Facing down record vacancies, flat rents, and budget crunches, the commercial buildings industry makes a hesitant step toward recovery in 2004.Emerging Trends in Real Estate 2004The fundamentals of today’s weak real estate market will improve slowly, according to Emerging Trends in Real Estate 2004, an annual report published by the Urban Land Institute (ULI) and PricewaterhouseCoopers LLP. But, the sustained improvement of commercial real estate markets isn’t likely to be realized until at least 2005 or later. In the meantime, a protracted downturn will continue to stress some sectors despite modest growth in the overall economy.Short term, annualized core real estate returns will be acceptable, if not surprisingly good, with figures in the mid- to high-single digits, the report says. These returns belie what the report pinpoints as “stinky” market fundamentals: near-record vacancies; falling rents, including plummeting ones in some office markets; hefty renewed concessions; mounting property taxes; and inflated operating expenses.Deterioration continues in all property sectors except retail, which has been kept solvent by consumers enjoying extra cash in hand thanks to refinanced mortgages and federal tax cuts. Grocery-anchored retail, “fortress” malls, and power centers have fared the best in this sector. Retail’s glory days, however, will not persist, analysts predict. The market will slack off from recent highs. It has peaked, experts say. Fortress malls and better power centers are keepers in 2004 investment strategies, while grocery-anchored retail, particularly those with less-than-top-tier supermarkets, will face ongoing showdowns with expanding discount superstores. The sector has become overrated, despite a good run.Industrial is always steady, respondents report. The warehouse sector tends to typically recover quickly and early in the economic cycle. Markets already show signs of stabilization and improvement after weathering vacancy rates that nationally exceeded 10 percent, the highest on record. Rents, however, are not expected to start increasing until vacancies fall into the eight-percent range. Income-only returns are anticipated in 2004.Multi-family also continues to remains strong, and the echo-boom surge of young adults, a prime rental audience, promises to swell occupancies through the next decade. The prospect of rising interest rates bodes well for the industry, which had been hit hard as prospective tenants decided to take advantage of rock-bottom mortgage deals rather than rent.While occupancy rates in the hotel industry uncomfortably fluctuate below 60 percent, owners in this sector are well capitalized and can hold investments through any downturn. Right now, hotels are climbing back up from rock-bottom and are limping along slowly toward some sort of recovery. Leisure travel has strengthened with many Americans opting to stay closer to home, a boon to domestic resort locations – a plus since many companies continue to tighten the proverbial purse strings on corporate travel and meeting budgets.Office markets lag behind the rest of the industry, with most observers predicting that there won’t be any “significant office leasing upswings” until 2005. Industry pundits also believe rents won’t increase until the markets show signs of returning to equilibrium.The perceptions of the office market’s poor health appear to influence overall attitudes about real estate’s investment potential. According to the Emerging Trends report, the abundance of vacant office space has chilled investor appetites for properties in general. Why? Soft tenant rosters and uncertainty about the depth of vacancies leave little room for comfort.Expect 2004 to be a transition year. Cash flows will key performance, while returns will be income-driven. While the market will continue to attract investors, it isn’t the safe haven that it used to be.The lengthening real estate downturn has sapped the line-up of choice real estate markets. Emerging Trends respondents give only Washington, D.C. unwavering endorsement but also cite the southern California power duo – Los Angeles and San Diego – as the only other market that merits favorable positions in the report’s risk/return diagram. Most other markets have slipped marginally deeper in lower-return/higher-risk territory, or what these forecasters call a “gray morass.” They will concede, however, that New York City is hanging tough. Midtown is solid for now, but downtown remains soft. New York City is still the “place to be” if you want to be a global player. Expect to see mainstream development being pushed towards a hiatus. Only D.C. and southern California rate even mediocre development prospects in the ULI/PricewaterhouseCoopers survey. Most other markets and sectors are oversupplied. And, in the case of New York City, most major development projects on the boards are nearing completion. Ambitious developers will find expanding opportunities in urban and suburban infill, however, as decades of sprawl argue against greenfield development.Lastly, technology’s impact on real estate continues to grow. It reduces the need for space and cuts demand growth in a number of ways. Office space requirements have dropped because of the increased use of hoteling and work-from-home arrangements – due to increased reliance on telecom, web, and satellite systems.More people are shopping from home thanks to the Internet, and it is steadily biting into brick-and-mortar retailing’s market share. Web sales climbed 50 percent in 2002 and could amount to more than four percent of total 2003 retail sales, based on preliminary estimates. Eventually, forecasters predict, online and offline merchandising will become more integrated, reducing the need for store space.Even the old stalwart warehouse market is feeling the effects of technology. Thanks to such inventions as radio frequency ID chips that allow shippers to track pallet shipments to their destinations with global positioning satellites, warehousing has been slashed as delivery needs are matched more closely to inventory requirements.Construction Outlook 2004After a sluggish start in 2003, the construction industry began to bounce back mid-year, regaining the plateau it had established during the previous year. McGraw-Hill Construction Dodge’s Construction Outlook 2004 estimates that total construction will register a slight one-percent gain, the same increase as 2002, reaching $506 billion for 2003.While this is definitely a more subdued performance than the 10-percent annual growth of the late 1990s, the construction industry continues to prove that it is one of the more resilient parts of the economy. Even with a yo-yo cycle of recession and hesitant recovery, the industry as a whole still continues to enjoy a healthy volume of activity. Case in point: Total construction starts, as reported by McGraw-Hill Construction Dodge, increased five percent in 2002.In 2004, forecasters predict the industry once again will see slight growth, climbing an estimated one percent to $509 billion. Income properties will grow nine percent in dollar volume and five percent in square feet, according to the McGraw-Hill forecast. Institutional properties are expected to decrease five percent to 500 million square feet, marking the third straight year of decline for this sector.Income properties’ square footage for 2003 is projected to be down just one percent. Within the sector, 2003 gains are expected for stores, hotels, and multi-family housing, offsetting continued weakness for the other building types, particularly the office segment. For 2004, the income property group is expected to rise five percent to more than 1.3 billion square feet.Office buildings peaked at 298 million square feet in 2000, and then construction fell sharply over the next two years, plummeting to 156 million square feet in 2002. Early predictions for 2003 show a hefty 10-percent drop to 140 million square feet as the industry continues to deal with fall-out from the tech bust of 2000 and the recession of early 2001.With employment remaining weak, forecasters say it’s likely there won’t be any improvement in office vacancy rates. Statistics from CB Richard Ellis show that the suburban office vacancy rate rose 17.9 percent in the second quarter of 2003, up from 8.6 percent in 2000. Downtown vacancy rates reached 14.4 percent in second-quarter 2003, compared to 6.2 percent in 2000.The Washington, D.C. office construction market remains the strongest player in the top 10 list, up 16 percent. The remaining nine: New York City, Chicago, Atlanta, Houston, Phoenix, Philadelphia, Los Angeles, Dallas, and Sacramento showed declines.Renewed growth in office employment is predicted to be slow, with office vacancies not receding until at least early 2004, according to McGraw-Hill forecasters. Appreciable rent growth likely won’t occur until the second half of 2004. Don’t expect a broad push in 2004 to spur more construction. Rebounds in large markets aren’t likely to occur, but secondary markets that did not take part in the boom of the late-1990s might become more active. Double-digit gains aren’t expected until 2005.In 2003, the multi-family sector saw moderate expansion, despite rising vacancies and flat rents in some markets after falling five percent to 394,000 units in 2002. It has climbed back up to the 400,000 mark. The record was 442,000 units back in 1999.While there are near-term concerns about the health of the multi-family market – as reflected by rental vacancy rates of nearly 10 percent in second-quarter 2003 compared to eight percent between 1998 and 2000 – longer-term factors for this sector remain positive. The real estate finance community views it favorably, thanks to its relatively stable revenue stream compared to other property types. Despite the fact that rents have been flat, the sharp rise in housing prices in certain markets leaves room for rents to climb.Total store construction fell eight percent to 257 million square feet in 2002 but is expected to recover in 2003 with a predicted eight-percent increase to 277 million square feet. Competition among the major retail chains, as well as demand for increased efficiency in store formats, has encouraged new construction.One of the most noticeable trends of the segment has been a continued shift away from mega-mall projects toward smaller-scale retail venues, such as upscale “lifestyle centers,” which are one-third the size of an enclosed mall.Overall, expect a two-percent rise in retail construction to a total of 285 million square feet in 2004, forecasters predict.In 2003, hotel construction strengthened, with activity for the year expected to reach 45 million square feet from 40 million in 2002. While this is well below the 1998 peak of 93 million square feet, the upward trend should continue into 2004 with a predicted climb of 11 percent to 50 million square feet. Mid-scale lodging is expected to fare the best since several chains are focusing attentions on mid- to lower-price segments to appeal to a more cost-conscious business traveler.Institutional properties are becoming more of a restraining influence on the construction industry. For 2003, it is showing a five-percent decline in square footage to 500 million square feet, which translates into a one-percent drop in dollar volume. This compares to only a one-percent drop in square footage for income properties, as well as total construction contract values.Much of this decline is attributed to the ongoing decline of state fiscal conditions, which are exerting a restraining effect on the various institutional categories. School construction is expected to decline for the third straight year since a record high in 2001. The market will drop five percent to 240 million square feet. Expect a fourth year of decline in 2004, down seven percent to 223 million square feet.Hospitals and clinics will decline nine percent to 88 million square feet in 2003. Activity in 2004 is expected to remain in this downward spiral with a predicted six-percent drop to 83 million square feet.Reduced contracting also is expected to be reported for courthouses, detention facilities, churches, and amusement-related projects.Robin Suttell ([email protected]) is Cleveland-based contributing editor at Buildings magazine.