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Commercial Real Estate: Time To Invest?

Should you invest in commercial real estate

A lot of investors are — in everything from offices, warehouses and retail to the stand-out category of recent years, apartments.

The commercial property market has been recovering from the downturn faster than housing has, observers say, with valuations and returns strong the past two years.

Investment returns are expected to stay above 8% the next few years — better than other asset classes with steady returns, such as bonds.

"It's hard to find good-yielding low-risk investments right now so capital wants to be in this asset class," said Real Capital Analytics Managing Director Dan Fasulo, who recently purchased a small apartment building in the Bronx.

Total returns in commercial property include gains attributed to net operating income, plus appreciation and capital gains.

IBD looks at some factors that may weigh into investing decisions: Jobs Economists consider job creation the most important metric in commercial real estate, especially as it pertains to office space. The more people working, the more office space needed.

The unemployment rate dropped from 8.5% at the start of 2012 to 7.8% in the fourth quarter. Some 453,000 jobs were created in the fourth quarter, down from 505,000 in the third quarter, according to the Bureau of Labor Statistics.

For the year about 1.8 million jobs were added to payrolls, similar to 2011. In December, 155,000 new jobs appeared, BLS data show.

"Improvement in demand for space is going to be lackluster as long as the job numbers are below 200,000 a month," said economist Asieh Mansour at commercial real estate services giant CBRE (CBG).

Industrial real estate responds to a somewhat different beat. It's not as reliant on job growth, says Brad Doremus, senior analyst with research firm Reis.

"It can do well as long as companies are doing well," he said. Industrial space is tied to firms in manufacturing, ports and e-commerce.

Shipments are increasing at a faster pace than employment, CBRE noted in a year-end report.

Mansour and other economists expect the U.S. economy to remain fragile and slow-growing in the first half of this year due to uncertainty over the "spending cliff" and debt ceiling, but to pick up in the second half and into 2014.

"Businesses are the ones that hire and they will remain uncertain in view of all the discussions still ongoing in Washington," Mansour said.

U.S. GDP is seen rising around 2% near-term, similar to 2012. Location Markets with jobs in high-flying tech and energy are doing best. Office fundamentals are strong in tech hubs such as San Francisco, San Jose, Calif., and Seattle; and energy hubs such as Houston and Dallas. Other spots with strong tech cores such as Boston, Denver and Minneapolis outperform too.

Though New York has been hurt by job losses in finance, it's seen new businesses form in other areas, including technology. Google (GOOG) and a host of tech start-ups have a growing presence in Manhattan.

But big investment money has bid up prices in major markets such as New York, especially for high-quality properties.

"Urban retail is as hot as it's ever been," Fasulo said, citing Manhattan's Fifth Avenue as an example. Smaller investors' "only option" is secondary markets, Doremus says.

Fasulo expects investment activity and prices to rise across the commercial real estate spectrum in secondary markets with decent economic growth. Look to Texas and Florida and metro markets like Seattle, Denver and Pittsburgh, he says.

Florida's economy "used to be a one-trick pony and now multiple industries are there," he said.

Suburban office and retail space has lagged metro areas, especially in outlying areas hurt by foreclosures. Though home prices have rebounded in many such markets, suburban commercial property hasn't much.

It's not apt to until the economy improves more dramatically and jobs return, analysts say.

The suburban office vacancy rate ended 2012 at 17.1%, 70 basis points below a year ago, CBRE noted. Downtown office vacancy ended at 12.3%, down 40 basis points.

Retail has lagged other sectors but is doing better in affluent areas home to higher disposable incomes.

"Westchester County (N.Y.) and Orange County (Calif.) are doing fairly well relative to some Midwest towns like Cleveland, Indianapolis or Columbus," Doremus said.

Supply "The good news is that supply has remained in check," Mansour said. "One of the trends that brought down commercial in past cycles was overdevelopment.

Retail was the only commercial sector overbuilt during the housing bubble, especially in the suburbs. Since then, new construction has been low for both retail and office.

"You're not going to see a lot of construction in retail and office until vacancies and rents do better," Doremus said.

Apartment construction, neglected in the housing boom, has inched up for three quarters. Last year 66,846 units were completed in the U.S. vs. 42,290 in 2011, Reis says.

"I think in 2013 you'll see a big spike," Doremus said. He expects industrial construction to pick up this year too, after little new supply.

It "will be concentrated in high-quality distribution and warehouse centers because that is what is in demand ," he said, noting that Amazon (AMZN) and other growing e-commerce firms want to be near population centers for quick deliveries.

Rents And Vacancies U.S. office vacancy slipped from 2010's 17.6% to 17.1% in 2012, Reis says. Office rents rose 2% in 2012 vs. an 8.9% drop in 2009, with San Francisco and New York logging the top 2012 gains, 7.4% and 4.2%.

Industrial vacancy peaked at 14.5% in 2010's third quarter and was down to 12.7% two years later. Rents stayed fairly flat in 2012.

Retail vacancy peaked at 11% in late 2011 and is off just to 10.8%. In 2005, it was at 6.7%. U.S. retail rents have barely budged in two years.

Apartment rents were up 3.8% in 2012 to $1,048 a month, as vacancy fell to 4.5%, from 5.2% in 2011.

"The last time vacancies have been this low was in mid-2001 and that was when economic growth was strong," Doremus said.