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2008 Commercial Real Estate Forecast Looking a Bit Cloudy

The commercial real estate industry has put on a brave front, but signs of pessimism about the coming months are increasing. The question has shifted from, "Will things turn?" to "How bad will the downturn get?" And, perhaps more importantly, "How will I be affected?"

The good news for retail is the answer to the last question might just be, "Not a whole lot."

The most recent assessment of market conditions came earlier this week as Chicago-based Grubb & Ellis, a commercial real estate advisory firm, on Wednesday hosted its 2008 Market Forecast Breakfast in New York City. While the sector is expected to experience some hiccups in 2008, retail will continue to rank atop investors' list of real estate interests, ahead of industrial, multifamily and office properties.

Meanwhile, in a survey of 332 commercial real estate industry professionals--conducted by DLA Piper the day after Federal Reserve Chairman Benjamin Bernanke cut the federal funds rate by a half a percentage point--a whopping 68 percent of respondents said they were bearish about the industry's prospects during the next 12 months. Asked that same question in April, only 22 percent of respondents held that position. And the credit crunch is by far the biggest concern for respondents that said they were bearish--a full 66.5 percent pointed to it in contrast with 23.7 percent saying that a sluggish economy was their main concern.

Looking forward, there are dampened expectations for GDP growth, which will affect all sectors of the economy. Michael Dee, senior vice president and national director of retail with Grubb & Ellis, estimated GDP growth at 1.8 percent for 2008, 20 basis points below this year's level. Another and the rapidly deteriorating housing market, retail sales will experience only moderate increases next year,.

Sales growth will remain in the positive territory, Dee noted, but will be below the level of recent years. In September, ICSC reported same store sales growth of only 1.7 percent--6 basis points below the year-to-date rate of 2.3 percent and 19 basis points below last year's growth of 3.6 percent. It is projecting growth in the 2.5-percent range for the holiday shopping season.

It's not expected to have much negative impact on national retail chains, Dee explained, but independent tenants will suffer, leading to a slight increase in vacancies at community and neighborhood shopping centers next year.

For the third quarter 2007, REIS, Inc. reported that vacancies edged upward 10 basis points to 7.4 percent and by the end of the fourth quarter the firm projects the national vacancy rate will hit 7.5 percent; its highest level in a decade. REIS also reported that rental growth rate of 0.4 percent during the third quarter was half that realized in the second quarter. And, brokers report seeing increases of 30 to 100 basis points on cap rates for lesser quality assets.

Nationwide retail rents, which currently average $19.32 per square foot, will stabilize in all but a few key markets, where demand still outstrips supply. Those include Washington, D.C., Baltimore, Seattle and Boston. The Urban Land Institute and PricewaterhouseCoopers LLP, in their recent report, Emerging Trends in Real Estate 2008, identified New York, Los Angeles, San Francisco, San Diego and Denver, in addition to the aforementioned cities, as the top markets in the U.S. because of their strong ties to the global economy.

On the other hand, Miami, Tampa, Phoenix, Orange County, Calif. and San Bernardino County, Calif., are likely see their retail rents decrease in 2008, Dee says, as the housing bust hit these overbuilt markets particularly hard.

All of these factors will lead to a 25 basis point to 50 basis point increase in cap rates for retail properties--well below the 100 basis point increase projected for the commercial real estate sector as a whole. The increase will also bring a respite from the recent cap rate compression. "I don't think we'll see the same kind of rates ever again," said Dee.

For 2007, year-to-date, Real Capital Analytics reports retail properties trading at an average of 6.58 percent, the lowest level since the real estate boom began in 2001. Last year, retail cap rates averaged 6.9 percent.

As for the DLA Piper survey, about 60 percent of respondents to the survey don't think the industry's prospects will brighten for more than nine months in contrast with just 37 percent that thought things would turn in six months or less.

"I think people see that several factors have to fall back into place," says Jay Epstien, chair of the U.S. real estate practice at DLA Piper. "They've got to get capital flowing again and bond investors have to buy the paper that's now just sitting at banks. Nobody thinks the capital has disappeared entirely."

On the debt side, there are also big concerns about the CMBS market. Most respondents--82.5 percent--anticipate there will be more conventional loans available than CMBS loans in the next 12 months.

The real estate market has entered a transition period, said Mark Larson, senior vice president with Grubb & Ellis, which means institutional investors will stay away from property purchases for as long as six months, until the market sorts itself out. He noted that while that might result in fewer deals overall, there will be an increase in private investment activity next year from buyers who are more comfortable with exposure to higher risk.

However, private investors still face the challenge of securing financing. Last year, they were able to lock-in on 85 percent loan-to-value ratios; but, today that figure has been lowered to approximately 60 percent. Larson contends private investors will conform to the tighter lending requirements by going after less expensive properties, avoiding portfolio deals and courting local bankers for bridge loans. The most popular products, he said, will be 1031 exchanges, single-unit freestanding buildings and grocery-anchored shopping centers.

"There is so much money out there it's unbelievable and there is not enough good product," Larson said. "So I think we'll see private investors proceed with an aggressive caution."

Not everyone is bearish, though.

John Dowd, senior vice president of development at the Goodman Co., a West Palm Beach, Fla.-based developer that has more than 4 million square feet of projects in its pipeline, thinks any issues in the market will be short-lived.

"The projects that were maybe ill-conceived, were speculative in nature that might have gotten financing a year ago are not going to get financed now," Dowd says. "But good quality projects with good quality borrowers are still getting a lot of attention from the lending community. That's always the case."

Dowd says the outlook in the market today is not nearly as bad as in the 1980s or early 1990s when the banking system ground to a halt during the savings and loan crisis. "I think the fact that the rest of the economy is relatively healthy is offsetting some of the concerns about credit and housing," he says. And, in the end, "growth always cures the problems."

--Elaine Misonzhnik & David Bodamer

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