U.S. recovery anchored in uncertainty in 2013

Real estate continues to meander along a slower-than normal recovery track, behind a recuperating U.S. economy, dogged by ongoing world economic distress.

But for the third-consecutive year, the Emerging Trends in Real Estate 2013 report [PDF] released last week by PwC and the Urban Land Institute at the ULI Fall Conference indicate that U.S. property sectors and markets will register noticeably improved prospects compared with the previous year, and the advances now gather some measure of momentum across virtually the entire country and in all property types. 

“Decent” though “relatively disappointing” job creation should be enough to coax absorption higher and nudge down vacancy rates in the office, industrial, and retail sectors, helped by “next  to no” new supply in commercial markets. Robust demand for  apartments holds up despite ramped-up new construction, and even the decimated housing sector “turns the corner” in most  regions. Improving fundamentals eventually should prod rents and net operating incomes onto firmer upward trajectories, building confidence about sustained—albeit tame—growth and  buttressing recent appreciation.

Commercial real estate’s slow recovery will continue in 2013, according to the Emerging Trends survey.

The report, generated by surveys and interviews with 900 real estate investors, developers, service providers and lenders, shows expectations that trends that have materialized in recent years will continue in 2013. Namely, gateway cities like San Francisco, New York, Boston and Washington, D.C. continue to be the best bets for investment and development—although there are fledgling concerns that pricing has gotten too heated. As a result, secondary cities may receive more of a boost in the coming months. But growth everywhere will continue to be tepid with gradual improvements in occupancies, rents and values for all property types.

“This is our recovery,” said Jonathan Miller, a partner and co-owner of Miller Ryan LLC, a strategic marketing communications consulting firm to the financial services and real estate industries and the principal author of the Emerging Trends report. “It's just been a long, hard grind. ... But the recovery is definitely happening and we're profiting from it.”

Despite slow job growth, vacancy rates in the office, industrial and retail sectors should continue to register improvements, the survey found, buoyed by limited new supply coming online. The apartment sector remains strong as well, even as construction there picks up.

In fact, Miller described the survey responses as “a little schizoid” with scores rising across the board, showing increasing optimism, but interviews with respondents revealing a host of concerns. “The ratings express an optimistic sentiment for next year,” Miller said. “But the interviews raised the ‘recovery in uncertainty concept.’ So you have to take that into account. And it flows from that we don’t know what’s going to happen in arenas beyond real estate.”

In terms of markets, San Francisco jumped to the top of the list for 2013. The survey ranks markets based on investment, development and homebuilding prospects. Washington, D.C. had topped the Emerging Trends list in recent years, but fell seven spots this year in part because of uncertainty over potential federal budget cuts.

By property type, survey respondents remain the most bullish about investment in the apartment sector (6.58 on a scale of 10) followed by industrial (6.17), hotels (6.02), offices (5.72) and retail (5.30). Prospects are a bit dimmer for most sectors for development with apartment again topping the list (6.87) followed by industrial (5.29), hotels (4.85), offices (3.72) and retail (3.64).

Survey respondents said they expect investors to take greater risks in 2013 in chase of higher yields. That means activity should pick up in secondary markets as cap rates in core markets have compressed too much to meet target return levels for some investors.

“In secondary markets, you have to be linked with local operators,” Miller said. “If you're not working with local operators, you're going to be in trouble. They are in the best position to make money.”

However, generating returns will take time. “It's a get rich slow business,” Miller said.

According to the report, investment capital’s interest in commercial real estate is expected to increase as other asset classes continue to offer minimal returns or too much volatility. The survey found that only six of the 51 markets covered exhibited a decline in investment prospects.

On the financing front, lenders are making more capital available, but refinancing properties that have leasing risk or high occupancies remains a challenge. Respondents also expect the CMBS sector to continue its slow recovery while also voicing concerns about how little the sector has done to address issues exposed by the 2008 financial crisis.

“A lack of confidence by investors in the CMBS sector could push the recovery off the tracks,” said Stephen Blank, a senior resident fellow for real estate finance with ULI. “Hopefully some of the issues will resolve themselves. Overall, we expect issuance to increase, but not that dramatically.”

OTHER FINDINGS
Respondents to the Emerging Trends survey cite a number of best investor bets for 2013, which include:

•    Concentrate acquisitions on budding infill locations: Top urban markets outperform the average, bolstered by move-back-in trends and gen-Y appeal. Top core districts in these cities have become too pricey, so look in districts where "hip" residential neighborhoods meet commercial areas. Construct new-wave offices and build to core in primary coastal markets: Major tenants willingly pay high rents in return for more efficient design layouts and lower operating costs in LEED-rated, green projects.

•    Develop select industrial facilities in major hub distribution centers near ports, rail corridors and international airports: In these markets, the industrial sector is driven by tremendous demand from large-scale users looking for specialized space and build-to-suit activity.

•    Use caution investing in secondary and tertiary cities: Focus on income-generating properties and partner with local operators who understand tenant trends and can leverage their relationships. Markets grounded in energy and high-tech industries show the most near-term promise, while places anchored by major educational and medical institutions should perform better over time.

•    Begin to back off apartment development in low-barrier-to-entry markets: These places tend to overbuild quickly, softening rent growth potentially and occupancy levels probably by 2014 or 2015.

•    Consider single-family housing funds: Housing markets finally get off bottom and major private capital investors make a move into the sector. Concentrate investments with local players who know their markets and can manage day-to-day property and leasing issues.

•    Repurpose the oversupply of obsolescent properties: Whether abandoned malls, vacant strip centers, past-their-prime office parks, or low-ceilinged warehouses, an overabundance of properties requires a rethink, a tear-down and, in many cases, a new use.