Commercial real estate will improve marginally in 2013. New construction activity will inch upward, operating income will be a little better, and property values will level off. Later, in 2014 or 2015, operating income and prices will both rise, triggering increased construction.
The recession clobbered occupancy of office, industrial and retail space, which pulled rents down. Landlords suffered from lower revenues. In the slow recovery, new construction dwindled to nearly nothing. Current need for additional square footage was nil, and those developers who wanted to build for future demand found that lenders were hesitant to take much risk.
The current situation is that leases are dribbling in, generating small increases in occupied square footage. The current pace of construction is not only lower than in the boom, but well below historic averages. We know that given even middling economic growth, we’ll eventually need to build at a much stronger pace. However, the high vacancy rates that are a legacy of the recession will limit new construction through 2013 at least.
Property values have done quite well despite lackluster tenant growth because of low interest rates. If one thinks of a valuation as future earnings discounted by some interest rate, then lower interest rates lead to higher property values. The best mortgage rates have been obtained on excellent properties: good cash flow and good tenants. For such deals, interest is so cheap that it’s almost free. Properties of lower quality have a much narrower range of financing choices, resulting in higher interest rates. High quality commercial properties have appreciated by six percent in the past 12 months, with lower rates of gain for other buildings.
Real estate is always local, and a few markets are seeing a bit of life. However, our perusal of activity in many markets points to mostly build-to-suits in construction activity.
Although there will be very little construction activity in 2013, landlords will see modestly better occupancy. They will curtail rent concessions. Some markets will even experience rent increases. These will help operating earnings.
Interest rates will not fall further in 2013, and long-term mortgage rates may rise late in the year. Thus the operating income gains will not translate into further increases in property values.
New construction in 2013 will be just a little better than this year. The real boost in activity is likely in 2014 or 2015, depending on the market area. Nationally, more of the gain will occur in 2015 than earlier.
Tenants with long-term plans for occupancy should lock in rental rates for as long a term a possible. Landlords, in contrast, should be eager to offer two or three year leases, to take advantage of better rental rates in the future. Developers should do the cheap part of planning new projects, but delay commitments to spend large amounts until we have surer signs of future demand. (credit Bill Conerly Forbes)