Financial Turbulence Rattles Sluggish Recovery, Prompting Revised Growth Forecasts

Weaker Near-Term Growth Undercuts Outlook for Commercial Real Estate Demand, Rents, Values

The effects from late summer’s national and international economic challenges have cast a huge shadow over the commercial real estate market recovery. Nothing postpones a leasing, development or investment decision like the uncertainty surrounding the prospect of a national default, volatile stock markets, a slowdown in retail sales, slouching corporate profit growth, and declining bank lending.

These indicators (while still pointing toward growth) have generally grown progressively weaker since late 2010. And while last year they all pointed to improved employment recovery, that expected level of job growth no longer appears to be the case.

In light of the financial turbulence, CoStar’s economists have joined other market watchers in re-assessing its recovery forecast from this past spring in light of the more sluggish growth occurring now.

Office: Weaker Near Term

By: Adrian Ponsen, CoStar Real Estate Economist
Of all the lackluster economic data that’s surfaced during the past few months, one of the most concerning for the office market was the decline in the ISM Non-Manufacturing Index.

The recent movement in the ISM Non-Manufacturing Index (historically a strong leading indicator of office absorption) best encapsulates the economic slowdown described above and its implications for office demand.

CoStar projects weaker near-term office demand growth. With our weaker near-term expectations of office-using employment growth, we are expecting about 13% less office demand growth than previously forecast through 2015 and higher vacancies in the near term.

One blessing is that this downgraded demand outlook isn’t surfacing at a time when developers are already underway on new projects. Along with weaker demand, supply growth will adjust accordingly, meaning fewer new projects will deliver during 2013-15.

The outlook for rents has deteriorated, but not severely. For example, whereas year-over-year rent growth of 2.6% was expected for mid-2012, the forecast now calls for a 2.1% growth rate.

The difference in forecast value growth is more material, as weaker NOI performance is expected to keep values nearly flat through early 2013. The strategic implications of the changing outlook are most important to value-add and opportunistic buyers, who depend on future growth to generate higher returns.

Warehouse: Still Has a Green Light

By: Shaw Lupton, CoStar Senior Real Estate Economist
Gauged by the shoring up of retail sales, manufacturing output and trade, the climate for warehouse demand has improved markedly since this time last year. However, the shocks to the system (oil prices, supply chain disruptions) that disrupted economic growth in the first half of 2011, combined with the recent turmoil in the stock markets, have led us to temper our near-term absorption expectations.

Consequently, we have also lowered our outlooks for rent and value growth. However, the takeaway remains the same: Now is an excellent time to invest in continued economic expansion by gaining exposure to warehouse properties.

Other lingering factors that could continue to hold back warehouse demand are shadow supply and oppressively low housing starts. Despite this, we remain cautiously optimistic that the pace of absorption will improve in coming quarters. There are good reasons for optimism.

Wholesale trade sales expanded at a 6% seasonally adjusted annualized real rate in the second quarter. Although lower than the previous quarter, this rate of growth is in line with the 2004-07 average.

With the ratio of wholesale trade inventories to sales within its “normal” band of about 1.1-1.2, firms have little choice but to restock in response to continued sales growth.

Inventory restocking has soaked up much of shadow supply in recent quarters, which should allow more future growth to translate to net absorption. As of June, wholesale trade inventories had clawed their way back to within 1.5% of their 2008 historical peak in real dollar terms.

Finally, we continue to see strong leasing of modern warehouse space in major distribution hubs, which bodes well for absorption in the second half of the year. Nationally, there were 10 deals between 500,000 and 1.4 million square feet signed in the second quarter alone, and many more in the over-250,000-square-foot range.

With construction at or near a low for the cycle, we expect a modest demand bounceback to translate into rent and income growth in coming quarters, giving developers the green light to build.

Retail: Little Margin for Error

By: Ryan McCullough, CoStar Real Estate Economist
The sluggish recovery scenario paints a bearish outlook for retail. The demand forecast is particularly dicey over the next four quarters; with a cumulative gain of just 1%, demand is barely expected to keep pace with population growth. This leaves precious little margin for error. Another shock like rising energy prices probably would be sufficient to send demand back into the red.

Growth in retail space, already weak, is even weaker in the current sluggish recovery scenario, and does not seriously threaten supply and emand fundamentals over the next few years. The end result is an economic vacancy curve that trends down over the forecast but at a sluggish pace indeed.

Much like demand, the outlook for rents and investment performance is notably weaker in the sluggish recovery scenario. Rent growth is expected to re-emerge in early 2012 but at a grinding pace. Values will bounce along the bottom through 2012, and cap rates will remain above 8% until 2013. Overall, rents and values will not come close to recouping their losses by 2015.

Apartment: Upside Has Been Largely Realized Short Term

By: Erica Champion, CoStar Senior Real Estate Economist
The performance of the apartment market has been very impressive over the past 18 months. However, the demand generated from falling homeownership rates, reduced shadow supply and decoupling of roommate and multigenerational households has largely been realized by now. Going forward, job creation will have to fuel further recovery.

But the job creation momentum that looked so promising at the very beginning of the year has been disappointing of late.

In a sluggish recovery scenario, stalled employment growth will dampen apartment demand throughout the forecast and most significantly through 2013. However, the low number of units in the supply pipeline and a lack of confidence in the single-family market should help maintain modest demans, and as a result, vacancy levels are not expected to reverse their downward trajectory.

As demand grows at a slower pace, however, developers will likely wait on the sidelines for a little while longer.

Rent growth for multifamily property will likely be less robust in the near term as vacancies hang a little higher, but should post similar growth during the outer years. The total hit to nominal asking rents would be about $50, or 3%, by year-end 2015. So while the national economic setbacks may rain on the parade, the forecast does not call for a violent downpour.

Source:  CoStar

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