NAIOP, a Commercial Real Estate Development Association, announced its decision to add retail to its foundation of office and industrial sector resources. This, among other topics, made it onto the table at the 2015 roundtable discussion held by leading members of the Arizona chapter. NAIOP-AZ members gather every year around a table, not necessarily a round one, to discuss the national and local issues and trends entering the commercial market. Here are the leading trends, promising statistics and market updates they’re watching.
Voit Real Estate Services
Ryan Companies US, Inc.
The Opus Group
Cushman & Wakefield
James Wentworth Jr.
Tom Johnston (TJ): What is different in July 2015 in our local commercial real estate industry from a year ago?
David Scholl (DS): With each passing year, I believe we are seeing a strengthening real estate market from the Great Recession. There seems to be more activity and less fear in the market. We are still not to the point in the cycle where there is much demand for new commercial development, but “chatter” is more about the search for development deals rather than buying existing broken deals. As employment continues to strengthen and the single-family residential market gets on firmer footing, I believe we will begin to see more pressure for new commercial development.
Molly Carson (MC): We are seeing continued growth from new companies entering our market, as well as expansion of existing firms. Companies continue to invest in their people, which manifests itself in the creation of a more optimal work space; with open areas for collaboration as well as closer proximity to amenities (food, shopping, transportation).
New construction and the reshaping of existing offices continue to benefit from this trend. The continuance of this requires ongoing improvement of our education; our ability to produce talent is a key factor — we need to keep this a top focus.
TJ: How would you compare our metro Phoenix commercial real estate market to other major markets throughout the nation and, specifically, the Western u.s.?
Larry Pobuda (LP): Without question, Phoenix has had a slower recovery, yet I don’t look at this as a bad thing, and actually think of this in very positive terms. We have come out of the economic downturn with a more diversified economy, driven by growth in technology, healthcare and financial services. This economic diversification provides relief from the construction/ housing roller coaster that has steep inclines and correspondingly steep declines that have taken our breath away in past cycles. In many ways, our recovery is similar to other markets; no longer can you look at aggregated market-wide statistics and draw meaningful conclusions. The Valley has “hot pockets” within various sub- markets. It is difficult to paint with just one brush.
MC: Our market was badly hurt by the collapsing of the housing market. Today, we’ve come back stronger than before, focusing on diversifying our economic drivers. This, coupled with our universities’ focus on educating the best and the brightest, is resulting in progress, slow and steady progress. (We’re seeing) a much different pace than Arizona’s past recoveries.
Chris Toci (CT): There is no question that the Phoenix real estate market was hit the hardest among national real estate markets and particularly those in the West. As such, it has taken longer for it to recover than most other markets. The silver lining rests in the fact that our delayed recovery means that, as a market, we have several more years of solid recovery. To use a baseball analogy, we are in the much earlier innings of recovery (4th or 5th) than most other major markets that we consistently hear are in the seventh or eighth innings.
Western markets like Seattle, Portland, San Francisco, Orange County, San Diego, Austin, Dallas and Denver are in the later innings. Though several of these markets may undoubtedly go into extra innings, Phoenix is attractive due to its bridled speculative construction deliveries, healthy job growth and strong housing affordability.
James Wentworth, Jr. (JW): When looking at the office and industrial segments, the other major markets in the western U.S. are outperforming Phoenix and seem to have much more wind in their sails. Tenants, developers and investors have been much more active in markets like Seattle, Denver, Dallas and California. All of those markets would be considered “great,” while Phoenix could be considered “good.” Having said that, we are still on an upward trajectory and seeing many encouraging signs. Our positive performance is happening without the “turbo booster” of the home building that we have seen in previous cycles. We may continue on this path if we don’t see substantial increases in the new home permits.
TJ: Where does arizona stand in its economic development plans? are we headed in the right direction or leave anything for the asking? is Gov. Doug Ducey on the right track? Is the furor over K-12 spending and high university tuition an issue? Have we done well to diversify our economy?
Matt Mooney (MM): Coming out of the Great Recession, Arizona has made tremendous strides in its economic development efforts. There are a lot of positives that have manifested themselves in wins like State Farm, Silicon Valley Bank and Northern Trust expanding here. Further, there has been a strong trend of California-based firms looking to take advantage of Phoenix’s business friendly environment and have expanded their footprint in the region. For instance, Zenefits, a fast growing human resources software company, recently announced it was expanding its presence in Tempe by leasing 135,000 square feet of new office space at Parkway Properties’ Hayden Ferry III development that will accommodate upwards of an additional 1,000 jobs. GPEC and most of the East Valley cities in the Phoenix Metro have been very aggressive and deserve a lot of credit. That said, nearly every other state is at the same time growing more competitive, so we have a lot of work to do, and K-12 is appropriately in the spotlight from Gov. Ducey.
TJ: What has been most surprising about arizona’s commercial real estate recovery?
MM: The amount of time it has taken to recover has been the most surprising. The hyper growth between 2005 and 2007 was so disproportionately fueled by access to debt, instead of fundamentals, that the scars from that cycle took a long time to heal and in some instances still haven’t healed. We built a lot of product that should never have been built, and it is born out in our stubborn overall office vacancy rate.
DS: We are six years into the current recovery and, other than multifamily, there has really been no pressure for sustained ground-up development. I think Arizona’s recovery has lagged behind the nation and we are seeing delayed demand for new buildings.
In the two previous real estate down cycles (’89-’90 and ’00-’01), I remember the Arizona market recovering at a quicker pace. The positive in this is that we may see the current recovery in rental rates last a little longer than usual.
JW: The subdued pace of the recovery is the most surprising. Phoenix has normally been a growth leader coming out of previous downturns. That simply is not the case so far in this cycle and we may act more like Denver did in the last couple cycles. The positive side of this is that we will hopefully not see the wild swing between peak and bottom in this cycle. The other surprising part of the recovery is how it has differed from submarket to submarket and by building type. For example, heavily parked office buildings in the Southeast Valley have outperformed the multi- tenant buildings in our historically strong submarkets of Camelback Corridor and North Scottsdale, both of which have vacancy rates hovering at around 20 percent.
CT: The most surprising element about Phoenix’s recovery from the Great Recession compared with other post-recession recoveries is its lack of a “snap back.” The hockey stick, or “J” curve, recovery of aggressive rent growth witnessed from 2002 through 2006 after the September 11-induced recession is sorely missing from this current recovery. The current recovery is more indicative of the 1992 to 1996 post-recession recovery in which zero speculative office construction occurred, 75,000 to 85,000 jobs per year were added, and in excess of 1 million square feet of net annual office absorption occurred. It was during this five-year period that rents grew most aggressively prior to the market’s sustained delivery of consecutive
years of speculative office space. The moderation of the ‘92 to ‘96 recovery cycle was predicated on no speculative construction during the early years, which ultimately led to a more sustainable nine-year period of growth that prevailed between the trough of 1991 and the trough of 2001. Similarly, a more moderate current recovery which boasts growth of 52,000 to 55,000 jobs per year, muted speculative office construction deliveries, and net office absorption averaging in excess of 1.5 million to 2 million square feet per year all point to another sustained period of growth that may rival the recovery cycle from 1992 to 2000.
TJ: What is the current state of our metro phoenix office market and what needs to happen to push the office sector into continued recovery?
MM: The Metro Phoenix office market is improving overall but remains very bifurcated in the strength of the recovery. Well-located new product with good access to transportation and amenities in the Southeast Valley and Scottsdale is approaching historic rents in many places — and certainly at rents that justify new development. At the same time, there is a lot of product in Metro Phoenix that is functionally irrelevant, due to location, parking constraints or inefficient floor plates. Some of this inventory still doesn’t make sense to lease at current rental rates and probably should be converted or demolished. The biggest catalyst to continued improvement is simply continued office-using employment growth in diverse industries. We are all invested in the job growth story.
LP: It’s been a moderate and generally steady recovery, not over- exuberant in any way. There is greater segmentation within the office market between older (last cycle) suburban office buildings that are parked four per 1,000 square feet with vanilla finishes and new Millennial-driven work spaces that are open, collaborative, more heavily parked, with walkable amenities nearby. The key driver is still job growth, yet we need to recognize that these new jobs are different from jobs in the past, and they are not necessarily going to locate where our current office stock is located. Ultimately, we cannot “push” the office sector into recovery. We can, however, exercise better judgement and discipline as it recovers.
TJ: Why does the Tempe sub-market appear to be so hot right now and what is the next hot sub-market? Is it central phoenix? Is light rail a driver?
LP: It is hot and it is a confluence of great academics, great business and a unique and vibrant downtown. It’s also difficult to overlook the inherent location advantages that Tempe offers — highway accessibility, proximity to Sky Harbor and workforce availability. The City of Tempe has also made smart investments in its future – Tempe Town Lake, light rail and now the proposed street car. This, combined with the leadership and vision of Michael Crow at ASU, and Tempe is
on fire. Phoenix is already strong and getting stronger. The next hot sub- market will be everything within the Loops 101 and 202, focusing “in” rather than focusing “out.”
MM: Tempe is the most urban city in the Phoenix Metro, and the majority of tenants across the country today are focused on urban locations as a means to recruit and retain talent, particularly Millennial workers. Tempe can boast border-to-border light rail, Mill Avenue amenities, Tempe Town Lake, Sky Harbor Airport proximity, freeway proximity and a connection to tens of thousands of ASU students. It is a compelling story. Several other sub-markets are already hot, particularly Chandler and south Scottsdale. If Scottsdale were to ever embrace light rail to connect its downtown, it could be even more compelling.
TJ: There’s a lot of buzz around adaptive reuse and redevelopment of downtown spaces, particularly in Phoenix. What significance does this development have to the industry? What have been some of the most important projects?
MC: Adaptive reuse is often not as cost effective as building new, but is a very important element for creating, strengthening and maintaining a city’s culture. This is a recent (and often challenging) trend for Arizona, one I hope continues to gain more traction. The last two years we have seen a number of innovative adaptive reuse projects not only come to fruition but thrive. Restaurants such as Fox (Restaurant Concept)’s The Yard and (Jim) Riley’s The Vig revitalized not only the buildings in which they occupy, but the respective neighborhoods. They’ve created gathering areas where previously there was none, bringing life to these older buildings. The redevelopment of the Monroe and Barrister buildings no doubt will bring life to downtown Phoenix.
TJ: What is the current state of our Metro Phoenix industrial market?
JW: The Phoenix industrial market is healthy. We have seen strong activity trickle from large users to the mid-sized users. Well-located and functional product is leasing, and we are seeing growth in the rental rates. Similar to the office market, certain sub-markets and building sizes are performing better than others. Vacancy rates are just above 10 percent with new development happening in select sub-markets. This development is much more controlled than in previous cycles.
TJ: Is the PhoenIx market ripe now for spec building? If so, where and what type of buIldIng type?
LP: We’re already seeing spec development, and I think this will pick up steam. The key drivers will still be great, irreplaceable location, more infill than ever before and strategic investments that have their finger on the pulse of business demand. The danger with spec development is when it is driven by the supply. We too frequently act like lemmings in our industry.
TJ: There’s more capital coming into the market right now. Where is this best invested? How is financing trending? What do the large pension funds think about our market for investment properties?
CT: Office buildings in the best locations with the best barriers to entry continue to emerge as a preferred asset class. Most institutional investors remain under-allocated to industrial product and have a voracious appetite for new, state-of-the-art, functional and institutional industrial assets. Long-term credit tenant leases with a minimum of 12+ years of lease term and annual lease rate escalations remain in strong demand as portfolio managers endeavor to mitigate risk. High street retail located within the best mixed-use developments in gateway urban centers continue to draw true “core” investors along with grocery anchored shopping centers. Functionally obsolete regional malls and strip retail centers will continue to flag. Though still sought after, luxury multi-family is feeling long in the tooth. Debt capital markets remain very active with bank and life company loans most heavily sought after. CMBS (commercial mortgage- backed security) loans allow for higher proceeds but are restrictive if resale is a consideration within two to three years. Institutional capital views Phoenix very favorably as it is perceived to be in the earlier innings of recovery (4th or 5th) compared with almost all other investment markets that are believed to be in the latent cyclical recovery stages (7th or 8th innings). Though there continues to be good depth of bidding, there remains an element of fickleness among investors. They have very keenly defined investment parameters and are not easily persuaded to adjust their yield requirements. Heretofore, “value- add” investors have been most active. However, we are beginning to see the return of the “core-plus” investor as well. Only the Super-A, or trophy, assets will garner the attention true “core” investors. Late 2015/early 2016 may induce additional core investors to the Phoenix real estate market as they continue to chase yields and are forced out of gateway markets.
TJ: What are the challenges for retail and what will the next five years look like? How does this inter-play with adaptive reuse and mixed use more generally?
DS: The retail sector is facing a number of coinciding challenges in the current recovery. First, the long predicted Internet sales impact is in full force. Many commodity retailers are struggling to survive and almost all large format retailers are studying smaller store sizes. Changing demographic preferences and improved fulfillment systems have truly boosted the acceptance of Internet retailing. Second, there is an old saying in retail development, “Retail follows rooftops.” Until the Arizona housing market fully recovers and new homes and neighborhoods are being developed, we will continue to see softness in retailer demand for new Arizona stores. Finally, pure demographic forces are currently working against retail development. Gen X (people born between 1964 and 1982) is roughly half the size of the Baby Boomers and Gen Y (Millennials). Now approaching peak earning years, Gen X simply cannot keep pace with the level of consumption our economy has grown accustomed to over the last 30-plus years. Until Gen Y gets into its peak earning years (early 2020s), we may be faced with a “new normal” in our consumer-based economy. One bright spot for retail development has been the recent demand for retail components in mixed-use projects.
A combination of a hot multifamily development segment, along with new planning models have created high demand for specialty retail and restaurant destinations in many mixed use projects that are in the planning stages. Once the office segment moves into the development phase of the current cycle, we may see similar demand for retail additions in commercial mixed use projects.