Five-Year RREEF Forecast Favors Bay Area

By Jon Peterson & Sharon Simonson

Tenant interest in San Francisco’s wildly popular South of Market may be eclipsing the appetite for the city’s traditional central business district, but it will not always remain thus, according to a new five-year forecast from RREEF Real Estate.

SoMa is one of four similar enclaves nationwide that are part of a central urban core but not in the CBD where technology, creative-services and boutique financial-services companies are migrating. In Seattle, it is the Lake Union and Downtown Bellevue submarkets; in Boston, it is the Back Bay and Cambridge submarkets; and in New York, it is the Midtown South area, including the meatpacking district.

“Most of the submarkets … are actually outperforming the CBD, due to current market demand drivers and conditions. Longer term, however, they will be complimentary,” RREEF says.

On the housing front, while apartments have been the favorite of commercial property investors for the last two years with occupancy and rent gains driving up values, and buyer interest compressing yields, the outlook nationally in the later years of the five-year forecast period is less sanguine. As housing prices have fallen, the calculus around the financial benefits of owning versus leasing has changed.

Today, it is cheaper to own nationally on average, with markets such as Phoenix, Miami, Chicago and Atlanta exemplifying the trend. Effective apartment rent growth is expected to peak in 2013 and begin falling thereafter, according to RREEF, and in the later part of the five-year period, apartments nationally will underperform.

But coastal markets that are “youth magnets” including the Bay Area, New York, Southern California and the Pacific Northwest should fare better, even with anticipated new supply. Renting continues to be cheaper than owning in San Francisco and San Jose, in Oakland and the East Bay, RREEF said.

“We like San Jose and San Francisco for apartments due to the combination of limited supply threats in the near- to mid-term plus strong demand drivers,” Andrew J. Nelson, a director on the research staff for RREEF in its San Francisco office, told The Registry in an email message. “These would be high incomes and strong job growth, particularly in sectors we expect to outperform over the next five years. Some examples of these would be technology, health care and life sciences.”

Through the third quarter of 2011, average effective apartment rents nationally beat their previous peaks in 2007 and 2008 by 2 percent. San Jose’s effective rents—what is paid after incentives or other offsets are included—achieved 109 percent of their former high; San Francisco rents reached 108 percent of their previous high, according to RREEF.

Even in the Bay Area, however, risks remain. Federal government-sponsored enterprises that have provided debt to the sector face restructuring, particularly after the presidential election, RREEF notes, and competition among investors is leading to “aggressive underwriting to justify current multifamily pricing.”

RREEF relied on multiple sources to prepare its U.S. Real Estate Strategic Outlook, including third-party market and economic data, interviews with real estate brokers and other market experts, and its own modeling. The company concludes that returns for so-called “core” real estate—the segment considered the least risky based on location, property type, tenancy and other factors—will be less impressive in the next five years than they have been in the last two. Job growth nationally in 2012 should advance at the same pace as last year, and the country should return to its previous employment high in 2014, it predicts.

But, the report concludes: “These economic forecasts continue to have large risks to the downside. …Further, we should not underestimate the potential for the U.S. government to make severe fiscal blunders that could significantly hinder the recovery.”

The real estate investment manager also has a positive outlook for industrial warehousing in Oakland and industrial “flex” space in San Jose. “[San Jose] is benefiting from solid real estate fundamentals. This includes having the lowest supply growth in the nation in the last five years. We see similarly constrained construction over the next few years. These strong fundamentals set the foundation for significant outperformance in the near to mid-term,” Nelson said.

Meanwhile, the office sector, which has been a lagging property type nationally, should surge, particularly in the later years of the forecast period, as employment growth accelerates and office employment growth in particular continues a 20-year pattern of expanding 1.7 times faster than the rate of the U.S. economy at large. Selected markets nationally, including San Francisco, San Jose, Austin, Boston, New York and Houston, have already seen solid rent growth, but San Francisco, Seattle, Boston and Houston remain among the markets that RREEF expects to outperform in the next five years, especially in the near term. In those markets, “2016 rents are forecast to exceed prior peak cycle levels,” the company said. Oakland will not.

Finally, the report concludes that the correlation between sustainable attributes and higher building values is becoming “incontrovertible,” though putting a precise value on the difference remains out of reach. Rent premiums range from 4 percent to 7 percent, according to studies cited by the real estate manager; one study found an average sales price premium of 25 percent for sustainable buildings.

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