Despite GDP Increase, Rents Forecast for Slower Growth

MBA (5/1/2008 ) Murray, Michael
Positive gross domestic product growth in the first quarter could avert a possible recession, but high fuel prices, less consumer spending and layoffs in the financial sector will likely lead to a slowdown in rent growth across all commercial real estate properties, based on a forecast from Property & Portfolio Research (PPR), Boston.

PPR forecasts annual rent growth will slow “severely,” as retail posts a nearly 1 percent loss, and office rents post a net loss this year, accounting for an 800 basis-point swing from 2007 levels. The report said retail rents drop most in Phoenix and Las Vegas while Seattle and San Francisco will see some of the largest gains. PPR forecast office rent growth in Houston and Seattle at more than 6 percent this year.

PPR forecasts retail to get hit the hardest with a vacancy increase of 190 basis points. PPR forecasts office as second highest in vacancy increases followed by warehouse and a 70 basis point rise in apartment vacancies.

First quarter demand was well below levels from one-year ago in apartment, office, retail and industrial properties from the largest 54 metros in the United States—as determined by PPR.

PPR forecasts warehouse and apartment rent growth at less than 2 percent. Apartment and retail had the biggest slowdown with a 75 percent drop in demand for apartment properties. While apartment and warehouse will have a major pullback, they should also come back by 2009 because of having less volatility, PPR’s report said.

“Office will also be a weak performer, as heavy office using tenants, like those in the financial activities sector will go from hiring mode to hiring freeze,” said Andy Joynt, real estate economist at PPR. “This will halt expansion plans and leave net absorption at a paltry six million [square feet] in 2008, compared with 90 million square feet in 2007.”

The PPR said that Los Angeles, San Francisco, Chicago, Boston, Atlanta and Dallas will see office vacancy increases of less than 100 basis points.

"There has been 7 [percent] and 8 percent rent growth over the past two years, so coming off that is not completely shocking to the market," Joynt added.

Without the commercial mortgage-backed securities market, the transaction market slows and puts downward pressure on pricing of assets, but it would still not affect fundamentals because supply slows down without financing, said Clint Myers, capital markets analyst at PPR.

"Projects that would be underway right now are not, and that means 12-18 months from now, when this supply would be hitting the market, it doesn't hit the market. It either doesn't happen at all or it gets pushed off a year or two. It means the fundamentals into 2009 are actually quite a bit better than they would be," Myers said.

Prior to yesterday’s positive GDP result, however, PPR forecast a modest recession as its most likely scenario, expecting it to last during the first two quarters of this year until the fiscal stimulus package and the Fed's easing monetary policy induces a "bounce back in the latter half of the year.”

“In the property type markets, this suggests that 2008 will be a challenging year, as we have already seen through the first quarter,” the report said.

The Mortgage Bankers Association also forecast a modest recession—negative GDP growth in the first and second quarters, bouncing back up to 2.7 percent in the third quarter.

Myers said the U.S. is not out of the woods for a recession, based on high energy and fuel costs, the housing and liquidity crisis. He expects a revision in the next year of the first quarter's positive .6 percent GDP growth to turn negative, adding that retail sales growth stood at 4 percent while inflation was higher, showing consumers cut down in spending last quarter.

"It's already happening to the consumer and it probably will get worse," Myers said.

However, PPR credits exports and the weak dollar in playing a part to keep a recession moderate as well as expecting the consumer to perform "above expectations."

"We do think [consumers] slow down throughout the second quarter as well, but there are a couple of reasons to point to in the second half of the year that they will not spend like they have in the past couple of years...their homes are worth less now than they were and they are going to depreciate," Myers said. "But they are using their credit cards, they are spending out of future wealth and the American consumer is just hard to hold down, especially when you have a Fed that is being quite accomodative in pushing capital into the system."

Despite PPR's forecast for a moderate recession, Myers could see the economy moving in an alternate direction as well. "It could become more serious—absolutely—and that is probably more likely than no recession scenario," he said.

The more serious scenario would be based on dual forces of the U.S. consumer holding back, which could lead to corporate defaults and bankruptcies, as retail already has seen with Linens 'n Things and Sharper Image.

"There is serious risk to a serious recession," Myers said. "We just think the most likely scenario is a more moderate recession which runs through the third quarter of this year."

With apartment vacancies on the rise in Phoenix, Las Vegas, some California metro areas—Inland Empire and Orange County—and all of the six major metros in Florida, PPR said metros will get hit "quite hard in the office and retail markets as well, with the worst offenders seeing increases between 4 percent to 5 percent in 2008 alone."

"The problem is that this isn't a huge downturn that we are going to experience so the bounceback is not going to be that great," Joynt said.

In the northwest, San Francisco, San Jose and Seattle should show apartment vacancy declines while apartment vacancies should drop in the Midwest—Indianapolis and Kansas City, PPR forecasts. Apartment rents, however, will take the biggest hits in Phoenix, Las Vegas and Fort Worth, Texas, PPR said.

"There is significant overbuilding, not only in Dallas and Houston, which are already established markets, but in San Antonio and Austin—which are not very big markets," Joynt said. "We often look at supply growth as a percent of current inventory, so it's easy for Austin and San Antonio once the building boom starts going for them to have these huge numbers in supply growth as a percent of inventory because their current inventory is fairly low."

The report added that supply in Texas is also somewhat manageable because the energy sector is thriving and help to keep demand afloat.

"In Texas, they are helped a bit because the energy sector is still pretty strong, but there definitely are some headwinds facing the Texas markets," Joynt said.