The Outlook for Real Estate in 2004

There seems to be no question that the economy of the United States has now decisively entered another growth cycle. The extraordinary growth of over 8% in gross domestic product that occurred in the third quarter of 2003, together with a stunning productivity increase of over 9%, are numbers that are not likely to be matched again in the foreseeable future. However, they do indicate that the recovery has become well established and is likely to continue for at least the next year or two. The large tax cuts enacted by the Bush Administration, and the resulting huge Federal budget deficits, combined with record low interest rates, have given the economy tremendous fiscal and monetary stimulus that is just beginning to have an effect.

One consequence of the economic revival has already become apparent and that is rising interest rates. The yield on the 10-year U.S. Treasury Bond now stands at 4.25%, almost 115 basis points higher than the low reached in June, 2003. And this has occurred without any action by the Federal Reserve Board, which has kept the Fed funds rate at an all-time low of 1%. As the economy continues to pick up steam, and as unemployment slowly declines, the Fed is certain to take action that will result in a further rise in yields in the bond market.

A rising economy and rising interest rates will affect all segments of the U.S. real estate market. There will be a positive effect on the basic fundamentals of the market as occupancy rates rise in office, industrial and retail properties. But the pricing of most property types is likely to be under pressure since rising interest rates will push capitalization rates higher, and higher mortgage interest rates will cause cash-on-cash yields to decline.

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The Office Market:

The office segment of the real estate market has been particularly affected by the low level of interest rates during the past two years. Properties on long-term leases to credit quality tenants have sold at very high prices and very low capitalization rates since cheap mortgage rates have permitted investors to realize very attractive cash-on-cash yields. It is this segment of the market that is likely to suffer the most serious consequences of rising interest rates. As mortgage rates continue to go up, investors will be less inclined to offer tremendously low cap rates for properties, preferring instead to maintain their after-debt-service yields by lowering their offering prices.

The multi-tenant segment of the office market is quite different, since the fundamentals of this market suffered quite markedly during the economic downturn. The office market vacancy rate reached a national average of 18%, although some cities, such as San Francisco and Boston, experienced much higher vacancy rates. The collapse of the high-tech and telecom bubbles had a particular effect on those cities that were most exposed to the high-tech parts of the economy. 2003, however, has seen this trend begin to reverse as net absorption of office space was positive during both the second and third quarters of the year. This is still a spotty recovery, with only 25 of the top 45 major markets in the U.S. reporting declining vacancy rates at this point.

Fundamental trends in the real estate market always lag the basic economy. It takes time for businesses to add employees and takes even longer before they begin looking for expanded space. We expect that the vacancy rate for multi-tenant office properties will stay near the 18% level in 2004 since a great deal of sublease space is still likely to come to market. In addition, many corporations are not fully utilizing all of the space they currently lease, and this so-called “shadow space” will also have to be absorbed. However, as the economic recovery continues into 2005, we expect to see the vacancy rate decline in most major markets, followed by a resumption of the long-term upward trend in rental rates. In Falcon Real Estate’s view, carefully selected multi-tenant office properties, in markets having excellent long-term growth prospects, can represent one of the better investment opportunities in 2004.

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