Bullish On Commercial Real Estate

Exclusive research shows resilient asset class remains hot despite weak fundamentals.

A wave of capital continues to flow into commercial real estate as investors remain cautious about other investment vehicles in a tepid economic recovery. The total value of assets in real estate investment trust (REIT) mutual funds increased by more than $5.5 billion through the first half of 2003, with the flow of new funds accounting for more than one-third of the gain, according to Lend Lease Real Estate Investments.

Increasingly, both institutional and private equity investors perceive commercial real estate as a safe haven. Lend Lease estimates that annualized returns for real estate over the next four to six years will be in the 7% to 8% range. While that may not sound spectacular by historical standards in real estate, battle-weary investors who have been burned in the stock market have come to value stability.

“This cycle has been unusual with prices rising, or at least holding, while rents and occupancies were declining. This has been a result of historically low interest rates, availability of capital and lack of alternative investments,” says Harvey Green, president and CEO of Marcus & Millichap Real Estate Investment Brokerage Co. “As the dynamics change, with an improving economy, higher interest rates and better stock market performance, the real estate investment market will experience a transition. However, the last two years have reignited long-term interest in real estate as a hard asset,” adds Green.

Job creation remains the lifeblood of commercial real estate. When jobs are plentiful, office buildings and apartments enjoy healthy occupancy rates and shopping centers benefit from strong consumer spending. Although the unemployment rate dropped from 6.4% in June to 6.2% in July, that improvement was offset by news that job losses totaled 44,000 in July, marking the sixth straight month of employment decline, according to the U.S. Department of Labor.

If corporate layoffs continue and interest rates rise sharply as they did in July, the stresses on landlords could become more acute, particularly when it comes time to refinance.

Against that economic backdrop, National Real Estate Investor magazine and Marcus & Millichap Real Estate Investment Brokerage Co. conducted an exclusive real estate investment survey between April and June 2003. Approximately two-thirds of the 561 respondents to the joint survey are private investors. The field of respondents is seasoned. On average, respondents have invested in real estate for 20 years and report an average of $21 million in commercial real estate holdings [See Figures 1 and 2].

Among the study's major findings:

  • Unforeseen shocks to the economy such as another terrorist attack top the list of concerns over the next 12 months. However, more than one-third of respondents also cite downward pressure on rents, high vacancy rates, the cost of insurance and creditworthiness of tenants among their top concerns for the coming year [Figure 3].

  • The demand for property remains high with 70% of respondents planning to increase their investment in commercial real estate over the next 12 months. Of that majority, 30% of respondents plan to increase their holdings by 11% to 25%, while another 29% plan to increase their holdings 5% to 10%.

  • Nearly one-third of respondents plan to expand into new property types. The majority of these respondents, 52%, plan to invest in apartments. Currently, nearly two-thirds of respondents are invested in apartments [Figures 4 and 5].

  • Investors appear to be the most optimistic about recovery in the apartment sector. Thirty-eight percent of respondents expect apartments to experience the biggest effective rent growth in 2004. Conversely, only 9% expect regional malls to experience the biggest effective rent growth in that time period.

  • Optimism about economic recovery is gaining steam. Only 6% of respondents believe the economy will be weaker 12 months from now, while 37% believe it will be stronger. The same question asked in a similar study conducted in the fall of 2001 found that a full 33% expected the economy to be weaker in the 12 months that followed.

  • Investors are willing to commit new money to upgrade existing properties. Overall, 47% of respondents have plans to redevelop, renovate or expand properties they are currently invested in. Additionally, 44% of respondents plan to invest in or acquire properties specifically for renovation, redevelopment or expansion.

What follows is an analysis of the study's findings across the apartment, retail, office and industrial sectors.


The apartment sector faces many hurdles, including a booming first-time homebuyer's market driven by low interest rates. Also sapping demand for rentals are mounting job losses that topped 280,000 jobs during the first half of 2003, according to Marcus & Millichap Research. Renters now represent 31.5% of all households, down from 36% in 1995, reports Lend Lease. The good news is that the worst appears to be over as vacancy was unchanged at 7% during the second quarter, according to Marcus & Millichap Research.

Although the majority of respondents, 56%, reported a decrease in effective rents over the past 12 months, 45% anticipate a rise in effective rents over the next year [Figure 6].

Similarly, 52% of respondents anticipate apartment values to rise in 2004. “Investors' expectations that job growth will finally materialize by 2004, accompanied by higher interest rates, explains why investors see a burn-off of apartment concessions and real rent growth in 2004,” says Hessam Nadji, managing director of research services at Marcus & Millichap. Another advantage of apartments is that they have multiple leases that turn over in relatively short periods of time, usually six months to a year. “That gives an owner a huge amount of flexibility in adjusting rents to meet market conditions to help cash flow,” Nadji adds.

Respondents are divided in their opinion of whether they plan to buy, sell or hold apartment properties over the next year. The largest percentage see now as the time to hold apartment properties (38%), but another 30% believe now is the time to sell [Figure 7].

SunAmerica Affordable Housing Partners Inc. in Los Angeles is definitely a net seller, notes Kenneth Levine, the company's assistant vice president of dispositions. Thanks to continued strong demand among prospective buyers, SunAmerica has found it an ideal time to liquidate the market-rate apartment properties in its portfolio as the firm focuses on its core affordable housing assets.

SunAmerica is in the process of selling roughly 12% of its portfolio, or 15,000 market-rate units. Most of the properties are Class-A properties that are 2 to 4 years old. “In many cases, we are seeing 15 to 20 or more bidders per property, and some guys are willing to reach down to 5% cap rates,” Levine says. Typically, apartment properties trade at a capitalization rate (a measure of annual return on investment) of 7.5% to 8%, although current rates are averaging 6.5% to 7%, according to Levine. (The lower the cap rate, the higher the purchase price.)

“It's a seller's market. You're seeing a lot of people buying real estate because they can touch it and kick it,” says Ted Bigos, president of Bigos Management in Edina, Minn. Bigos owns more than 5,000 market-rate apartment units in the Twin Cities. Optimism that the apartment market will start to improve, as well as a lack of other investment alternatives, is pushing more private buyers into apartment investments, Bigos adds.

The high prices have even prompted some investors to turn to development opportunities. Boston-based AEW Capital Management, for example, is building Alta West in Atlanta. Despite vacancies that topped 11% in metro Atlanta during the second quarter, AEW Capital chose an infill location west of Midtown, and is targeting a modest price point with two-bedroom rents at about $1,000. The project is set to open this fall. “When properties are trading at above replacement cost, we would rather build new ones than pay those higher prices,” explains Doug Poutasse, AEW chief investment strategist.


Throughout the recession and choppy economic recovery, the retail sector has outperformed all other real estate property types, evidenced by the relatively stable rents and only moderate increases in vacancy. In the top 40 U.S. retail markets, the average vacancy rate for retail is at 10.5% currently, up from 8.5% two years ago, according to Marcus & Millichap Research. In addition, rents rose a slight 0.6% to average $16.89 per sq. ft. in the second quarter.

The majority of survey respondents predict a similar pattern of stability for the next year with more than half of all respondents anticipating that both rents and property values will remain the same. “Generally, it was a flat year in terms of rents, but the retail investment pace will continue because it's a good product,” says Bob Sutton, executive vice president of investments at Equity Capital Partners in Fort Wayne, Ind.

“Retail will generally outperform in a down economy because it is not as cyclical as other sectors,” says Scott Wolstein, chairman and CEO of Beachwood, Ohio-based Developers Diversified Realty, a real estate investment trust. “Leasing has held up very well, although we are starting to see some signs of weakness, especially among the small shops.” DDR has maintained a portfolio-wide occupancy of more than 95%.

One concern is that the bidding up of prices for grocery-anchored centers is causing the market to become overheated. The prices being paid are at historic highs, which has caused cap rates to plummet 200 basis points over the past two years. Now, some industry experts argue that the valuations of grocery-anchored centers should actually be discounted due to the risks grocers face in an increasingly competitive environment — including a major threat from Wal-Mart Supercenters.

Yet when it comes to predicting effective rents, investors remain more bullish on grocery/drug-anchored centers than any other retail property type [Figure 8]. Some 28% of respondents indicate that effective rents for grocery/drug-anchored retail will increase over the next year, compared with 20% for regional malls.

What's more, grocery- and drug-anchored centers are the only retail property type in which a larger percentage of investors believes now is the time to buy rather than sell properties [Figure 9]. Thirty-two percent of respondents indicate now is the time to buy grocery/drug-anchored centers vs. 26% that believe it's time to sell. Conversely, only 13% of respondents believe now is the time to buy regional malls vs. 41% who indicate it is time to sell.

Competition for grocery-anchored neighborhood retail centers remains intense. “We often see as many as 10 to 20 or more bidders that cover the spectrum, from pension fund investment managers to 1031 exchange buyers,” says Poutasse of AEW. As a result, cap rates in that sector have continued to compress.

These days it takes aggressive bids to land retail properties of all types. “We're seeing shopping centers that might have been built for $90 to $100 per sq. ft. now selling for $240 per sq. ft.,” says Jay Brown, a private investor based in Evanston, Ill. Brown recently bid a healthy sum over replacement cost for a non-grocery-anchored strip center in Arizona. However, his offer of $125 per sq. ft. fell far short of the high bid that topped $155 per sq. ft.

Despite that heightened competition, Brown expects to spend $8 million to $12 million in the next 18 months to more than double his retail portfolio from 100,000 sq. ft. to 225,000 sq. ft.


Office properties have been hard hit by the sluggish economy and mounting job losses. For each type of office property, an overwhelming majority of respondents report a decline in effective rents over the past year. For example, 73% of respondents indicate that downtown office rents are lower than they were a year ago. That's not surprising in light of the fact that the national office vacancy rate reached 16.8% at the end of the second quarter of 2003 and is projected to rise to 17% by year-end, according to Marcus & Millichap Research.

And many respondents are not confident that the office market will improve in the coming 12 months. Nearly half of respondents expect effective rents to remain the same, while 28% anticipate a decline in both office/R&D and downtown rents, and 26% expect a decrease in effective rents for suburban office [Figure 10].

“The expectations of only a moderate recovery in the office sector reflect the lag time between job growth and office space absorption,” Nadji says. “Companies need several more quarters of profit gains before they begin to hire and expand, putting the recovery in demand well into 2004.”

Investors such as AEW Capital are being extremely selective in office purchases. In fact, Washington, D.C., is the only market the pension fund advisor is shopping for office properties. “Office markets are in terrible shape, and we don't think all of the risks are being priced appropriately,” Poutasse says. Vacancies in Washington, D.C., on the other hand, have remained favorable with CBD vacancies at 7.4%.

“Rents [in D.C.] have held up to a point where you can forecast rents, as opposed to Boston or San Francisco where it is impossible to know what the rent is today and what it is going to be tomorrow,” Poutasse explains.

With the unemployment rate at the highest it has been in nine years, office product is difficult to underwrite, according to Andy Smith, CEO of L&B Realty Advisors in Dallas. “Employment drives office, and when employment is soft the need for office deteriorates,” Smith says.

As a direct result of low interest rates, owners of office properties have been able to refinance and continue to operate properties with high vacancies and negative cash flow. So there have been few “forced turnovers” of office properties that might have provided investors with bargain prices, Smith says. “Interest rates will start drifting up, thus you want to keep an eye on the office sector because there may be some turnover at some attractive prices,” he adds.

For now, it appears that most owners are trying to hold on to office properties. Fifty-six percent of respondents see now as the time to hold office/R&D space, 51% see now as the time to hold suburban office and 43% see now as the time to hold downtown office properties [Figure 11].


Although the industrial sector is typically one of the first sectors to benefit from an economic recovery because it's more dependent on inventories than job growth, few respondents have yet to see improvement materialize. When asked to assess the investment market for warehouse space compared with 12 months ago, 80% of respondents indicated conditions were the same or weaker.

Only 20% felt the investment market for warehouse space was stronger. Similarly, 84% of respondents indicated that the investment market for manufacturing was the same or weaker than a year ago. Just 16% of respondents pointed to a stronger manufacturing market.

National statistics offer some insight as to why investors aren't gung-ho on the industrial sector. The overall industrial vacancy rate at year-end is expected to reach 11.8%, up from 11.2% at the end of 2002, reports Reis Inc., a New York-based research firm. At the same time, average rents are likely to remain relatively flat, dropping slightly from the $4.57 per sq. ft. at year-end 2002 to a projected $4.55 at the end of 2003.

Part of the problem is that cheap capital has fueled additional development, which adds to the supply. “Corporate America also continues to find more efficient ways to store its goods, so that means it needs less warehouse space per dollar of sales,” says Paul Rubacha, a principal at Ashley Capital in New York, which owns about 16 million sq. ft. of warehouse/distribution space.

Rubacha expects industrial vacancy rates to remain the same or drop slightly in the near term. “This is not a gloom-and-doom scenario, but investors acquiring warehouse and distribution space should not expect rental rates to increase in the near term,” Rubacha says.

The majority of respondents — 59% for manufacturing and 53% for warehouse — expect effective rents to remain the same over the next 12 months [Figure 12]. Sixty-one percent of respondents see now as the time to hold manufacturing properties, while 56% plan to hold warehouse properties [Figure 13]. Buyers appear to be in the minority with just 15% of respondents indicating they plan to acquire manufacturing properties in the next year, and 26% likely to buy warehouse space.

Still, struggling markets have fueled interest for buyers such as Ashley Capital. “In those markets in turmoil, we're hoping to find some opportunities,” Rubacha says. In one extreme example, Ashley Capital bought a 500,000 sq. ft. warehouse and distribution facility from a corporate owner in Atlanta last year. The building, which the corporation had vacated, sold for a purchase price of less than $10 per sq. ft. when Ashley Capital provided a quick commitment to close. Bulk warehouse facilities typically sell for upwards of $20 per sq. ft.

Ashley Capital fully renovated the facility, including adding truck docks and new interior lighting, with renovation expenditures nearly equaling the acquisition price. Ashley Capital was able to lease the upgraded facility to a single corporate tenant, which generated a solid double-digit cash return, Rubacha says.

Effect of Interest Rates

The high prices being paid for commercial real estate are a direct result of what some industry observers refer to as “artificially low” interest rates. Even though the 10-year Treasury yield has jumped more than 100 basis points over the past two months to register 4.4% in mid-August, the rates remain highly attractive for borrowers. The big question now is where rates are headed in the near term.

“Rates are at all-time lows, so it is hard to imagine that they are not trending upwards,” says Scott McMullin, an executive managing director at Holliday Fenoglio Fowler in Los Angeles. But Federal Reserve Board Chairman Alan Greenspan has emphasized that he wants to keep rates low for the foreseeable future to stimulate the economy. “So there is still a lot of uncertainty as to what will happen,” McMullin says.

When asked to predict interest rates, 44% of respondents indicated that they would climb higher over the next 12 months. Only 1% of respondents expected rates to go lower. The potential impact of higher rates is huge. The record low rates are responsible for the feeding frenzy in real estate acquisitions, particularly among private investors willing to leverage the cheap debt to compete with institutions for higher-priced properties.

A typical institutional investor will use 50% to 65% debt to buy a property. An entrepreneurial investor, on the other hand, will take advantage of his ability to leverage debt and use 75% to 90% debt to buy properties — basically getting more bang for the buck. “Interest rates moving up costs us as much as it helps us, but it could weed out some of the competition,” says Sutton of Equity Capital Partners.

One indication that the buying fervor could continue is that nearly one-third of respondents plan to expand into new property types over the next 12 months. “As investors perceive one product peaking, they are looking to leverage their equity by investing in properties that will be recovering in the future such as office properties,” says Green of Marcus & Millichap. Many also are investing in less management-intensive properties and safe investments such as single-tenant, net-lease properties, according to Green.

In summary, the study's results show investors haven't been scared off by the weakening real estate fundamentals. If anything, they believe the market has likely bottomed and that brighter days are ahead. “The major theme is that real estate remains a solid investment vehicle that will stay intact,” Green says, “even with higher interest rates and more competition from other forms of investments such as stocks.”

Survey Methodology

Data for the 2003 Real Estate Investment Survey conducted by National Real Estate Investor and Marcus & Millichap Real Estate Investment Brokerage Co. was collected between April and June 2003. Questionnaires were mailed to a list of NREI finance subscribers and Marcus & Millichap's private and institutional clients. A link to the survey also was posted on the NREI Web site. A total of 561 usable surveys were tabulated. The purpose of the survey was to gauge future investment plans and determine which property types — office, industrial, retail and multifamily — were most attractive to investors. Respondents were primarily long-term, private investors.

A provider of investment and real estate brokerage services, Marcus & Millichap closed $7.7 billion of investment transactions for private and institutional investors in 2002. The company has more than 700 brokers in 34 U.S. markets, the largest in the industry.

NREI provides in-depth analysis of trends in commercial real estate with an emphasis on tracking the capital flows. Readers include owners/developers/managers, brokers, finance and investment professionals, and corporate real estate executives. This special report also appears in each of the following publications within Primedia's Financial Services Group: Registered Rep, Trusts & Estates and Retail Traffic.

The report was prepared by Beth Mattson-Teig, Matt Valley, Elinor Rice and Jared Reeder in conjunction with Marcus & Millichap's Managing Director of Research Hessam Nadji. Warren Bimblick is senior vice president of the Financial Services Group and publisher of Retail Traffic. Rich Santos is the publisher of NREI, Registered Rep and Trusts & Estates. Geoff Lewis is the editorial director of the Financial Services Group.

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