The long, hot summer of 2020 just added to the misery index in Arizona. The state has managed to still move forward with many new developments, and the pace of building has remained steady. There are signs all around the Phoenix market that this COVID-19 induced economic downturn will be a short-lived one when compared with what occurred in Arizona just over 10 years ago.
Leading that recovery will likely be the industrial and office markets. As companies return to normal operations in the post-COVID era, there are indications that more space will be needed for office workers, not less, which could create opportunities for office developers. Industrial developers never really stopped launching new projects, even in the midst of a historic pandemic, and there are still companies actively looking to move and build new operations centers in Arizona.
AZRE Magazine posed questions to a roundtable of NAIOP Arizona members, looking for their thoughts on the market, how it will look coming out of the pandemic and where the real estate opportunities are for those ready to take the lead in our economic recovery.
DF: Derek Flottum, Vice President of Development, Irgens
JWe: Jim Wentworth, Principal, Wentworth Property Company
JWo: Jeremy Womack, Senior Managing Director, Capital Markets, JLL
KM: Kate Morris, Senior Vice President, Healthcare Services, Transwestern
DP: Darren Pitts, Executive Vice President, Velocity Retail Group, LLC
CR: Candace Rosauro, Director of Business Development, Layton Construction
AZRE: What do you think the economic recovery will look like, and how long will it take? What sectors do you expect to recover first, and which will lag?
DP: We expect the remainder of 2020 to have continued overall uncertainty. We are still in the thick of COVID-19, civil unrest, and an election year — which all mix together to create a level of uncertainty for many corporate decision-makers. In 2021, we are anticipating more stability. This will be fueled by the hope that a vaccine for the virus gets closer to the finish line. As far as our commercial sectors are concerned, industrial and multi-family sectors, which have experienced very little slow down during the COVID shut-down will remain the strongest coming into 2021. Single-family residential is also maintaining a strong performance in Arizona as the lack of resale inventory is driving new home sales even higher. Through April, new housing permits were up 24 percent on a year-over-year basis. Office will be looking for innovation to help pave the way as office occupiers find their business models shifting with many employees working remote part time and full time. For retailers, we will continue to see more consolidations of concepts, as well as opportunities which focus on drive-thru models to expand.
JWo: The U.S. economic recovery will remain disjointed in nature with starts and stops until a meaningful COVID-19 vaccine and therapeutics are developed and distributed widely.
Unfortunately, there will continue to be market winners and losers along the way. Medical, healthcare, food and beverage, re-shored manufacturing, e-commerce, third-party logistics and other “essential” industries will sustain or flourish while non-business travel, crowd-centric public activities and related events will remain challenged.
KM: Once a vaccine is in place, we expect pent up demand for health services and surgeries to keep providers busy until the backlog is caught up, estimated at 9–12 months.
CR: I think the recovery speed will be in phases, but will also depend on how long the shutdown lasts. From a construction standpoint, recovery will lag similar to what happened after the Great Recession. The market segments we expect to recover more quickly include data centers, due to the increase of employees working from home, as well as distribution centers such as “last-mile” facilities. The sectors that will lag are those that are dependent on tourism, such as hospitality, retail, and entertainment.
JWe: I think industrial, self-storage and medical will be more recession resistant this downturn. Office and retail will lag by a year or more due to the amount of vacancy and timeline for normal behavior to recover. Unfortunately, a vaccine will dictate the timeline for recovery and when people will feel comfortable getting back to normal.
I think the recovery will take time with starts and stops as we have seen with the COVID response. Despite our current trends related to the virus, I believe over the long run the United States will remain the most attractive international location to invest capital. Nationally, I think there will be geographic winners and losers. Markets that are conducive to lower density, affordable living and quality of life will experience an expansion following the inflow of workforce capital, while some of the more traditional dense urban markets will experience a contraction.
The US economy is largely built on consumers. And it is consumers who have the most immediate impact on the retail and hospitality markets. These sectors have carried a lot of the burden over the past six months and will take time to recover. I think other sectors that provide goods and services to those markets will lag but still experience the effect of that slowdown. If consumers are not pushing dollars though the economy because of job loss, fear of job loss, or inflation, it could have a precipitous effect on the timing and flow of our recovery.
AZRE: How would you compare our Metro Phoenix commercial real estate market to other major markets throughout the nation, and specifically the Western U.S.?
JWe: Phoenix should perform better than many of the dense gateway markets in the Western U.S. Unlike most prior cycles, we have not overbuilt office or industrial product. Phoenix was much slower to rebound from the last recession than many of the other major markets and we have done a good job keeping inventory in check. We have also greatly diversified our economy and have not been as reliant on homebuilding and real estate as an economic driver.
DF: No metro market has been spared the effect of this event, however long term I absolutely believe in Phoenix. Phoenix’s modern infrastructure, educated work force, business friendly environment and affordable cost of living makes it an ideal choice for corporate expansion or relocation. Phoenix has added thousands of jobs during this cycle in financial/insurance, healthcare and biomedical, e-commerce and distribution and continues to be a leader in the semiconductor and advanced manufacturing fields. This has created a more dynamic economic base than we have had in the past and leaves us well positioned to grow in the future.
JWo: The metro Phoenix market is fortunate to have robust population growth, a pro-employment political environment and a strategic location to the ports of Los Angeles, Long Beach and Mexico. Additionally, Phoenix offers a high quality of living to low- and middle-income families, which is something more difficult to achieve in the coastal markets.
DP: Despite the effects of COVID-19, Phoenix is one of the strongest growth markets in the nation and remains considerably less expensive compared to the coastal markets of Seattle, Portland, San Francisco, Los Angeles and San Diego and inland markets of Las Vegas and Denver. In comparison, the market 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. The Phoenix area offers a desirable lifestyle and affordability.
AZRE: What are the biggest opportunities that exist in the Phoenix market over the next three to five years?
JWo: Phoenix has a tremendous opportunity to become a major western U.S. hub for technology, manufacturing and related global supply chain logistics due to its deep, qualified, affordable workforce; reasonably priced and reliable energy; and direct access to Mexico and the ports of Los Angeles and Long Beach. With an influx of new residents looking to reside in a lower tax, pro-business state, we see an opportunity for many sectors to grow. Arizona provides a high quality of life which attracts people for its climate, recreational opportunities, low taxes and employment opportunities. With population growth comes the need for housing, essential service real estate and new and upgraded infrastructure.
KM: We expect to see Phoenix’s growth continuing over the next 3-5 years. Because the Valley is already stretched for medical services, we anticipate continued strategic placement of new services and medical providers during this period.
DP: We anticipate strong retail shopping cores to get stronger, such as Kierland, Desert Ridge, Fashion Square, San Tan, Chandler Fashion and the Biltmore corridor. Humans are social by nature and despite COVID we expect these centers to perform well and fill any large box vacancies that may occur. Look for more mixed-use redevelopments of defunct retail centers. A great example is Park Central Mall, which transformed with higher education, office, medical and retail space within the central Phoenix location. Metrocenter and Fiesta Mall, though several years away, will be the ones to watch over the next 36 – 48 months. The grocery sector continues to get more efficient as value and low price leaders disrupt the market. With Aldi entering the market near the end of 2020 we see continued downward pressure on prices in this highly competitive arena, as all of the players will compete for their market share.
CR: The Phoenix market will benefit from the manufacturing companies seeking to re-shore their operations. We continue to attract new residents, thus increasing our workforce, and have been successful in promoting our business-friendly environment. Our manufacturing footprint will continue to grow as more data centers and highly-technical manufacturing industries, such as semiconductor and life sciences, expand in the Valley.
DF: I think Phoenix has become a financial services/insurance, biomed, and technological manufacturing hub and this will continue. Both State and City government has been committed to being open to new technology and innovation and has done a good job in promoting its business-friendly environment through its political leadership, economic development departments, and wonderful metro organizations like GPEC.
JWe: I expect the office market to offer the biggest discount and value add opportunity. Some current owners don’t have the right kind of debt in place to handle the disruption we are seeing with COVID. There will be higher than normal vacancy in both suburban and urban submarkets. There will be opportunity to buy and then push occupancy once social behavior starts to return to normal.
AZRE: How has the increase in last-mile delivery impacted how investors and developers view industrial opportunities? Is the metro Phoenix market positioned to take advantage of these changes?
CR: One of the most important aspects to last-mile facilities is the requirement for parking and delivery van queuing. Site coverage has always been one of the key factors for industrial developers. The emerging last mile model has very little building coverage and enormous amounts of surface parking / van queuing. Developers should always be studying how truck courts and trailer parking can be converted into vehicle parking.
JWo: Last-mile delivery service is the next step in the comprehensive multichannel e-commerce paradigm. An industry that was once growing at 12 percent to 15 percent annually is expected to double in 2020. Phoenix has a significant amount of older, infill, inefficient industrial building stock that will offer unique, urban last-mile solutions. Amazon’s large metro Phoenix footprint validates the dynamic nature of this type of commerce.
AZRE: How have the needs of industrial occupiers changed with the acceleration of the e-commerce trend?
JWo: Many of today’s modern industrial occupiers require more energy for climate control (both HR recruitment and products) as well as equipment and IT within their facilities. Additionally, car parking, truck trailer drops and building clear heights have all increased. Site security is also paramount for employers who mandate technology propriety as well as easy access to interstate and major highway systems.
CR: The supply chain model has changed drastically in the last few years as e-commerce has become the virtual brick and mortar stores. Industrial occupiers are requiring buildings and sites that allow for efficient product movement, where the design of new buildings are larger in size and height. Industrial buildings have evolved by growing taller to allow mezzanines throughout the building, becoming more technologically advanced to break down the bulk packaging, and more user-friendly with higher occupancy levels to provide same-day or two-day delivery.
AZRE: 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 vacancy rate has risen only slightly from 7.5 percent at the second quarter 2020, compared to 7.3 percent at year-end 2019. Absorption is negative for the first time since 2011, with less than 153,000 square feet. COVID has had an impact on retailers who already were struggling with high debt, or a large number of lower performing stores. They found that the quick shut down caused irreparable damage, and some may not reopen. On the other spectrum some retailers have used COVID as a pretext to enter Chapter 11 reorganization without the normal stigma attached. They have been renegotiating leases and eliminating non-performing stores all without taking a hit to their brand identity. The benefit of this is that the retail market should be stronger and more efficient than it has been in the last decade. We fully expect to get to the other side of this with better logistics, technology, delivery platforms and healthier retailers.
AZRE: In light of social distancing measures, what are the prospects for co-working over the next several years?
JWo: Unsurprisingly, most new office deals are lease-expiration-driven transactions, as companies attempt to preserve cash and cut discretionary spending.
Large occupiers have rapidly adopted agile space strategies. Although freelancers are more likely to shed coworking space as the COVID-19 outbreak stalls business, 67 percent of CRE decisionmakers are increasing workplace mobility programs and incorporating flexible space as a central element of their agile work strategies.
After the initial wave of uncertainty has passed, some of the larger, well-capitalized flexible space operators will restart their expansion drive, picking up assets and market share from those unable to weather the storm. Market consolidation will yield a healthier marketplace, with strong flexible space operators remaining. At the same time, we will expect growth to shift from leases to fee-based management agreements, white-labeling or self-perform concepts by landlords.
In a revived post-pandemic market where flexibility is high on the corporate agenda and the purpose of the office is centered around collaboration, flexible space should emerge stronger than ever and growth could quickly return to its impressive pre-COVID rates.
AZRE: Is the Phoenix market still ripe for spec building? If so, where and what type of buildings?
CR: Yes. Speculative industrial buildings will continue to be a part of the Phoenix market and all the surrounding markets. As the need for last mile distribution continues to increase, the need for speculative industrial buildings in every market in the Valley will continue to rise. The industrial market is not just about the 500K – 1M SF buildings. The market for smaller 150K – 300K SF buildings will need to fill the last mile demands of e-commerce.
JWo: Over the next five to six years, we will witness the Phoenix West Valley/Loop 303 submarket double or even triple in size from its current 15 million square feet, leveraging significant population growth, new Loop 202 extension and expanded Northern Parkway. The submarket offers operators 30 percent or more in cost savings while maintaining accessibility to Southern California’s ports and large population.
KM: Speculative medical buildings are unheard of in the Phoenix market; we do not expect this to change.
JWe: Definitely for industrial. We will have to wait and see what the office sublease market looks like and how long it takes to absorb that space. Spec office development will be much more selective in the next couple years. Once the tenants can start touring space again, Phoenix should continue to see large tenants expanding and relocating here from other markets and we could have a shortage of large blocks of space in no time.
DF: I think certain submarkets can support spec building. Financing them is another question. Building along the transit infrastructure where you have seen consistent demand for a particular type of product is the safest for spec, for example distribution warehouses in the West Valley, large floorplate offices in the East Valley and class A office in North Tempe, North Scottsdale and Downtown Phoenix. There have been a significant number of projects in the past five years that secured credit tenancy because there was product to meet an immediate need. This needs to be balanced with the risk of fronting capital for an undetermined amount of time into a potentially changing economic cycle as you move through the construction process.
AZRE: Do you expect suburban office to regain appeal due to the COVID-19 pandemic? If so, for what reasons?
KM: Healthcare companies had already been expanding their services to outlying areas. They want their patients to have easy access to their physicians, testing, surgery centers, etc. This trend will only accelerate as suburbs gain popularity.
DF: I do. I think, in general, larger floorplates, fewer floors reducing the need for elevators and confined spaces, and absence of required mass transit are all conducive to a post COVID market. People that want to have the ability to distance from others can do so in that setting. I think people will want to spend less time commuting, work in their own general neighborhoods and can spend more time with friends/family. I think you will see more community clusters where people can meet all their needs without spending considerable time in their cars.
JWe: Yes, though I’m not sure that it ever lost its appeal. We have seen strong absorption in suburban markets like Chandler, Tempe and Scottsdale in recent years. The desire to be in the suburban markets will continue as large tenants relocate to Phoenix from more dense markets. Large tenants will be attracted to these markets for many of the same reasons such as proximity to labor and cost. They will also be attracted to large floor plates that allow them efficiency and flexibility in layout.