The “Era of Less” Is Not Over Yet

Despite increases in available capital and improved investment prospects in some U.S. cities, the real estate market remains stagnated, according to the latest installment of the report, Emerging Trends in Real Estate® 2012.

Despite increases in available capital and improved investment prospects in some U.S. cities, the real estate market remains stagnated, according to the latest installment of the report, Emerging Trends in Real Estate® 2012. With growth concentrated in a few global gateway cities, a lack of demand, and an uncertain future amid a global economic downturn, the “Era of Less” not only is not over, the report says, but is still going strong.

The more than 950 real estate experts interviewed or surveyed in Emerging Trends 2012 agree that slow job growth is the number-one factor stalling market recovery. A lack of jobs is not only pushing down demand for office space, but also is affecting the retail and industrial markets by reducing consumer spending. “Job creation is clearly the critical ingredient for a sustained recovery in commercial real estate, and the market participants we surveyed uniformly struggled to identify new employment engines,” says Mitch Roschelle, U.S. real estate advisory practice leader for PwC. The job problem is clear, Roschelle says, but the solution is not. An aging population, growing competition from abroad, sustained personal debt, and a government that is lacking in coherence and solidarity make job generation a complex, if not daunting, task. “As a result, businesses are focused on squeezing profitability out of productivity gains, and families forced into belt-tightening are using less square footage, which follows the Era of Less sentiment we forecast last year,” he says.

Only core, well-established markets in global cities are producing solid and predictable single-digit income-oriented returns, the report says. Secondary and tertiary cities continue to see little capital. “The return landscape for 2012 presents a mixed bag, and all depends on where and when investors bought, the amount of leverage employed, and asset quality,” says Stephen Blank, ULI senior resident fellow for real estate finance. “Many players will back off from bidding on trophy properties in top-tier markets, fearing that pricing is outpacing the potential for recovery in net operating incomes.”

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The list of cities with the best outlooks is not surprising. Washington, D.C., for example, is number one for the third year in a row. A historically solid market amid economic downturn, Washington has a diverse employment base and a growing retail market, and is seeing a gradual increase in home prices. D.C.’s reign at the top may be short-lived, though: some interviewees suggest that political upheaval and federal cutbacks may dampen the market in years to come.

Although a medium-sized city and relative newcomer to the list, Austin made the number-two spot because of the presence of the University of Texas, an abundance of government jobs, its high-tech industry, and its energy-based economy. Other cities with the best growth prospects are those that also have energy- or technology-based economies—Houston, Dallas, San Jose, Seattle, and San Diego, among others.

San Francisco, which sits at number three on the list, keeps investor interest with its high-quality offices and apartments. The city’s home prices are also picking up faster than those anywhere else in the country. New York City benefits from its diverse labor force and a hotel industry flourishing because of the influx of overseas tourists. Interviewees also predict that a lack of new apartment supply will help New York City rents increase and push up values in co-ops and condominiums. Boston, with its well-educated workforce, and Seattle, with its high-tech industry, round out the top five.

Although only 40 percent of cities ranked as fair or better prospects in 2011, more than 60 percent of cities attained that rank in the 2012 report. Survey respondents believe that capital will begin to take on more risk and spread to some of the less obvious markets.

Beyond the global gateway cities, the report states, investors are shaken by limited opportunities and the discouraging growth potential in real estate. Predicting returns even in the midteens is proving difficult because of high risk and the uncertainty of supply and demand. What is certain, though, is that fewer people will buy and more will try to sell. “Overall ‘buy’ sentiment will subside, selling appetites will increase, and more owners will hold until the economy untracks,” says Roschelle. “This is part of ‘the new normal’ as investors are coming to grips that they may not be selling for more than they paid.” The report’s interviewees also worry that pricing will begin to outpace the potential for recovery, causing many investors to back off. One upside, though, according to Blank, is that “investors believe that cap rate compression has ended, and a leveling off is expected with possible upticks in cap rates for some property sectors in certain markets.”
Within the property sector, developers and builders will continue to “twiddle their thumbs,” according to the report, while waiting for a pickup in demand. Interviewees predict that only multifamily projects will receive funding, and apartments will do well because of sustained uncertainty surrounding the security of the housing market. While apartments likely will get built, interviewees says, offices will not. The offices that will be developed will be located in urban areas rather in suburban office parks, the report says. Generation Y, the large demographic cohort of those age 16 to 32, will prefer to work in green, energy-efficient buildings located near where this group most commonly lives—dense urban areas.

Retailers also will continue to suffer because of the encroachment of internet purchasing. If new retail projects are to be built, they will be mixed-use projects centered on office space or a grocery store, the report says. The hotel industry does show some promise, but again, growth is predicted only to occur in the core, global 24-hour cities.

Turning to the international market, Emerging Trends reports that Canada has the most stable real estate market in North America because the country has a resource-rich economy, employs conservative fiscal policies, and ensures that its institutions hold on to their best properties. Toronto and Vancouver will remain top markets because of strong interest from Asian investors, especially in condo projects.

In Latin America, investor confidence in the two largest real estate markets is bifurcated. According to the report, Brazil is on the road to becoming a powerful core player. With districts in Rio de Janeiro and São Paulo boasting prices that compete with those in New York City, one interviewee says, “Brazil looks less like an emerging market.” On the other end of the spectrum, investors are backing away from Mexico due to political, social, and economic turmoil, especially related to drug violence. In smaller markets, Colombia is drawing increased interest after the discovery of offshore oil fields.

The report concludes that investors and developers should focus on gateway cities and go where the jobs are, especially if they are related to energy, technology, health care, or education. Owners should lock in long-term fixed-rate financing now, and investors can expect good returns as borrowers get good deals on mezzanine debt and preferred equity. Purchasing land to hold will also allow cash buyers to claim single-family lots for cents on the dollar. As one interviewee states, although capital is available in 2012, “Don’t let availability of capital cloud judgments.”

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