New Supply Ramping Up

With real estate fundamentals improving, acquisition costs soaring and debt still cheap, the next few years will see a steep increase in fresh income-producing properties, according to a new report from Manhattan-based Reed Construction Data.

The report indicates that the value of all commercial projects in the planning, bidding and start phases of the construction pipeline increased by 38% in 2006. Given that the value of these projects only jumped by 7.8% in 2005, last year’s increase is particularly significant.

Analysts agree that the increased movement of capital into development is worth noting since excess supply can hamper fundamentals growth. And two sectors likely to see the most new supply are the office and industrial markets.

So what’s driving more investors to place capital in new office and industrial projects? According to Boston-based Property & Portfolio Research, steep acquisition costs are forcing them to take on development risk. Plus, construction costs appear to have leveled off over the past few months. These factors, coupled with tightening vacancy across most markets and property types, have swayed lenders into financing projects. Perhaps even more alarming than the quantitative shift towards added supply is the quality of this space.

Construction of Class-A office space has been rising slowly over the past two years and that trend will continue, but with a more significant slant towards speculative product, according to the latest PPR Real Estate Portfolio Strategist report.

In fact, Class-A office vacancy in the nation’s largest central business districts (CBDs) was just 7% at year-end, down from 8.5% one year earlier. Tight markets only compress cap rates, which explains why many office buyers are paying above replacement cost to acquire these properties. That’s why PPR expects that there will be a speculative office building underway in every major market by the end of this year.

“It certainly makes sense that more money would flow into new projects this year versus last,” says Bob Bach, national director of market research at Grubb & Ellis. “The timing may not be so great either as we project demand to subside a bit this year across most property classes.”

The industrial sector, in particular, is ripe for overbuilding. Bach believes that industrial markets are by nature more vulnerable to overbuilding given the ease with which developers can build them. Landlocked markets such as Chicago have also expanded outward so far that sites are easy to come by.

PPR also sees industrial market exposure to new supply to increase as slower global economic growth in 2007 causes import and export growth to slow down. PPR projects that national industrial vacancy will actually increase from 8.9% to 9.4% during 2007. Chicago’s 10.2% vacant industrial market, which PPR calls “the current poster child for speculative warehouse construction,” should post one of the steepest vacancy increases.

Even so, Bach of Grubb & Ellis isn’t ready to compare 2007 with the heady days leading up to 1990 when commercial construction went through the roof, leaving vast pockets of vacant space across the market. But he’s cognizant of the need to keep a weather eye on new supply even if it’s early in the cycle.

Says Bach, who lived and worked through the late 1980s building boom that precluded the bust: “I’ll reserve judgment on the extent of this new supply. It still seems too early to call it chronic overbuilding.”

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