NAIOP Arizona experts: Here are the opportunities for 2020

Real Estate | 2 Oct |

The national economic growth cycle moved into uncharted territory on July 1, as the United States broke the record of 120 months of economic growth, according to the National Bureau of Economic Research. As of September 1, the run has reached 122 months of economic growth.

Here in Arizona, we are seeing that growth first-hand, most notably in the development of office and industrial properties. Nearly 3 million square feet of office product and 7 million square feet of industrial space is expected to come online before 2019 ends. Absorption rates remain solid and vacancy rates are at or below record levels while rents continue to climb.

So it’s safe to say that the Phoenix market is enjoying robust activity and AZRE Magazine gathered some of NAIOP Arizona’s finest members to learn more about what’s going on in the market, how it compares to other markets in the country and what they see in their crystal ball.

NAIOP Roundtable participants:

• Molly Ryan Carson, Senior Vice President, Market Leader, Ryan Companies US, Inc.

• Danny Swancey, Partner, ViaWest Group

• John Orsak, Vice President, Lincoln Property Company

• Jim Wentworth, Principal, Wentworth Property Company

• Darren Pitts, Executive Vice President, Velocity Retail Group, LLC

• Andrew Cheney, Principal, Lee & Associates

• Cathy Thuringer, Principal, Trammell Crow Company

• CJ Osbrink, Executive Managing Director, Newmark Knight Frank

1. “What has changed in our local commercial real estate industry over the past year?”

DP: All sectors of the commercial market have been affected by rising construction costs and the shortage of skilled tradesmen. The costs for materials, site work, labor, and rising land costs are all factors that are affecting the economics of new projects coming out of the ground. Discussion of tariffs has added additional uncertainty to this dynamic in the marketplace.

CO: We have continued to see more out-of-state and even foreign capital venture into Phoenix in search of best-in-class assets with attractive yields. This surge of out-of-state capital is a direct result of compressed yields in gateway markets that are seeing a much deeper and more aggressive buyer pool. If you look at the breakdown of the buyer pool over the last two years, for multi-tenant office over $10 million, only 19 percent of the buyers are based in Arizona, whereas 81 percent are out of state and 29 percent are from California.

JO: Big Tenant activity! The big tenant activity started an up tick more than a year ago, but in the past year it has really picked up a lot of momentum. You see large firms dip a toe in the Phoenix market with a 7,000 – 10,000 square foot space. They see the quality of labor, the quality of life and cost of doing business and quickly decide to take a much larger position, some of which end up being several hundred thousand square feet.

AC: Increased confidence. The drive along Loop 202 from Gilbert through Tempe is a good example of the growing faith that businesses have in our region. New office buildings have popped up on either side of the freeway including Rivulon, Park Place, Viridian, One Chandler, Discovery Center Rio 2100, SkySong 5, The Grand, Watermark, I.D.E.A. and Novus. It’s exciting to see brand new companies come to Greater Phoenix and occupy these buildings, or existing businesses grow here in a major way.

JW: The number and quality of institutional investors has changed in the past year. Many of these investors are looking at Phoenix for the first time as a result of getting priced out of the tier 1 and coastal markets. Phoenix has very solid fundamentals and the investors are getting much better risk adjusted returns here. Our economy is more diverse this cycle and is giving comfort to the investors.

DS: More speculative development in select submarkets sparked by continued positive absorption, tightening vacancy, and rates that are at or quickly approaching replacement costs.

CT: From an industrial standpoint, the biggest change has been the proliferation of data center users entering the market and paying significant amounts for industrial land. In addition to reducing the inventory of available land for industrial development, the pricing levels paid by data center users inflate the expectations of land sellers which, in addition to rising construction costs, equate to additional strains on spec development economics.

MR: This isn’t so much of a change, rather a continual, steady growth across the board for product types. Arizona continues to attract companies seeking affordable educated employment and a great quality of life; spurring continual relocations and expansions for companies in a multitude of businesses. (technology, financial, insurance and healthcare being the most active), Farmers Insurance and McKesson being two of the most recent expansions. Our business friendly/focused Governor and superior Universities continue to help Arizona be a desirable location for growing companies.

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

DP: Phoenix is one of the strongest growth markets in the nation and remains the “Bargain of the West”. We are also 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 remains very affordable. This coupled with a strong labor pool make Phoenix an attractive choice for corporate expansions or relocations. We provide a desirable lifestyle and affordability.

CO: Phoenix is well-positioned relative to other major US markets and specifically on the Western US given its attractive yield and going-in basis with the consistent and positive fundamentals we have witnessed over the last few years. When you can buy a Class-A multi-tenant office building in the low to mid $300 per square foot (PSF) range, compare that to what we are seeing in markets like Los Angeles ($1,400 per square foot+), Orange County ($600 per square foot+), San Francisco ($1,500 per square foot+), Palo Alto ($2,000 per square foot+), and Denver ($700 per square foot+).

AC: The difference in Greater Phoenix to other Western markets is simply opportunity. We have the most of it. We have the nation’s most innovative university in ASU, plenty of quality real estate (both existing buildings and sites) and incredible momentum. Both investor/landlords and end users recognize we are the next best thing to a gateway market. This is because of our favorable business climate, quality of life and extensive labor force. No other western market can boast this same combination.

JW: For office and industrial, Phoenix was late to rebound this cycle compared to other major markets. We have finally hit our stride while still showing discipline and not overbuilding. We are currently one of the more desirable markets for institutional investors. Also, Phoenix is continuing to attract good quality companies and is seeing relocations or expansions from other Western U.S. markets. This is due to the access to quality employees and a lower cost of doing business.

DS: Looking at most of the key quantitative and qualitative metrics that CRE folks track, Phoenix is performing extremely well on a relative basis both regionally and nationally.

CT: Though we still encounter those who want to view Phoenix in the rear-view mirror, our consistently steady population and job growth levels together with our pro-business focus and measured and disciplined growth this cycle are propelling Metro Phoenix as one of the top real estate markets in the country.

MR: Metro Phoenix remains a strong secondary market, which I believe is a terrific place (to be). We remain attractive for the reasons I mention above.

3. “What are the biggest opportunities that exist in the Phoenix market over the next three to five years?”

DP: The Phoenix area continues to create new jobs and attract new residents. Phoenix adds 174 people daily just from inter-state migration, of these 37 percent are coming from California. Governor Ducey and GPEC have excelled in their efforts to attract companies to Arizona as we continue to be known as a pro business state. Phoenix is finally seeing significant urban renewal and infill redevelopment projects, including a new Fry’s Food & Drug store in downtown Phoenix. Additionally, the long-awaited redevelopment of Park Central will develop as a vibrant new urban core adding mixed-use density in the heart of our marketplace.

CO: The Phoenix economy has recently posted very healthy and attractive statistics with respect to population growth, job growth, corporate migration, and cost of living relative to other gateway/primary markets. I believe we are going to continue to see these attractive fundamentals have a positive impact on rent growth, absorption/vacancy, and eventually new inventory which will provide ample opportunities for the commercial real estate industry across the board (developers, architects, leasing/sales brokers, escrow/title, etc.)

JO: I think that Phoenix will continue to capitalize on the population growth and in-migration to the absolute benefit of the commercial real estate industry. We are seeing new construction that is more urban and dense in nature whether it be high rise residential in downtown or office mid-rise campuses in North Tempe. It looks like that opportunity will continue as long as the economy continues to expand.

AC: There’s been a huge rise in Office supply in the Southeast Valley. The next three to five years there will be about 3 million square feet of office space built with more room for growth for many years to come.

The biggest opportunities that exist in our market are delivering what tenants want: a vibrant place to work with amenities and parking nearby. This can be accomplished by repositioning older buildings or delivering modern, compelling buildings at great sites.

JW: If we keep our costs in check, metro Phoenix will continue to see strong population and job growth over the next five years. There will still be capacity for well-located and functional office and industrial buildings. Infill locations near freeways are more and more difficult to find but those that find them at the right basis will be heavily rewarded.

MR: YES!

As companies continue to expand and relocate office space will continue to be in demand, IF we continue to be responsible/modest with increasing our rental rates. Select sub markets remain ripe for office development at market rents. Tempe’s office vacancies remain sub 3 percent and office space is nearly non-existent in Central and South Scottsdale; speculative product would allow for expansions and new tenants looking to enter the market.

There is still strong demand for speculative Industrial at both the small and large scale. Nationwide the industrial sector remains healthy and stable, this is true for greater Phoenix. Rents remain at near all-time highs in several submarkets. A slight slowdown could occur in late 2020 depending on how interest rates behave.

Multi Family and Senior Living are speculative by design, Metro Phoenix seems to have a long run ahead of itself in both sectors. With 50,000-100,000 people net per year projected to move to AZ each year combined with the large number of people entering their golden years, these market sectors will continue to be successful IF we maintain market rate rents.

One of the biggest opportunities Phoenix has is affordable housing. Phoenix is projected to keep growing 50k-100k people net per year for the next 10 years. Most apartments being built are luxury high rent projects. Most of the population can’t afford these rents and their neighborhoods suffer with little new product being built. If Phoenix wants to sustain this growth it must built in affordable locations with affordable product, but also needs to incentivize developers because the numbers don’t normally pencil.

4. “What is the hottest sub-market right now and what is the next hot sub-market?”

DP: 3 key markets on the retail side – Queen Creek, Laveen & Surprise. Queen Creek’s housing growth is very attractive to retailers and is still underserved from a retail perspective. Expect a new 370,000 square foot power center to be built at the northwest corner of Ellsworth Road / Queen Creek Road along

with a new Aldi-anchored grocery center on the northeast corner of the same intersection. Laveen’s new regional retail intersection at the newly created diamond-interchange at Loop 202 / Baseline Road will be the focal point for more than 300,000 square feet of new retail space. Finally, Surprise continues to see strong housing growth – look for a new Costco and a new Sprouts along the Waddell and Cactus interchanges on the 303 in 2021.

CO: Hottest submarket is the Southeast Valley (specifically Tempe and Chandler) when you look at rent growth, absorption, and office vacancy as well as depth of buyer pool. That submarket is driving over 40 percent of the workforce in the Phoenix MSA and has access to ASU (and a young millennial workforce), multiple freeway systems, the light rail, Sky Harbor Airport, and more. I think we have already begun to see this spillover into the neighboring submarket of Gilbert, which I would call the next hot market.

JO: It’s hard to argue with the North Tempe story right now. With record low vacancy rates and an impressive roster of tenants that have located there, Tempe is definitely the belle of the ball.

AC: The hottest submarket in the Phoenix metro is Tempe. Tempe is the highest rent in the Phoenix metro and the second lowest vacancy of 8.2 percent. Chandler is the next hottest submarket. There will be about 2-3 million square feet of office buildings built within the next couple years.

Tempe then central Scottsdale, south Scottsdale and downtown. Clearly Tempe is still the darling of the entire market with the lowest vacancy, highest demand, and highest rates. The next hottest area will be either South Scottsdale, Downtown and Chandler. All of these areas have unique stories, very cool new construction and sound fundamentals.

DS: North Tempe continues to set the pace from an office perspective with several other core sub-markets humming along nicely. Regarding next hot sub-market, Downtown certainly has a lot of key ingredients that are attractive to tenants and I believe it will continue to increase its relative competitive position over the next few years.

CT: For industrial, the Southwest Valley continues to outperform given its concentration of big box product. Next hottest submarket for industrial would be the Southeast Valley communities of Chandler, Gilbert and Mesa. For multifamily, Downtown/Midtown and Scottsdale are at the forefront in terms of overall activity. Similarly, North Tempe is the hottest office submarket given the inventory of projects underway. Chandler and North Scottsdale are both poised to see an uptick in activity over the next 2-3 years.

5. “Are there any product types or submarkets where you feel supply and demand are out of balance?”

DP: Tenant demand for big boxes has softened while demand for visible multi-tenant pad buildings continues to be very intense. This has added additional fuel to the big box glut that plagues many shopping centers in the Phoenix area. Competition for in-fill pad sites is strong as developers and end-users compete for superior sites at prime intersections.

CO: It feels like there is an imbalance in supply and demand for Class-B/C office in secondary locations within the Valley. There is certainly no shortage of it, but the demand for that type of product is not as broad as we have seen for the best assets in the best locations. Outside of office, we are also seeing a fairly large disconnect in supply and demand in the Power Center retail sector. There is no shortage of Power Centers in the Valley, and compared to 36 months ago, the demand for this type of product has fallen off significantly.

AC: After being the hot spot in the last cycle, North Scottsdale has been slower this time around…but is making a turn. The supply has not been out of balance as much as the new demand has been lacking. Stay tuned for next quarter, however, as a couple of large uses could change the momentum up there quickly.

CT: Probably the West Valley and availability/supply of office product. The labor story is very compelling, and rents have improved slightly, but it is still difficult to make spec development economics pencil given the rise in construction costs and land pricing expectations.

6. “Is the Phoenix market still ripe for spec building? If so, where and what type of buildings?”

CO: We have started to see more spec office buildings pop up but in markets that can justify the rents to build and tenant demand. Markets like Tempe (i.e. The Grand). Otherwise, unless it is a submarket with high barriers to entry, attractive (and growing) rents, and high tenant demand- it feels most activity would be centered around build-to-suit or larger tenant pre-leased product.

JO: So far demand has outstripped supply and there has been a very healthy level of new deliveries to the market. As long as that continues, we will still see some developers building spec product. The demand side of the equation still feels really good. Likely the biggest deterrent to spec building will be banks’ willingness to lend into this long recovery. A recovery won’t die of old age, but it sure will make the lending community a little more cautious.

AC: Yes in several areas! Metro Phoenix demand is on track to outpace supply in 2019. Again, tenants crave vibrant new places in which to work and relax. Multi story class A office will continue to do well in Tempe, South & Central Scottsdale and Chandler. The surprisingly tight area that could also use new product is Peoria. Whoever gets a new office project up in the Arrowhead area will be handsomely rewarded.

JW: Metro Phoenix still has capacity for spec office buildings in select locations. The more insulated markets like Tempe and Scottsdale can still handle spec buildings but the developers will need to find equity and debt that understand the metro Phoenix market. At this stage of the cycle, lenders and equity investors are increasingly cautious of spec developments.

DS: There are definitely submarkets where both industrial and office spec development pencils. The challenge for many developers as it relates to spec office is the lack of attractive debt solutions. Many lenders are still not keen on spec office without substantial pre-leasing and/or heavier recourse. This can create challenges when large tenants’ have shorter-fuse timing requirements and cannot wait for a build-to-suit.

7. “What is the current state of the retail market in metro Phoenix? What changes do you expect to see for retail over the next few years?”

DP: The retail market has returned to a healthy vacancy rate of 7 percent which is the lowest it has been since 2008. New construction is minimal with most projects being fully committed prior to the start of construction. The market has averaged about 1.35 million square feet of new construction post-recession compared to 7 million square feet pre-recession. New construction in retail is a fraction of what it has been historically.

Retailers continue to evolve. To survive today, they must provide value and instant convenience to the consumer. Delivery options are plentiful and allow the consumer to get what they want when they want and where they want. Retailers are embracing omni-channel options and revising stores to accommodate the demands of the consumer. We will see more of these operational and physical changes in the coming cycle as retailers continue to channel data, use geo-locating, and provide targeted offers to customers. Also look for significant changes in restaurants and their food delivery networks & systems.

8. “How have the needs of industrial occupiers changed with the acceleration of the e-commerce trend in recent years?”

JO: There is no doubt that industrial is hot! E-commerce has fully transformed the industry. The needs of industrial occupiers are much different now. Long gone are the days of hot, dusty industrial buildings with a crew of forklifts grinding away the day. Occupiers today are employment centers. They need to attract skilled labor and RETAIN that labor. The buildings are now fully air-conditioned and will let with the latest LED lighting packages. There are cafeterias and break-rooms full of arcade games, TV’s and fitness facilities. The high-ceiling warehouse space is still a necessity, but the approach to the employee experience has made a complete shift.

CT: The need for facilities closer to consumer bases is, for some users, resulting in establishing multiple smaller footprints across targeted MSAs. In climates such as Phoenix, most facilities are trending to all A/C environments based on product needs, but also to attract and retain labor. Material handling technologies continue to advance to get product in and out quickly and more efficiently. When designing speculative projects for potential e-commerce users, primary project attributes need to include 1) abundant power with expansion capability, 2) upsized structural load capacities, 3) ample and expandable auto parking, and 4) efficient truck circulation with plentiful trailer parking.

9. “Do you see industrial cap rates increasing, decreasing, or remaining stable over the next year?”

JW: It is obviously interest rate dependent, but I believe they will be stable over the next 12 months and may even go down for some of the best product. Obviously, the credit of tenants and lease terms factor into this. Industrial is currently the most favored product type amongst institutional investors across the country and it is very difficult for them to get enough of it. Most of them are “under-weight” on industrial and are willing to stretch on pricing for it. This is particularly true when it comes to newer and functionally relevant industrial buildings. We are still considered a good value compared to the coastal markets.

DS: For multi-tenant product, I believe you’ll see them remain fairly stable as you’ll likely have improving operating fundamentals offsetting any mild upward interest rate pressures.

CT: Cap rates will decrease on best-in-class newer product that is brought to market in 2019 and 2020 if interest rates remain stable and cap rates for like-kind product in gateway markets continue at current levels of compression. For all other industrial product, cap rates should remain stable over the next year given the amount of capital seeking investment in industrial projects.

10. “How have co-working spaces changed the market? Do you expect this trend to accelerate or have we maxed out on the number of co-working facilities?”

JO: Co-working spaces have changed the office landscape by offering what is now so important to tenants… short term flexibility. For a Landlord, we begin to wonder if co-working is a benefit or a competitor for our business. I think the answer is both, so long as there is balance. It remains to be seen how much of this type of operation the market can absorb. At some point, there will be winners and losers, but I don’t think anyone can really tell when that might happen. There will likely be some sort of consolidation event that will eventually start to set that boundary and answer the question of how much is too much.

AC: Co-working groups are competing for more significant users, not just small companies like they have done in our market previously. They are doing this through flexibility- chasing after users who typically would look at longer term leases and offering them significant amounts of space at a healthy premium, but at much shorter terms. We expect all the players here to continue to grow. And I wouldn’t be surprised if WeWork doubles in size over the next two years.

JW: Co-working operators have made big moves in metro Phoenix over the past 12 months and have signed major leases in downtown Phoenix, Tempe and Scottsdale. This has happened in metro Phoenix later than other major markets. Corporate America sees co-working spaces as a flexible way to expand or contract in markets and are becoming larger users of the co-working spaces. The co-working spaces are no longer just for the startups and small businesses. As a result, I would expect them to continue to expand in metro Phoenix.

DS: One of the primary impacts of co-working is tenants now have an option that provides term flexibility, albeit at a premium. For high-growth tenants this is often important so there are some pressures on traditional landlords to consider shorter-term leases to compete with co-working. The flip side is that landlords are benefiting from tenants becoming more accepting of less-customized tenant improvements which can significantly lower upfront leasing costs.

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