Correction expected in real estate market

More than 600 of the nation's leading real estate experts expect the sizzling commercial real estate market in the U.S. to slow in 2008, with a healthy correction that will likely bypass long-term investors but penalize late-to-the-game speculators and overleveraged buyers, according to the annual Emerging Trends in Real Estate 2008 report, released by the Urban Land Institute (ULI) and PricewaterhouseCoopers LLP.

According to the report, real estate investors and developers believe uncertainty will characterize 2008. They expect capitalization rates to rise and risk to be repriced, with the harshest effects being felt by those who have relied on debt strategies. More than three-quarters (78 percent) anticipate more stringent underwriting standards in the year ahead. Yet, despite this apprehension, respondents expect most real estate investments to outperform both the U.S. stock and bond returns in the year ahead, and are counting on ample capital sources to cushion the property markets.

Respondents believe the correction in the commercial market will not be as severe as in the residential real estate market. Commercial real estate supply and demand is relatively strong, development is in check, and the fundamentals are still healthy, according to respondents.

"The commercial real estate market has been going full throttle for several years with easy money and low interest rates that drove some sectors into questionable lending practices and highly leveraged spending," said Tim Conlon, partner and U.S. real estate practice leader, PricewaterhouseCoopers. "But the run went on too long for some participants. Those who went beyond moderation will likely experience some headaches in 2008. Depending on what happens with the U.S. economy as a whole, it could be painful for some, but overall, a correction could be good for the industry, keeping supply and demand in balance, curbing overdevelopment, and flushing out low-quality investors. By the same token, there are still investment opportunities and there is still a good deal of demand from investors."

Richard Rosan, president, ULI Worldwide, said the report points to the value of sustainable building, which results in development that remains in demand despite market cycles. "We are seeing an increasing emphasis on building efficiently to accommodate growth -- on pedestrian-friendly, mixed-use development, communities that provide housing near jobs, and development connected to transit," Rosan said. "What is selling now and will continue to sell are projects that cater to strong consumer desire for convenience. Those are the best bets."

He noted that the issue of climate change has elevated the importance of sustainable land use, giving such development a competitive advantage that will increase as the market improves. "It's clear that building in a way to cut auto dependency is a key part of the solution to climate change," Rosan said. "This is the type of development with long-term value."

Markets to Watch

The top markets to watch, according to the report, are those that have positioned themselves as 24-hour cities with a global pathway to international markets. They all have a major international airport and/or shipping port, export-import hubs, an educated workforce, and walkable residential neighborhoods. They have made a concerted effort to revitalize downtown areas or nearby "urban burbs" that have made them magnets for corporate headquarters, business elites, the best and the brightest of the workforce, as well as the largest share of investor dollars.

"The most successful investment opportunities are markets on the coast, reinforcing the real estate truism that it's all about location, location, location," the report says. "But as many interior cities such as Denver have demonstrated, it is possible to transform a city into a 24-hour global pathway city with master planning around infrastructure, transportation, and economic development."

The report ranks New York City as "the hottest commercial real estate market in the country" and the "ultimate American 24-hour city." "Vacancies in New York are in the mid-single digits, rents have skyrocketed, and pricing is at all-time highs," states the report. And while the market may have peaked recently, the weak dollar actually makes the city's "monster" prices look cheap to foreign investors who are pouring and parking money into Manhattan real estate, the report says.

According to surveyed real estate experts, not only is the New York market hot, but the entire commercial real estate industry has also acquired a "New York state of mind" as Wall Street and real estate have converged. In part because of its sheer size, New York now sets the tone for the entire U.S. commercial real estate market and influences investor psychology as the bellwether for the rest of the country. According to the report, real estate used to be characterized by local buyers and local lenders, and is now dominated by national financial institutions and landlords, many of whom are located in New York.

Seattle is also a standout market for investors, receiving top or near top "buy" ratings for all property sectors. Growth controls and geographic barriers have led to concentrated high-density, mixed-use development, which has drawn residents to new downtown neighborhoods, making Seattle a 24-hour city on Asian commerce routes. With so many "corporate heavyweights" headquartered in or near Seattle, it has a highly diversified economy. Seattle is also the highest-rated metro area for home building.

Other top markets identified in the report demonstrate a clear bicoastal focus, with Boston and Washington, D.C. joining New York as the East Coast's most watched markets. On the West Coast, Seattle, San Francisco, Los Angeles, and San Diego top the list. Denver is the lone non-coastal metropolitan area among the top markets to watch.

  • Washington D.C. The nation's capital continues to be one of the most watched commercial real estate markets because the government never stops and the ever-churning Washington machine provides a cushion for real estate owners against abrupt downturns.

  • Los Angeles. According to the report, southern California is the crest of the housing market slowdown as high prices have driven some business and residents to seek shelter in lower cost states. While the Orange County office market has softened, the office market in West LA has never been better. LA/Long Beach remains the nation's top port, but transportation routes are clogged, creating a hindrance to trade.

  • San Francisco. This highly livable city's market has been propelled by resurgent technology businesses. View space is once again commanding over $100 per square foot, even as supply creeps upward.

  • Boston. As the greater Boston market rebounds from the "tech wreck" of the early 2000s, it is seeing resurgence in its offices. New industries, such as professional services firms and bio-tech companies, are beginning to recycle space left vacant by corporate headquarter departures in the recent past. But questions remain about the depth of Boston's tenant population, causing investors to keep a close and wary eye on the market.

  • San Diego. While one of the most attractive places to live, San Diego is a leading indicator for a market correction. Office turnover and out-migration of prime business centers to Del Mar and Oceanside have left San Diego's downtown looking for new growth opportunities.

  • Denver. The only non-coastal city in the top tier, Denver has retooled its downtown to create an "urban burb," a hip and exciting urban core in the midst of a sprawling suburban area, connected to downtown via a light-rail transit.

    While investors typically back away from smaller markets during a correction, markets to watch in this segment include: San Jose, CA; Honolulu, HI; Austin, TX; Raleigh-Durham and Charlotte, NC; Portland, OR.; Sacramento, CA; Las Vegas, NV; Orlando and Tampa, FL; Salt Lake City, UT; Jacksonville, FL; Nashville, TN; and Minneapolis, MN.

    Among property sectors, income-generating industrial and apartment sectors remain favored investment categories, according to the survey. Office space in dominant downtowns should perform better than in suburban-oriented markets. As tapped-out consumers restrain their spending, ratings may fall most dramatically for housing-related categories, with condominiums landing in the basement.

    For the first time, the report also provides an outlook for Canadian real estate. Canada benefits from a more conservative investment environment than the United States, avoiding the consequences of lax underwriting. In Canada, institution-dominated markets appear to be avoiding "transaction mania," but real estate values have reached record highs and a strong economy has accelerated tenant demand for space.

    Interviewees remain positive about sidestepping any serious impacts of a possible U.S. correction. Western provinces showcase the strongest growth trends and lowest vacancies in North America. Calgary and Edmonton are the top choices for investors. All property sectors share positive prospects, especially industrial and retail. Housing prices skyrocket toward new highs without overdoing mortgage financing.

    Now in its 29th year, Emerging Trends is the oldest, most highly regarded annual industry outlook for the real estate and land use industry. The report reflects interviews with and surveys of more than 600 of the industry's leading real estate experts, including investors, developers, property company representatives, lenders, brokers, and consultants. You can view a copy of the Emerging Trends in Real Estate 2008 report.


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