2007: The Outlook for U.S. Commercial Real Estate

The U.S. commercial real estate market has been in a persistent uptrend for the past fifteen years. The last major recession in real estate occurred in the late-1980’s in connection with the tremendous overbuilding that had taken place at that time. Developers, lending institutions and regulatory agencies all learned a great deal from that crisis, and there has been much greater discipline as to development in the real estate market since then. As we go into 2007, overbuilding has not become a major problem in the U.S. market, except to the extent that condominium development is considered to be a part of the commercial market. But in all other sectors of the market, new construction appears to remain at reasonable levels.

All of the other major factors affecting the commercial market – the state of the U.S. economy, the level of interest rates, the amount of funds that are seeking investment, and the persistent rise in construction costs – all of these factors seem to support a continuation of the very strong real estate market and the historically low level of capitalization rates that exist today. The yields available in the U.S. real estate market continue to compare favorably with other asset classes, and Falcon Real Estate does not see this situation changing in the near future.

It should be noted, however, that declining capitalization rates have been one of the most important factors contributing to the excellent investment returns that have been earned from U.S. commercial real estate in recent years. Since it seems impossible to expect further declines in capitalization rates, any future price appreciation in real estate will depend primarily on increasing rental rates and increasing net operating income.

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The U. S. Economy

There is virtually unanimous opinion among economists that the American economy will continue to expand in 2007. The U.S. Federal Open Market Committee decided in December 2006 to keep its target for the federal funds rate at 5-1/4 percent, stating that the economy seems likely to expand at a “moderate pace” over coming quarters. Similarly, the Washington-based International Monetary Fund forecast that the U.S. is expected to grow by 2.9% in 2007, down from a 3.4% growth rate in 2006. This decline is attributed to some weakness in the nation’s housing market. Other economists have produced similar forecasts for continued moderate growth in the economy. In Falcon’s opinion, growth of approximately 3% would continue to provide a strong underpinning for the commercial real estate market.
As we noted in last quarter’s Newsletter, the commercial market almost always lags the overall economy. Before corporations begin to expand into additional or larger offices, industrial warehouses or retail facilities, they will generally wait until the business recovery has proceeded for some time, giving them both the need and the confidence to warrant an expansion. It is our view that the current business recovery has now proceeded for a sufficient period of time so that corporations have a clear incentive to expand their facilities. We are seeing strong evidence of this throughout the real estate market at the present time.

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The Supply/Demand Situation:

With a strong and expanding economy, and a growing demand for office, industrial and retail space, vacancy rates are falling and occupancy rates are rising in all asset classes and in most geographic markets. In some office markets, such as mid-town Manhattan, Washington D.C., Houston and even downtown Los Angeles, vacancy rates have fallen to such an extent that large blocks of space have become very difficult to find. And even in a city such as Chicago, where there has been a significant amount of new office construction, the overall occupancy rate has continued to edge upward. The real estate market invariably falls into recession when there is a significant oversupply of space, but such a situation does not exist today. As we enter 2007, market conditions generally appear very healthy across the United States, with rising occupancy rates and rising rental rates..

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