Sam Zell wasn’t dancing on any graves at the National Association of Industrial and Office Properties’ national convention in San Diego.
In a speech to commercial real estate investors on Oct. 22, the last day of the four-day event at the San Diego Marriott Hotel & Marina, Zell — dubbed the "grave dancer" as a result of his opportunistic investments during the 1990s — showed measured optimism regarding the U.S. economy and real estate.
"The U.S. economy is in good shape. It will continue to improve," said Zell, the chairman of Chicago-based Equity Group Investments, parent company of real estate investment trust Equity Office Properties. "Occupancy is improving across the board."
Equity Group is the country’s biggest landlord. Equity Office owns 128 million sq. ft. of office space.
While building occupancy is improving, rents are not rising at the same level as property values and construction costs. "The gap between rents and replacement costs is widening," said Zell.
To justify new construction, rents should be 30% to 40% higher than the market rate, according to Zell. Lower rents, combined with disciplined underwriting by lenders, will help limit new development. "But as you know," he joked, "developers never listen to the facts."
With construction costs skyrocketing, the best place to invest money in commercial real estate is high quality assets in markets with high barriers to entry, such as a limited amount of land for new development. "Southernis among the top markets in the country and is improving," Zell noted.
San Diego, for example, is among the markets with barriers to new construction, according to Mike Philbin, a senior vice president and principal at San Diego-basedBurnham Real Estate. The city’s small inventory of employment land and relatively low vacancy in existing buildings has contributed to rising values.
However, Philbin said limited space for new construction makes it difficult for San Diego to attract companies in high-tech and biotech industries, which are trying to expand in the region. "Companies are going further out for their campuses," he explained.
But companies in search of young, bright talent "could not attract employees without being in the city. Location, location, location is more important," Zell emphasizes, adding that cities with downtowns that provide housing, jobs and entertainment 24 hours a day, seven days a week will be the most successful office markets in the future.
Zell predicted that developers will take on more infill development opportunities in urban centers. Fortunately for more expensive areas, he noted that real estate costs are becoming a lesser concern. As businesses focus on technology and other investments, alternative priorities are replacing real estate as the No. 2 business expense.