“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.”- Warren Buffett

The Phoenix Metro Area has seen robust recovery in commercial real estate values over the past 10 years. Things are as good as they have been in quite some time and it is fairly easy to find positive metrics to support the giddy feeling some are feeling. Subsequent quarterly increases in lease rates or sales numbers are recently being touted as whatshutterstock_724682302 some indicate to be a near perfect environment and closer to the economic utopia we are searching for. When you look at Q3 compared to Q4 or 2016 compared to 2017 most indicators are trending positively. However, when you zoom out you realize those numbers are only returning the same levels as they were at the end of last cycle or approximately 10 years ago. Ask yourself what is more likely; Prices and rents will continue to increase for years to come? I am thinking it is more likely that we are about to (or have already begun to) enter a period of contraction?

Two product types that I see “Leading the Way” in to the period of contraction are Retail and Office. I have summarized my perspective on some key indicators below:

Retail

Rents- up over the past 4 years but only returning to the levels of 2011. The median sales price is down 6% from 2016 near the 2009 levels.

Volume- down 4% in 2017 despite a robust Q4. And through the first three quarters of 2017 the average sale price was $131/sf compared to $164/sf for the same period in 2016 (Per CoStar Year End 2017 Report).

Cap rates- have seen a fairly significant increase from 2016 increasing from 6.9% to 7.3%.

Vacancy rates- are leading the headlines as they have continued to decline since 2011. However, some markets like North Phoenix stopped seeing declines in vacancy rates and stand a strong likelihood to see increases soon.

Absorption- is expected to decrease in 2018 (per Colliers 2017 Q4 Greater Phoenix Research and Forecast Report). The combination of these factors tell me that the market is peaked and beginning to point down. Specific markets and product type will endure longer than others, however investment and lending practices should be tailored to the point of the cycle we are in.

Office

Inventory- In my last post “Changing Perspective Dependent on Market Cycle” I recommend you keep an eye on the movement of unleased space being absorbed and amount of net product coming online. The previous two costar reports reflect the following for the first three quarters of 2018:

  • Q3 2017 Report projected 720,000 sf would be delivered with about 240,000 sf being unleased or 33% unleased.
  • Q4 2017 Report had projections of 1,100,000 sf projected for delivery over the same period with about 520,000 sf being unleased or 47% (yearend report also reflects that the subsequent quarter of 2018 Q4 would see deliveries of 350,000 sf all unleased).

These deliveries are the result of construction starts in Q4 2017 which were at theshutterstock_71686480 highest level since Q1 2015 (840,000 sf new starts and 1.7MM total under construction). Is there demand to offset this new inventory?

 

Vacancy- Phoenix rates are well above the national average; locally we have become accustomed to that. Rates are 14.7% similar to what they were in 2008, the end of the previous cycle. Is this the low point of the current cycle or do rates continue to creep downward?  Vacancy rates have benefited from absorption outpacing new deliveries helping eat away at the inventory created by last cycle’s overbuild. Bringing the current new inventory to market without the demand will surely have downward pressure on lease rates and value. Continue to monitor the future deliveries and the un-leased percentages of those deliveries.

In Conclusion

shutterstock_219690922Be Proactive, stay ahead of the cycle. Augment your underwriting to reflect the true microeconomics of the specific environment that your subject asset is most vulnerable to. Macroeconomics are not to be ignored and naturally make themselves far more evident, however be careful not to lose sight of the details when inundated with all the positive news that is being touted in our market.

 

Contact Proactive Consulting to assist with Distressed Asset Management and Mitigation

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s