Real Estate Sector Review, Managing Change ....

By Brian Ruane, CPCU
Executive Vice President

Director Willis Real Estate and Hotel Practice
 
There are many macro economic forces and changes in the way we work, shop, store goods, live and travel that are having profound consequences for the real estate industry. These changes are against a backdrop of economic forces which have reduced demand for real estate across all sectors and have put pressure on the bottom line.
 
We understand the role we play in assisting our real estate and hotel clients manage these changing forces by helping them identify and mitigate risk and control their insurance costs.
 
In this article we will review each of the Five Sectors, where they stand in the First Quarter of 2012, and discuss both the headwinds and tailwinds that could impact each sector.
 
Office 
 
The recession took its toll on this sector. Between 2008 and 2010 the amount of space used by businesses was down 137 million square feet. This drop in demand was caused by the recession and loss of jobs and was exacerbated by the trend toward a smaller amount of space required per employee. Henry Chamberlain, The President of BOMA, stated “because of increasing use of technology like i Pads employees do not need quite as much office space”. This trend is likely to continue regardless of the state of the economy and is a mega trend that all owners of office space will need to manage.  
 
The sector has , however, been posting consistent signs of recovery with the national vacancy percentage falling 30 basis points to finish the year at 17.3 percent. Rents rose modestly in 2011 and now average $27.97 per square foot.
 
The recovery has been, somewhat, uneven with strong results and recovery in cities such as New York, Washington , Boston and San Francisco and bigger challenges in secondary and tertiary markets, particularly suburban office space where the vacancy percentage is over 20 percent in many places.
 
One concern is that many office leases, which generally run for 5 to 7 years, were signed at the height of the market, when rents were at their highest and vacancy low. Many leases will need to be renegotiated in 2012. The concern for owners is that they may need to offer reduced rates to retain these tenants.
 
Many feel the recovery will be aided by the fact that relatively little development has occurred in the past 5 years reducing the inventory of space available for lease. From a historical perspective, during the period 1999 to 2003 over 100 million square feet of office space was developed annually. From 2004 to 2008 this number dropped to an annual rate of 49 million square feet and last year it dropped to only 12 million square feet.
 
Retail
 
The retail real estate sector continues its slow recovery from the ravages of the recession. It was impacted as much, if not more, as any real estate sector owing to its reliance on the consumer and therefore directly impacted by the high unemployment rate and subsequent bankruptcy of many retailers. From 2008 to 2010 retailers vacated 31.6 million square feet of space.
 
The recovery continues, albeit, slowly. The vacancy percentage at Malls in the top 80 markets was down to 9.2 percent as of December 2011 from 9.4 percent in September 2011. While a sure sign of improvement, it is still significantly higher than the rate of 5.5 percent in December 2007. Rents rose slightly finishing the year at $ 38.92 per square foot. 
 
The results at shopping centers were somewhat more challenging. The vacancy percentage for this class of retail space improved modestly ending the year at 11 percent with rents rising 0.1 percent to $ 19. 40 per square foot.
 
The impact of on line shopping is beginning to takes its toll on this sector. Online sales represent only 8 percent of total sales but are growing 4 times faster than sales made in stores. This has also, to some degree, reduced the demand for space by existing retailers. For example, the average lease for Best Buy is now 33, 000 square feet compared to 2007 when it averaged 40,000 square feet.
 
Development, as in the other real estate sectors, is at historically low levels. The amount of new space opened last year was the lowest in 31 years. This should aid in the recovery.
  
Hotel 
 
We attended the American Lodging Investment Summit in Los Angeles in January. The mood by hoteliers was generally upbeat. While industry fundamentals are improving they are climbing a wall of worry. The concern is that while all of the key performance metrics are improving, macro economic forces could derail the recovery.
 
According to Smith Travel Research, RevPar reached its highest level in 3 years in January rising 8.2 percent from January 2010 to reach $61.38.
 
An article in Hotel Business quoted TravelClick which stated that RevPar, Occupancy and ADR will rise by 6.8 percent, 4.8 percent and 4.0 percent in 2012 signaling that a robust recovery may occur. These improving numbers have, to some extent, been aided by the return of the business traveler who accounts for between 65 and 75 percent of the demand for hotel rooms.
 
The number of hotel rooms opened in the past 2 years and under development are at historically low levels suggesting the recovery could gain momentum and accelerate as demand continues to rise and the increase in supply is muted. 
 
Industrial 
 
The industrial sector is enjoying improved results for several reasons. Trade, both imports and exports, is gaining strength from an improving economy. The demand for large spaces, over 500,000 square feet, is increasing particularly fast, and the trend toward shipping to lower cost fulfillment centers in lieu of higher cost retail space, as online shopping increases, all contribute to an increased demand for industrial space. 
 
The industry results reflect the increasing demand. The vacancy percentage dropped 80 basis points, year over year, to 10 percent as of December 2011. Rents, however, showed little movement ending the year at $ 5.05 per square foot. Many expect this number to rise in 2012 due to an increase in demand for space and, as in all the other real estate sectors, relatively little new development.
  
Multifamily
 
Profound changes are positively impacting the multifamily industry. Doug Bibby, The President of the National Multi Housing Council, stated “we are seeing a surging demand for rental housing and a preference for apartments, providing a great growth opportunity”.
 
Demographic trends are favoring the industry as immigration, an increase in household formations coming out of the recession and the “echo boom”. all contribute to an increased demand for rental housing. These factors combined with a reduction in the percentage of single family home ownership create a strong demand for rental properties.
 
The apartment vacancy rate dropped to 5.2 percent as of December 2011 down from 6.6 percent in December 2010 and 8.0 percent December 2009. These improving results have been fueled by a general dearth of new supply. According to an article in the Wall Street Journal “little construction and surging demand created a shortfall of 2.5 million apartment units the largest shortfall in 50 years”. We note a trend toward development of multifamily units and are working with many of our clients to support them in this effort. 
  
We will continue to study the trends and changes in the real estate industry and develop the appropriate risk management programs to manage these changes.

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