Forecast 2005

12/29/2004 |

Two well-established reports offer insight into opportunities and challenges

Emerging Trends in Real Estate 2005
The next two years will probably determine whether restored confidence in the property markets has been well-founded or overplayed, according to Emerging Trends in Real Estate 2005, an annual report published by the Urban Land Institute (ULI), Washington, D.C., and PricewaterhouseCoopers LLP. "Make no mistake, the race is on - can real estate supply/demand fundamentals improve enough in 2005 and 2006 to offset the potential negative impact of rising interest rates on property values and pricing? In turn, will enough job growth and economic improvement occur to help push down vacancies and increase rents in the face of continuing geopolitical distress, uncertainty over terrorism, and related inflationary oil prices, which inevitably crimp consumer and business confidence?" the reports asks.

"Cautious pessimism" was the prediction of interviewees in the 2004 report; in 2005, they anticipate a "soft landing." Although poor demand in all sectors - except retail - was the situation in 2004, most investors realized returns that held up. "Despite some nervousness over the economy and market imbalances, interviewees almost without exception are confident that U.S. real estate markets can avoid scenarios that would crater property values," the report goes on to say. "Nothing catastrophic appears on the horizon."

Although the report suggests that office, industrial, and apartment markets have stabilized with signs of more animated tenant demand, and hotel occupancies have finally rebounded, it concludes that the economy appears positioned for modest growth. "Real estate has become a 'yield play, not a great story,' " states one prominent researcher. " 'Steady-eddy performance' is an acceptable condition," explains a mutual fund executive. "Real estate will have a lower risk profile, generating moderate returns with lower volatility."

Most of the interviewees in Emerging Trends 2005 expressed discouragement over the slow pace of office market recovery (with vacancy rates in the high teens for suburban and mid-teens for downtown buildings). Lower income - coupled with tenant improvement packages, higher local taxes, and capital costs - are further challenges. "Although the worst is over," many observers extend the recuperation period into 2007 and beyond.

But shifting lifestyles have developers changing their attitudes about location. "Mounting traffic congestion and a lack of mass transportation in many built-out suburbs focus attention on infill and mixed-use town center projects with pedestrian-friendly design," reports Emerging Trends 2005. To support this market reality, one developer in the Northwest says, "A lot of multifamily development is taking on the urban village concept. With fewer fields to plow down, abominable traffic, and the land density issue, people want to live closer to work or transit. This will lead to more expensive, complex, and dense development." Another driver is an interest of the workforce in shorter commuting distances in response to high energy prices.

As growing numbers of empty-nesters seek housing closer to downtowns and mass transit, the suburban market close to school districts is less a selling point. "Household growth is childless; lifestyles are changing," notes the report.

Emerging Trends 2005 offers the following development advice:

  • Develop resort/second homes for Baby Boomers.
  • Develop 24-hour market infill residential projects.
  • Develop housing for active seniors.
  • Cautiously pursue urban mixed-use projects.
  • Look at niche development.
  • Yellow-flag some condominiums and starter homes.

In property sectors, the report is bullish on moderate-income apartments, warehouse development, and full-service hotels, but is cautious about continued strength in retail. "Steer clear of commodity office," it adds. (See Prospects for Major Property Types in 2005 chart, page 45.)

Top investment markets mimic those noted in the 2004 report: Washington, D.C.; New York City; southern California; and south Florida. "Big money continues to go bicoastal," noted one of the report's interviewees. "Middle America is a hard sell."

Among the key points of the executive summary in Emerging Trends in Real Estate 2005 are:

  • In 2005, owners should sell non-strategic assets, taking advantage of strong capital demand, and leverage holdings before interest rates rise any further.
  • Development remains controlled in most commercial sectors. Homebuilders stay in step with buyer demand, not ahead of it.
  • Delinquency and default rates will stay under control in 2005. REITs expand their dominance in institutional equity markets, and CMBS conduit lenders continue to gain market share in the debt markets. Private investors back off when leverage strategies become less enticing, and pension funds increase activity to fill the void.

Construction Outlook 2005
In 2004, the construction industry performed better than expected, according to McGraw Hill Construction's Construction Outlook 2005. "New construction starts [were] up 9 percent in 2004 to $577 billion. Aside from the robust housing market, the year 2004 [saw] more broad-based improvement from commercial building, including the first gains for offices and warehouses in four years. And, while tight fiscal conditions continue to restrain both institutional building and public works, the dampening impact is not as severe as what occurred during 2003."

In 2005, the annual report projects the economic expansion will decelerate to about 3.5 percent. Long-term interest rates are expected to move upward, and other risks include the continued rise in the cost of building materials and the delay in getting a new federal transportation bill passed.

On the plus side, however, it is believed that job-hiring will pick up, which could bode well for the demand for offices and multifamily housing. Construction Outlook 2005 also notes that while interest rates will probably be higher in 2005, "Lending standards have eased, which will help increase access to funds for construction projects." With an improved economy providing some benefit to institutional building structures, rising student enrollments and a growing elderly population should contribute to the ongoing need for additional schools and healthcare facilities.

With respect to Year 2005 national estimates, Construction Outlook 2005 offers the following growth percentages in construction starts:

  • In floor area, total commercial and manufacturing (stores/shopping centers, office buildings, hotels/motels, other commercial buildings, and manufacturing buildings) is predicted to increase by 7 percent - with a rise in all sectors except retail, which might show a drop of 3 percent from 2004 starts. However, the contract value (dollars) of construction starts in these property types is estimated to be up by 10 percent, with an increase in all areas.
  • In floor area, total institutional (educational buildings, healthcare facilities, and other institutional buildings) should increase by 3 percent, with a growth in all sectors. In dollar values, total institutional construction starts are predicted to show an increase of 7 percent.
  • For all total nonresidential building, the Construction Outlook 2005 report forecasts a 2005 increase in floor area of 5 percent, when compared to 2004, and an increase in total contract value of 8 percent.
  • Regional estimates of 2005 new construction starts in nonresidential buildings - when compared to 2004 numbers - point to a 4-percent increase in the Northeast; a 6-percent increase in the North Central United States; an 11-percent increase in the country's South Atlantic; a 10-percent increase in the South Central United States; and a 9-percent increase in the West.
  • Construction Outlook 2005 suggests a 2-percent gain for total construction in 2005, with the main difference being that single-family housing won't be providing the outward momentum. "In effect, the construction industry is now showing a more stable performance than prior decades, due to the balancing behavior by major construction sectors."

Both provide valuable insight into market conditions and drivers, as well as investment and development opportunities.

For More Information
The complete report of Emerging Trends in Real Estate 2005, published by the Urban Land Institute (ULI) and PricewaterhouseCoopers LLP, can be ordered by accessing the ULI website (www.uli.org) and following the prompts.

The complete report of Construction Outlook 2005, published by McGraw Hill Construction, can be ordered by accessing the McGraw Hill Construction website (www.mcgrawhill.com) and following the prompts.


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