortages looming, the recommendation was made to take the risk early in a project and lock in prices. A developer cannot afford to be short of product or to have to pay future higher prices. There is a growing shortage of skilled labor. Perhaps the slowdown in residential will free up trades for commercial work.
On goods movement—Barry G. Hibbard, director of real estate, Tejon Ranch Company, hosted a lively discussion on the future of goods movement in the U.S. All participants at the table agreed that there needs to be a national transportation policy. Among the other items they discussed:
Ports of Long Beach and LA (LB/LA) growing at 12 to 14 percent per year.
Extended gate hours at LB/LA have been approved.
The talk in Sacramento is about promoting both “green and growth”— focus is on green, not growth, said participants.
Weakest link in the movement of goods is port trucking.
Wal-Mart and Target have led an effort in recent years to diversify their shipping operations.
Lazaro Cardenas, a port on the west coast of Mexico, could be functioning in three to six years.
Prince Rupert, British Columbia, Canada is being looked at because it is a deepwater port in an old, depressed manufacturing town. It also has good rail connections to the American Midwest.
Roundtable participants agreed that short-haul rail from LB/LA to distribution centers in the Inland Empire won’t work unless mandated by government.
East Coast ports will do well in coming years, in part because the shipping lines and railways all negotiated with each other about 10 years ago for long-term contracts to move containers from West Coast ports to the rest of America. The railways negotiated low contracts. They will now raise their prices by 25 to 40 percent and many shippers will find it more economical to sail to the East Coast rather than ship over land.
Savannah and Norfolk will do well because infrastructure is in place.
There will be tension in many areas over competing uses for land near ports.
On health care real estate development—A roundtable facilitated by Larry Pobuda, principal, Stewart Lawrence Group, determined that demographic trends are strongly positive for health care real estate development: 76 million baby boomers are living longer and better; they are spending more on alternative medicine; they are moving away from having procedures at hospitals to large free-standing outpatient facilities; medical office space could also house “medical light,” that is, doctor practices such as dentist, chiropractors, etc; 20 percent of GDP will be spent on healthcare by 2020, which could exceed $2 trillion; and one in five jobs will be in healthcare.
International Development: Challenges and Opportunities
A popular session in the CEO Insights category at the conference was ProLogis CEO Jeff Schwartz’s presentation about international development. Although he disagreed with predictions that China would have the world’s number one economy in 20 years (it will take 50 years, he said), clearly China and other Asian countries are critical to ProLogis’ growth. In all countries, the company takes pains to staff up with nationals. In China, for example, all 165 staff members are nationals.
“There is no country in the world yet that does rail well for passengers and freight,” he said. “China is building two sets of tracks.”
A panel of experts addressed an impending talent crunch in the industry. Panelists included moderator William Chillingworth of CB Richard Ellis; Hamid Moghadam of AMB Property Corp.; Carl Panattoni of Panattoni Development; Edward P. Roski Jr. of Majestic Realty Co. and Rusty Rueff of SNOCAP.
Rapid real estate growth and investment prompted the Chinese government to adopt a new measure in July to regulate foreign investment in Chinese real estate. The Measure, as it is called, requires that foreign investments in Chinese real estate be held through China onshore entities that are subject to government regulations and taxation, such as the foreign investment enterprise (FIE). It also limits a foreign investor’s ability to fund China real estate projects by adding controls that limit borrowing.
ProLogis entered this market in 2004. Schwartz observed that “Had we known that [the Measure] was going to happen, we would have done 100 million square feet. As it is, we have 45 million square feet, as first mover.”
He also pointed out that “Sustainability is a key initiative for us. Developers will need a core competency in environmental building to succeed. It is a business imperative throughout the world.” As for developing brownfields sites, he explained that “It varies from country to country. We won’t do it where there is no established law.” He added that “Japanese law is close to California law.”
New building techniques have been created out of necessity: In Japan, which Schwartz said has only come out of its recession in the last year, every building has to be at maximum floor area ratio (FAR).
As a result, “building a warehouse facility there is like building a mid-rise,” he said. The seven-story ProLogis Parc Tokyo, for example, has a 400 FAR, with spiral ramps that are one way going up, one way coming down. Rents are $20 net per square foot. The facility features seismic isolators (patent pending) to protect against earthquake damage. These are like mechanical shock absorbers, which can ultimately save money on steel and enable construction with fewer columns. ProLogis has been asked to license the design, but has not, Schwartz noted smiling.
His advice for other companies entering overseas markets: “Be sensitive to other cultures and open to adopting best practices from all over the world. Delegate to empower your people in the field but dedicate the time to enable their success.”
Serving a Global Distribution Market
At another CEO Insights session, Hamid Moghadam, chairman & CEO, AMB Property Corporation, explained that this company has 2,700 customers in 42 markets in 11 countries. Four years ago, it was in four countries. It has an enterprise value of $8.6 billion, with a $1.2 billion development pipeline (13.4 million square feet in 45 projects).
AMB is targeting eight of the top 10 seaports globally as ranked by total container volume and has exited some U.S. markets not consistent with its growth strategy, such as Columbus, Charlotte, Portland and Cincinnati. It has $910 million invested in Europe to date and $1.8 billion invested in Asia. He noted that two percent of global trade moves by air but represents 40 percent of value. Inland ports, such as Chicago, Seattle and northern California, are good for truck-to-rail movement.
He observed that faster ships are being developed and that retailers are trying to set up their own hubs and ports. Companies are becoming more focused but consolidating within their area of focus, where they had previously been fragmented. AMB has found that clients want a single point of contact.
Achieving Success Through Public-Private Partnership
Public-private partnerships can be challenging structures, but the payoff can be tremendous for the developer, the city, its citizens and the entire region, according to Ross Perot Jr., chairman, Hillwood Development Corporation, Fort Worth, Texas As keynote speaker at the Chairman’s Breakfast, Perot spoke about two of his company’s major developments: AllianceTexas and Victory Park. Hillwood’s AllianceTexas project, he said, is a 15,000-acre development northwest of DFW International Airport. The project’s foundation is an international trade and logistics complex, offering inland port transportation options via the world’s first 100 percent industrial airport, two main rail lines, BNSF Railways’ fourth largest intermodal yard and connecting state and interstate highways. In all, the development encompasses 25 million square feet, more than 140 corporate residents, 24,000 employees and more than 5,200 single-family homes.
Perot is now creating a significant master-planned urban development in the Southwest, once again through a successful public-private partnership. Victory Park is a 75-acre site that connects Dallas’ revitalized downtown to affluent in-town districts such as Uptown and Turtle Creek. Victory Park represents an investment of over $3 billion and at build-out, a total of 12 million square feet.
“Billions of dollars in public and private investment are going into this part of Dallas,” said Perot. “This will become a real magnet in the north Texas area. This project will be so strong that it will start pulling developers back from the suburbs into core Dallas. This will be a great economic story for the city of Dallas.”
Ellen Rand and Ron Derven are co-editors of Development
