Improving Fundamentals Spreading Beyond San Francisco Bay Area Into Other Western Markets
The commercial real estate
recovery finally appears to be spreading across the West, arguably the most profoundly affected region of the country by the twin blows of the housing collapse and Great Recession five years ago.
For the last two years, a handful of select technology and energy-based markets in California, Texas and a few other states have served as tent-poles propping up the nation’s fitful office market recovery. But analysis of recent data shows broadening strength in fundamentals for other West Coast commercial property sectors, including multifamily, retail and the region's battered construction market, even as housing-bust metros in Arizona, Nevada and the Golden State struggle to retain their economic footing.
The most recent CoStar Commercial Repeat Sale Indices (CCRSI) report found that the U.S. west posted the strongest pricing gains among the four major U.S. regions. The strong quarterly increase in the second-quarter 2012 Composite Index measuring price gains in all types of CRE surpassed the Northeast region with a 5.5% rise stemming mostly from exceptionally strong price increases in the multifamily and retail property sectors. Through the first half of 2012, the West Composite Index rose by 11.4%.
The Northeast, where commercial property pricing bottomed two years ago, the CCRSI Composite Index has risen by a cumulative 16.6% and still holds the overall edge in the U.S. with pricing closest to its peak levels. All major property sectors except industrial are experiencing pricing recovery. The Midwest and South Composite Indices remained near the trough of their pricing cycles, with little change in the Composite Pricing Index for both regions from the same period last year.
However, CoStar’s Western apartment and retail composite indices have spiked upward so far in 2012. And although pricing for office and industrial properties has flattened in most U.S. regions this year, West Coast office markets have showed strong year-over-year demand growth along with growth in office-using jobs.
That has translated to positive changes in occupancy and strong net absorption at mid-year 2012 in San Jose/Silicon Valley, the San Francisco Bay Area, San Diego, Seattle, Orange County and even Phoenix, according to CoStar and PPR data.
"Clearly the strongest markets are being driven by technology related job growth, which is impacting the San Francisco, San Jose and Austin markets, with a smaller impact upon Orange County and Seattle," said Walter Page, director of office research for Property and Portfolio Research (PPR), a CoStar company. "While this has been a strong demand driver, because of slowing venture capital funding, slumping stock prices for some tech firms, and the national elections, we are preparing for a slower second half of 2012 for nearly all office markets."
Vulcan Real Estate's decision to free up capital for further development in Seattle by putting the buildings housing Amazon.com's 11-building, 1,8 million-square-foot corporate headquarters is an example of the value that investors see in West Coast office CBDs.
"The Amazon Corporate Headquarters buildings represent exactly what core capital wants today: new product featuring durable, credit income streams in great CBD locations," said Kevin Shannon, the CBRE vice chairman who will lead marketing of the properties. "Markets like South Lake Union, South of Market in San Francisco and Silicon Beach in Santa Monica command premium rents because of huge tenant demand.
"Technology and corporate tenants love state-of-the-art campuses in amenity-rich, transit-oriented environments like Amazon’s because these locations allow them to attract and retain the best talent in the workforce."
As tech and energy have carried the recovery, absorption has traveled westward across the U.S., according to Jones Lang LaSalle’s Second Quarter Office Outlook. Tech-dominated West Coast markets comprised more than 55% of absorption gains in the quarter, with energy bastions Houston, Dallas, Denver and Austin making up the lion’s share of the remaining growth.
On the leasing side, cautious corporate occupiers and weak job growth are expected to contribute to reduced leasing volumes for the year for the nation as a whole -- around 10% below 2011 levels - and West Coast markets are helping pick up the slack, according to Colin Dyer, president and CEO of Jones Lang LaSalle.
San Francisco, Seattle, Silicon Valley, Denver and Houston remain some of the tightest markets in the U.S., with strong absorption and rent growth continuing at steady paces, leading to more balanced supply-and-demand fundamentals and a new wave of speculative development.
"In the U.S., demand driven by the technology and energy sectors in Western and Southern U.S. markets is being offset by weakness in the financial and government sectors in the East," Dyer said.
Office rent growth in San Francisco led the nation at 16.8% in the second quarter, with San Jose and Los Angeles also posting notable year-over-year increases.
Rents remained flat in Seattle and San Diego and continued to decline modestly in Orange County and Phoenix. However, PPR forecasts that rents in top-tier tech-based markets will outperform the nation through 2016, with smaller increases in Phoenix and tertiary West Coast markets such as Portland, Las Vegas, Salt Lake City, Sacramento and the Inland Empire, CA.
That said, it's the multifamily and retail sectors that are shining very brightly for investors as West Coast markets with growing populations try to bounce back from housing foreclosures and heavy job losses.
Home demand in the San Francisco district of the Federal Reserve continued to improve in July and early August, while demand for commercial real estate was largely stable, according to the latest "Beige Book" report covering economic conditions in the Fed's 12 districts.
Although it is still well below its historical average, the sales pace for new and existing homes picked up further in many areas, with some contacts pointing to pent-up demand that may spur additional gains. Contacts also reported that the share of foreclosures and short sales in overall home sales has been declining, and the quality of the inventory of available homes has improved.
In some parts of the district, a shortage of lower-priced homes and rental units has led to an ongoing increase in construction activity, particularly for multifamily rental projects. Demand for nonresidential space was largely stable overall, with construction activity largely limited to various public projects and remodeling of commercial and industrial space
Essex Property Trust Inc. (NYSE: ESS
), a Palo Alto, CA-based apartment REIT, has focused its portfolio on acquisition and development in selected West Coast markets. With new multifamily housing supply remaining very low, Essex is executing apartment development deals underwritten on today's rents that are generating initial capitalization rates ranging from 5% to 5.5%, with estimates of 6.25% to 7% upon property stabilization, said Michael J. Schall, CEO, president and director.
"These favorable supply conditions will allow Essex to grow rents at or beyond expectations in the coming quarters. Therefore, as long as job growth continues to meet or exceed expectations, we continue to believe that the fundamentals in our West Coast markets will help us deliver solid revenue growth into 2014," Schall said.
On the retail side, Retail Opportunity Investment Trust is trying to tap into the rising buying power of consumers in the densely populated upper and middle income markets in the West with 55% of its portfolio located in Northern and Southern California, 23% in Portland and 22% in Seattle.
Meanwhile, construction is starting to stir anew throughout the U.S., and there's evidence demand is finally picking up in the West, hammered for years by the collapse in the housing market since the Great Recession.
Associated Builders and Contractors (ABC) reported last month that its Construction Backlog Indicator (CBI), a forward-looking economic indicator measuring the amount of construction work under contract, rose 4.3% in the second quarter after declining the two previous quarters.
The West registered the largest quarterly gain among the four U.S. regions, with construction backlog rising from 6.6 months to 7.5 months, surpassing the Northeast, which posted the smallest gain in construction backlog to end the quarter at 7.28 months. Despite a decline in the quarter, decline, the South continues to report the lengthiest backlog at 8.75 months.
The CBI predicted both the broader economic softness experienced during the first half of 2012 and a flattening of the nation’s nonresidential construction recovery, and the latest CBI data is now projecting gradual acceleration in nonresidential construction spending and perhaps a slight increase in the overall pace of construction activity, said ABC Chief Economist Anirban Basu.
"The West has experienced increasing backlog for two consecutive quarters and arguably enjoys more forward momentum than any of the four regions monitored by ABC," Basu said. "California’s innovation economy, Washington’s active aerospace and technology industries and Arizona’s overall economic improvement are creating new opportunities for contractors, both directly and indirectly."