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Commercial Sector Faces Cloudy Future

Is the bloom coming off the commercial real estate investment rose as the opportunistic capital moves towards a reviving technology sector? According to an outlook report for 2007 put out by PricewaterhouseCoopers and the Washington-based Urban Land Institute, the boom in commercial real estate investments is likely to slowdown next year. Home prices are also seen declining.

The emerging trends report, based on a survey of over 600 industry professionals, expects that while the industry is likely to experience a slowdown, returns on most property types are likely to remain satisfactory while reverting to levels closer to their historical averages.

"Most respondents expect to sleep well at night, and are comfortable with high-single digit returns for core properties," according to Stephen Blank, ULI senior resident fellow.

"There may be some who still want to believe that halcyon returns will last indefinitely, but most sense the boom is over."

And William E. Croteau, U.S. real estate practice leader for PricewaterhouseCoopers, noted, "Nothing lasts forever. The fact is that real estate has enjoyed a very healthy 'up' cycle for a longer period than normal.

"Even so, real estate is still viewed favorably as an asset class and there is still a lot of money - especially from private funds and institutional investors - looking for the right opportunity. Although we don't expect any major downturn in the marketplace, it's likely that real estate's overall performance will be more modest in 2007."

The report identifies New York, Washington, Los Angeles, San Francisco and Seattle - which it dubs "global gateway" metropolitan areas - as the top major U.S. markets for real estate investment prospects. The most promising opportunities are seen in the "investment meccas" on both coasts.

The characteristics of top markets that the report identifies include: locations along global pathways with major international airports and harbor ports, 24-hour features, attractive settings in reasonably comfortable climates, geographic barriers limiting sprawl and brainpower jobs attracting an affluent, highly educated workforce.

While some cities in the South and Southwest, such as Dallas, Houston, Atlanta and Phoenix, remain development magnets, their tendency toward oversupply is seen as compromising their standing with investors.

"Sun Belt development havens consistently fall behind global gateways for investment prospects, even as their economies continue to grow. They remain relatively affordable, but these areas lack strong 24-hour cores and mass transit systems, while interior locations make them secondary destinations for international business," the report says.

Denver is cited as a market with strong development prospects, due to its growing light-rail system, evolving 24-hour downtown district, natural beauty and international-scale airport.

The report identifies infill, mixed-use projects as a favored type of development, offering greater convenience for busy professionals. These projects are also seen as appealing to both empty nesters and their young adult offspring since they provide easy access to retail properties, restaurants, parks, supermarkets and offices. Transit-oriented development at subway or light-rail stations "almost cannot miss," while senior housing, student housing and infrastructure are favored niche property types.

Interviewees rank construction material costs, land costs, construction labor costs, high vacancy rates, growth controls and inadequate infrastructure as key industry-related issues that could pose problems for real estate investment and development next year.

They also cite insufficient job growth, interest rate increases, inflation, minimal income and wage growth, and energy prices as economic issues that could present obstacles.

The consensus among respondents is that the economy "has enough steam to support demand growth in real estate markets, which seem well positioned to muddle through any mild distress associated with a slowdown." The pessimists worry about the ramifications of a decline in the housing sector and any drop in consumer spending.

The apartment sector - specifically the moderate-income category - is ranked highest for investment return potential, replacing hotels, which captured the top rating last year.

The report attributes the apartment market's strength to rising mortgage rates and high housing costs, which have shut some entry-level buyers out of the home buying market. However, as the for-sale market softens, conversions of condominiums into apartments could give rise to some competition, the report cautions.

In the for-sale housing market, affordability problems - especially in high-cost areas - combined with an oversupply of units available for sale, is causing "housing angst," the report says, adding that home prices could decline off the market highs of recent years.

Even then, only the most recent purchasers who are forced to sell quickly risk losing on their investments. "Most people are well ahead of the game and will stay there."

Among the cities seen as offering the best prospects for owner-occupied home building are Austin, San Francisco, Washington, Los Angeles, San Antonio, New York, San Jose, Jacksonville, Seattle and Houston.

And product categories seen as offering the best development opportunities are infill and in-town housing, second and leisure homes, attached single-family homes, and detached, single-family moderate-income homes.

The survey touches on the outlook for individual property sectors, too.

Lodging markets are likely to continue to be boosted by a surge in business travel and rising leisure travel by aging baby boomers. However, new construction getting underway "just as the economy retrenches" signals an approaching peak in the hotel markets.

Investors are more likely to sell limited-service hotels that are easy to complete. Full-service hotels, especially those in global business areas, have legs as long as the economy holds up.

Decent job growth is likely to continue to fuel the spending spree in the retail sector. Lifestyle centers in upscale suburban markets score well. It is possible though that slowing retail sales could finally do in a consumer-dependent economy. And new retail space is being delivered just as "bullish sentiment may peter out."

Investors' best bet is to hold fortress malls and neighborhood centers with first-rank grocers, sell weaker grocery-anchored retail, and cash out of second- and third-tier power centers. Considering that shoppers are likely to let up, returns are expected to slip back to the mid- to high-single digits.

In the warehouse sector, the best bet is seen as intermodal locations that serve global shipping lanes. Contrarians are focusing on older warehouse properties in infill sites suitable for redevelopment as mixed-use. If prospects for chip makers and software designers continue to improve, research and development markets may be poised to move again.

The office sector is "poised for strong absorption, burned-off concessions, real rent growth, and increased earnings." Job growth is likely to aid the Downtown office sector. However, tenant demand is not likely to be so strong outside of major markets.

The best bet is to hold prime office space in 24-hour cities and tight southern California markets which are likely to benefit immediately from increasing revenues, as leases roll over into higher rates.

Greater divergence in pricing is expected to appear between supply-constrained, low-vacancy markets on the coasts and higher-vacancy suburban-oriented markets. Investors are also seen as discriminating more between trophy and commodity properties.

One trend that is identified as cutting across all property sectors and worth watching is green building. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com