Expect returns on commercial real estate properties to be powered more by income gains than price appreciation over the next two to three years as the super-heated investment sales market cools slightly, forecasts Bob Bach, senior vice president of research for Grubb & Ellis.

Price appreciation accounted for two-thirds of the total return for commercial real estate in 2005, while income gains represented only about one-third, according to the National Council of Real Estate Investment Fiduciaries (NCREIF), which tracks institutionally owned properties. Historically, these figures industry-wide have been reversed, with income accounting for the lion's share of returns.

“Real estate is an income-based asset,” Bach says. “Most people realize that the rate of appreciation just can't go on forever.” Indeed, there is growing anecdotal evidence that the investment market has peaked and is pulling back somewhat. “There are fewer bids for properties, buyers aren't as aggressive,” Bach says, “and there is a lot of rebidding taking place.”

Bach's remarks were delivered to a gathering of about 80 institutional investors and brokers at the Lodge of Torrey Pines in La Jolla, Calif., during the first quarter of this year.

Hosted by the Institutional Investment Group within Grubb & Ellis, the two-day networking and educational event also featured a presentation on the global outlook for commercial real estate by Stephen Mallen, senior managing director of global client services for Grubb & Ellis. Additionally, NREI moderated a roundtable discussion on the state of the industry today. (An edited version of the roundtable is available at nreionline.com)

Jobs, the great antidote

Steady employment growth has been just what the doctor ordered for the beleaguered office market. The economy generated 2 million new jobs in 2005. About one-third of that job growth occurred in office-using sectors. As a result, the national office vacancy rate has fallen from 16.4% a year ago to 14.3% at the end of the first quarter. Bach predicts office vacancy to dip to 12.8% by the end of this year, a figure he describes as “very near the rate of equilibrium,” widely considered to be 10% to 12%.

Absorption is exceeding new construction by a wide margin (please see accompanying chart), and Bach expects that trend to continue throughout the remainder of this year. The net absorption of 14 million sq. ft. nationally in the first quarter was nearly three times the rate of space completions.

Construction has largely been held in check, but Dallas is a market where the real estate recovery has been hampered by new development. “In Dallas, they always start out of the gate early, and they just keep [building] further north. One of these days, they are going to get to Oklahoma City,” says Bach.

Some 2.7 million sq. ft. of office space is currently in the construction pipeline in the Dallas/Fort Worth market, down from 3.6 million sq. ft. at the end of 2005. “The widespread construction, which the metroplex has become accustomed to, is anticipated to slow as the year progresses due to spiking construction and development costs,” concluded a newly released Grubb & Ellis research report on Dallas/Fort Worth office market trends.

Despite obvious softness in the metroplex — the area-wide office vacancy rate is 21.7%, though it's only 6.9% in the Fort Worth CBD — absorption hit 1 million sq. ft. in the first quarter of 2006. That's the highest quarterly gain since 2000. Here again, the key is job growth. The market is expected to generate 87,000 new jobs in 2006, which if realized would translate into 3.2% employment growth.

Top office markets

What's the No. 1 market for office investment over the next five years? Phoenix tops the list, says Bach, whose selection is based on an analysis of 15 different indicators, including demographic, economic and real estate data. “Rental rates are rising in Phoenix, [population] growth is phenomenal, and there is not a lot of vacant land in Phoenix.” A minimal amount of available land is a barrier to entry that investors highly value because it tends to restrain development. In both Las Vegas and Phoenix, either the federal government or Indian reservations own a significant chunk of land.

The Washington, D.C., market, which includes suburban Maryland and northern Virginia, ranks No. 2 on the list of Bach's top investment hot spots because it's outpacing all markets in terms of net absorption. Third on the list is the Inland Empire in Southern California, which for decades was recognized largely as a big-box warehouse distribution hub and a bedroom community of Los Angeles.

The Inland Empire (Riverside-San Bernardino-Ontario) posted a vacancy rate of 7% in the first quarter of 2006, the lowest of any major market, even beating out New York. “The Inland Empire is just great,” says Bach. “The office vacancy rate has just plunged in the last couple of years, and there is tremendous demand out there for office space now.”

With so much capital pouring into U.S. real estate from both domestic and international sources, core cities aren't the only markets on investors' radar screen today. Finding attractive yields is growing more difficult, particularly in coastal markets, resulting in a lot of money flowing into secondary markets such as Richmond, Va., Raleigh, N.C., Albuquerque, N.M., and even Oklahoma City. “It's very possible that the pressure [to place capital] in these smaller markets may continue for a while,” says Bach.

So, what's the best strategy for investors in 2006? “Be more discriminating, “ Bach urges. For sellers, it might be a good time to recycle capital from retail into office properties, he suggests. With real estate fundamentals improving, landlords should be able to push rents higher, adds Bach. In other words, if you're a tenant “make your deal early.”

A global phenomenon

The unprecedented cap-rate compression that has taken hold in the U.S. property markets also is occurring in Europe and Asia, says Mallen of Grubb & Ellis. The key driver to low cap rates abroad has been a high volume of capital overhanging the market. Yet, demand for space remains “fairly lackluster” and rents haven't risen appreciably.

“Traditional economic theory would suggest that's a very dangerous shift because what we have is the capital markets potentially disaggregating themselves from the underlying demand cycles,” explains Mallen. The traditionalist theory suggests that there is some mispricing of assets occurring in the property markets, and that a number of investors are likely to get burned.

“Real estate is very much a sunshine asset at the moment,” acknowledges Mallen. “There is a lot of latent demand from private investors, and ongoing demand from institutional investors, but we need to be very careful of what we're buying, where, why and how it's priced.” Mallen, whose credentials include nearly 20 years as a real estate consultant and researcher, has encountered many instances globally of late where investors have paid “crazy money” for assets in certain markets. In those instances, Mallen seriously doubts that investors' return expectations will ever be met.

Opportunity knocks

In the U.S., 24% of real estate is owned and occupied by corporations, while real estate investors control the balance. That's in stark contrast to most foreign countries, where large property companies, development organizations and major institutions control the real estate market.

Mallen predicts that over the course of the next decade, a growing number of real estate assets abroad will transition from corporate balance sheets and government-owned portfolios into the capital markets, a sea change that is already well under way in the U.S. property markets. “American investors have the experience, track record, pedigree and knowledge to take advantage of this trend,” says Mallen.

The weighting of real estate within foreign pension funds also is likely to rise in the years ahead, says Mallen. The emerging consensus of experts, based on an analysis of pension funds in Western Europe, is that about 15% of a diversified pension fund should be weighted toward real estate, up from a current level of 5%.

“That shift would bring in a vast volume of capital,” says Mallen. “So, if we think that the real estate investment market is aggressive and competitive now, my own view is that it will stay that way for the foreseeable future.”

Matt Valley is editor of NREI.