How can we maintain a positive commercial real estate outlook?

Real Estate | 10 Oct |

The Phoenix market has seen these kinds of heady days before. Industrial space is filling up as fast as it can be built and the office sector is enjoying rising rents, healthy vacancy numbers and strong employment levels. On top of that, Phoenix has seen its retail market buck the national trends with improving vacancy and rental rates.

Can it continue? To answer that question, we gathered these experts for a roundtable discussion:

• Phil Breidenbach, executive vice president of Greater Phoenix, Colliers International

• Bryon Carney, managing principal, Cushman & Wakefield

• Molly Ryan Carson, senior vice president, market leader Southwest Region, Ryan Companies

• Andrew Cheney, principal, Lee & Associates

• Ericka LeMaster, senior vice president of commercial real estate, Alliance Bank of Arizona

• Darren Pitts, executive vice president, Velocity Retail Group

• Danny Swancey, partner, ViaWest Group

• Chuck Vogel, senior vice president, VEREIT

Moderator: Candace Rosauro, director of business development, Jokake Construction

The board members we gathered from NAIOP-AZ have more than 100 years of combined experience and they know all too well that what goes up will eventually come down. These market experts sat down to field questions about how the Phoenix market has performed in 2018 and what has changed in the decade since the last boom/bust cycle swept through the industry and what the market can expect from 2019 and beyond.

CR: What is different in 2018 in our local commercial real estate industry than a year ago?

EL: Urbanizing our suburban cities. Developers and Cities collaborating on core, urban mixed-use projects to enhance or gentrify the City’s core. Creating mixed-use environments with more walkable amenities to multifamily and single-family housing developments.  Centering new development around entertainment.

MC: Construction costs are higher and continue to creep up; the tariffs imposed on steel and aluminum isn’t doing our industry any favors.  Labor shortages in the construction field remain and have increased in most states. The rising interest rates and the impact of the 2017 tax law are also new variables since a year ago.

From a positive standpoint, new job growth continues in our state, in strong fields like finance, banking and manufacturing.  We are also seeing even more companies expand their operations in the Valley. It’s just great four our state and helps continue our growth for several years to come.

DP: Our market continues to improve year over year and 2018 is no exception.  One of the biggest things our clients talk about regularly is how the Phoenix housing market seems to finally be back on track.  I would also say that we continue to diversify our economy in many key sectors including healthcare, technology, manufacturing, distribution which give our market a broader economic foundation and makes the economy much healthier than in prior years.

DS: The office market activity feels similarly good with things continuing to tighten as positive absorption outstrips new supply.  On the general industrial front, we’ve seen vacancy tightening significantly with rents increasing accordingly causing many to kick off new speculative developments.

AC: The Metro Phoenix office market has posted 1.4 million SF of positive net absorption (net jobs added) as of June 2018.  By this time in 2017 we had only absorbed 353,000 SF.  And right now there is 2.7 million SF of new office buildings under construction, as opposed to 1.3 million in June of 2017.

PB: There is a level of freneticism, an impatient anxiety to get stuff done we typically don’t see with developers.  Some of it is corporate user indecision, some of it is a race against rising costs, some of it’s concern over political volatility – whatever it is, The business is fun and interesting right now for sure.

CR: How would you compare our Metro Phoenix commercial real estate market to other major markets throughout the nation and specifically the Western U.S.?

PB: We’ve always been more volatile, but, this recovery has been led by a variety of more stable (and sustainable) industries (e.g. Finance, Education, Healthcare) which has tempered that.  We are still a region leader in growth, and while we are not the low cost option (in terms of employee and cost of living) we once were, quality of life, access to talent, and business friendly political environment help us to continue to grow.

MC: Metro Phoenix continues to benefit from steady growth, that is the outcome of years of hard work and investment (that) the government, universities and larger business community have made.  This is the slowest recovery greater phoenix has experienced in more than 3 decades.  Because of this, we can expect this favorable environment to continue on, likely longer than some of our coastal neighbors.  We have a strong workforce coming out of our universities, an affordable, high quality of life, a favorable tax structure and minimal risk of natural disasters.  In short, Greater Phoenix remains a solid, cost effective choice for a large variety of corporations.

DP: Phoenix is one of the strongest growth markets in the nation and remains the “Bargain of the West”. We are one of the country’s leading markets in new single family permits annually. Compared to the coastal markets of Seattle, Portland, San Francisco, Los Angeles and San Diego and inland markets of Las Vegas and Denver, our market here in Phoenix on both the residential and commercial side remain very affordable.  This is good news for corporate expansion and relocations where lifestyle and affordability are important.

AC: Our market can be misleading due to the relatively high vacancy factor we have (currently 18.6%). Tenants and landlords that understand the nuances in our market, however, can capitalize on opportunities our vacancy figure provides.  Due to our continually diverse economy, great labor force and quality of life, investors are increasingly considering Phoenix along with other western gateway cities.

BC: Phoenix’s population growth rate is twice the average of the Western U.S. and three times the national average. New Phoenicians tend to be well-educated domestic migrants from high tax states like California and Illinois. This population growth affects all of the building types in Commercial Real estate. High rent growth in multifamily is fueling a record amount of capital markets activity. Retail vacancies are below average, even after a decade of sustained e-commerce pressure.

Expensive west coast markets see Phoenix as a desirable location. Large financial users and software companies are leasing large amounts of office space. Warehouse and distribution space in the west valley is increasingly attractive as an alternative to the Long Beach and Inland Empire markets.

CR: We now have a number of years of consistent expansion of the economy, both nationally and locally.  How long will this continue? What do you think has the biggest chance of derailing the positive trajectory of Phoenix’s commercial real estate market?

AC: This has been the slowest economic recovery on record, so I wouldn’t be surprised if it went on another 3 to 4 years.  Whether its debt getting out of hand or just a feeling of lack of confidence in the national economy, I think the next downturn will be relatively soft.  Then, as usual, we will be due for a significant correction at the end of the next cycle.

CV: As we continue to have steady job gains and declining unemployment rate, we should see personal income growth. This is driving our continued economic expansion along with our population growth. Any national events that would have an impact on our economic expansion such as trade war or rising interest rates, could reduce our job growth and slowdown commercial real estate.

MC: Overbuilding, building to a rental rate that our market is not yet ready for. In addition, the current referendum on the fall ballot promoting significant increases in taxes would reduce Arizona’s tax advantages compared to our neighbors.

PB: Our economists and research team suggest we have several years of “runway”, but we are beginning to see the signs of an overheating market.  I give us 2 years, maybe 3.

DP: I think the fundamentals are solid going forward in the near term.  This long period of historically low interest rates has allowed businesses to grow and thrive.  If I were to put on my worry hat, I continue to be concerned about the federal government’s debt and deficit levels.  Too much debt always kills a good thing.  Obviously, any major geopolitical event could significantly change the current growth cycle as well.  Arizona was slower recovering from the economy than most markets and has good momentum going forward.

EL: Economic growth could continue for the foreseeable future if the State and our respective Cities remain focused on utilizing all economic tools available to win corporate relocations. These strategic gains will add moderate to higher wage jobs in conjunction to the Valley’s existing job force. Access to an educated workforce, as well as payroll and property taxes remain meaningful factors with employer growth and retention.

DS: Ah, the million dollar question.  There’s nothing within the internal metrics that we track that is pointing to an imminent downturn.  A national recession will likely be what derails the Phoenix market, it’s just not clear to me what the impetus will be this time around.  I also believe the proposed legislation to increase state income taxes on high-earners could have a substantial chilling effect.  Increasing taxes on high-earners who are often small business owners is generally counterproductive to economic expansion.

CR: Has Downtown Phoenix finally turned the corner?  Do you believe a viable downtown is essential to our city’s success?

DP: Yes, I’d say Phoenix has turned the corner probably in the last 12 months.  The sentiment is positive and transactional volume is strong.  I think it’s key for every market to have a healthy downtown.  The expansion of the University of Arizona and Arizona State University’s campuses into downtown has been a game changer.  Fry’s Food & Drug is under construction bring the first mainstream grocery store into downtown.  The addition of significant residential product in downtown has been the key to transition downtown from an event destination into a viable submarket.

DS: Yes and yes.  It’s difficult to predict how quickly or slowly the positive trend will continue, but I think it’s become clear that a significant transformation is underway.  There’s no doubt in my mind that a viable downtown is one of many key factors in determining which cities will be successful in the future.

AC: Downtown Phoenix has indeed turned a corner.  Healthy occupancy rates, ASU Downtown campus, the Quicken Loans case study and the tremendous amount of capital infused into that submarket are proof we have a vibrant downtown.  The renaissance of Renaissance Square and the birth of Block 23 are attracting a lot of tech and out-of-state tenants.

PB: Variety of industries, a vibrant young resident base, and social sentiment have made downtown “a thing”, but the resident base must continue to grow, along with more services for those residents, and with continued in-migration of businesses for Phoenix to have a truly significant downtown.

CR: What is the hottest sub-market right now and what is the next hot sub-market?

MC: From an office standpoint, the submarkets with significant potential for new construction are Tempe and North Scottsdale. Trends for Real Estate to closely watch: Co Working facilities, Self driving cars, smart buildings/cities, Generation Z’s entrée into the workforce.

DP: From a retail perspective, the growth markets of Surprise, Gilbert and Queen Creek are the hottest 3 markets in the Valley.  New retail follows new rooftops and that’s certainly the case in these 3 growth trade areas.

PB: 1. Chandler; 2. Areas round Chandler; 3. Watch out for a renaissance on Camelback Road.  Too many great neighborhoods, restaurants and companies are “circling the area”  and with the new, renovated, and proposed projects on the corridor we believe even more growth is on the horizon.

AC: Tempe remains the hottest, particularly along Tempe Town lake.  The buzz is unmistakable. However, there is a buzz too in South and Central Scottsdale and Downtown Phoenix as these areas are constantly vying for the next hottest spot. Overall, vibrant, infill locations have flourished this cycle.

DS: No one can argue that Tempe, specifically around the university/lake, continues to be hot.  It’s probably a toss-up after that with a lot of demand across several key sub-markets like North/South Scottsdale, Camelback, and Downtown.

BC: Hot Office: North Tempe, Next: Price Corridor, Southeast Valley. Hot Industrial-Southwest Valley/Goodyear for Distribution, Next:  Gilbert, Chandler Airport, Mesa Gateway.

CR: Are there any product types or submarkets where you feel supply and demand are out of balance?

AC: Central Scottsdale and the Arrowhead area are substantially lacking in new Class A office product, and new construction.  Rents in both areas have risen sharply there is minimal supply in the immediate pipeline.

DS: Yes, but it really depends on the dynamics of the micro-submarket and land basis.

PB: Chandler needs more industrial space, and while real estate around Tempe town lake has been wildly successful, there are a lot of proposed projects that, if they build as planned could be a problem for that market.

DP: I would say that in retail, most of our markets are fairly balanced.  We continue to see a tremendous number of multi-family and self-storage projects in nearly every submarket.  Those sectors are very popular with today’s active lenders.

CR: Is the Phoenix market still ripe for spec building?  If so, where and what type of building type?

MC: For Industrial, yes. I believe we have a continued opportunity to capture industrial company expansions and new firms entering our market.

AC: Yes it is. Check out Phoenix’s office fundamentals compared to all major markets in the Southwestern United States.  If you build it (spec, multi-story product), they (tenants) will come.

PB: Yes, and though it scares developers and lenders to do it, the needs of Corporate America are more urgent such that having spec inventory offers the developer a significant competitive advantage to land the large institutional user.

CR: What is the current state of our Metro Phoenix retail market? What is the biggest risk for Phoenix retail?

DP: The Phoenix retail market overall is healthy again.  Vacancy rates continue to fall.  User activity is solid. Aldi is a 23,000 SF grocery store concept that is creating dozens of new retail opportunities around the metroplex.  Costco, Lowe’s, At Home, Sprouts, TJ Maxx, Nordstrom Rack, Top Golf, Ashley Homestore and others have announced plans for new stores in the Valley.  Restaurant activity has been very strong in all submarkets as busy lifestyles have families eating out more and more.  We have still not seen a significant return of multi-tenant ground-up shopping centers – most of the activity is user buildings.

BC: The underlying drivers of retail, population growth and job growth, are as strong in Phoenix as anywhere in the country, so new projects continue to deliver all over the valley. Many other cities have trouble with replacing unwanted retail projects, so they stay vacant for years. Phoenix has comparatively low replacement costs, so obsolete buildings are replaced more quickly than in peer markets.

The biggest risk in metro Phoenix continues to be the threat of internet retailers and ecommerce. Amazon had its IPO 21 years ago in 1997, so the playbook for the competitors is well-practiced now. The successful malls and neighborhood and power centers will be able to replace struggling tenants quickly and keep shoppers interested with unique opportunities, experiences that are shared on social media, and competitive prices. Unsuccessful malls are targets for redevelopment.

PB: Not being a retail specialist, not certain I have a good opinion, but it seems like the restaurants popping up will not be able to sustain – a person only eats 3 meals a day…

CR: How has the increase in last mile delivery impacted how investors and developers view industrial opportunities?

PB: Again, not my specialty, but warehouses will keep getting bigger and more plentiful, and a new paradigm in delivery services (think UBER meets Amazon) will soon be a thing.

CV: As consumer expectations for fast delivery continue to grow, the last mile of distribution will increase in priority for both brick-and-mortar and online retailers. This has created a new niche for institutional investors who are now competing for small, previously obsolete class-B, -C and -D industrial buildings in urban locations. For this reason, whole portfolios of this asset class are being purchased at an increasingly rapid rate.

These last-mile-focused retailers have taken advantage of older warehouse stock. Urban distribution centers prioritize fast delivery over large amounts of inventory which means high ceiling heights and conveyor belts are less of a priority. Large modern facilities are no longer necessary, but parking for trucks and employees is now essential.

Development of last-mile strategies are still in the early stages, so the average distance traveled in many metro areas is likely to shrink in the coming years. I also expect to see different types of real estate considered for last mile centers. For example, many old grocery facilities are being redeveloped and repurposed into modern logistics warehouses. For industrial owners, renovating old spaces creates an opportunity to avoid the prohibitive price of land while generating rent growth.

CR: How have the needs of industrial occupiers changed with the acceleration of the e-commerce trend in recent years?

CV: There is a strong need to move logistics centers to urban environments closer to the customer. In an effort to narrow the gap with brick-and-mortar stores, e-commerce and logistics companies are looking to accelerate their investment in last mile warehouse spaces. Global and domestic tenants are expanding their presence beyond single mega-warehouse facilities, to multiple U.S. locations, using logistics space to extend their reach and better connect with customers. At the same time, distribution models are changing and location strategy is more focused on proximity to labor and customers. As e-commerce operations mature, tenants will seek smaller distribution centers closer to urban centers. As demand for these spaces increase, finding the right location will be a challenge.

PB: They need bigger, better-located, more sophisticated warehouse/distribution center. Look for warehouse to be more expensive to build than office buildings – largely because of what’s inside.

DP: Most of our retailer clients are expanding their e-commerce platforms and are building vast fulfillment centers to accommodate this growth.  Healthy retailers have both a successful fleet of stores as well as a strong e-commerce platform.  This new world has created tremendous opportunities in the industrial sector beyond traditional distribution centers that service stores.

BC: More truck parking, more docks, and higher clear heights. Further down the line, increased robotics and more fresh food options should increase electrical demands on distribution buildings. Brick and mortar food retailers are leveraging their experience in nondurable goods logistics to both lower their costs and branch out into food delivery. Kroger, the parent company of Fry’s announced a driverless grocery delivery service on June 28th.

CR: Do you see industrial cap rates increasing, decreasing, or remaining stable over the next year?

EL: On average, I’d expect the cap rates remain stable. The investor appetite appears to remain competitive among industrial for most product types with flex industrial lagging slightly. The institutional sector may experience more cap rate compression given Phoenix remains a core, value-add market with strong credit quality, size and scale of projects. This allows investors to place capital at higher yields than gateway markets without taking on construction risk. Unless investors find short term bonds more appealing, stable industrial will continue to be the darling of commercial real estate.

CV: Industrial pricing remains strong. Investors and lenders alike continue to be under allocated in industrial product. The lack of product fuels this demand. Real rent growth is occurring across the country, particularly in infill locations. Cap rates have compressed significantly in the last year. I would expect this strong capital flow to continue for industrial properties and maintain pressure on cap rates to remain low.

MC: Though I see cap rates remaining relatively stable for 2018 and 19, cap rates historically have crept up as interest rates have risen.

DS: I think they’re likely to remain stable.  Even with rising interest rates, I think the embedded growth in rents on existing product will provide a counterbalance keeping cap rates relatively stable.

PB: It’s hard to fathom cap rates going much lower, but with the general demand for more industrial, rising construction costs, and the continued availability of hungry investment capital, a sharp increase in interest rates would be necessary for any real change.

Comments
Show Buttons
Hide Buttons