Back to the basics in Commercial Real Estate

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by Paula C. Squires

It might feel like winter all year for commercial real estate.  With the U.S. economy in recession, credit hard to come by and uncertainty about a new president’s economic policies, companies in Virginia are hunkering down in survival mode. “I don’t feel like commercial will be hit as hard as residential, but we anticipate 2009 being a very difficult year,” says Trib Sutton, a senior vice president and principal for CB Richard Ellis in Richmond.

“We haven’t come into this as overbuilt as in past down markets,” adds Sutton, “but the bad news is we haven’t had credit dry up like we did last year.”

Heading into 2009, other troublesome signs are emerging. Default rates on commercial mortgages are heading up. Real estate values are falling in many areas and sales of commercial properties are down in Virginia and the U.S. In fact, sales were off nearly 75 percent nationwide in October compared with 2007, according to New York-based research firm Real Capital Analytics.

The Urban Land Institute says 2009 will be the worst year for commercial real estate since a 1991-92 industry depression. In an annual report on trends, it predicts the industry will bottom out in 2009, continue to struggle in 2010 and head for recovery in 2011.

With President-elect Barack Obama and his administration taking office later this month, there’s a lot of uncertainty about federal bailouts and stimulus packages and their role in jumpstarting the economy. A continuing shortage of credit will pummel the industry because commercial real estate relies heavily on debt to finance the development and purchase of office buildings, warehouses and shopping centers. 

“It is an uncertain environment. We don’t know what the economic picture will be. No one expects a quick fix,” says Ron Kuykendall, vice president of communications for the National Association of Real Estate Investment Trusts (NAREIT) in Washington.

What is clear is that banks are putting a premium on existing relationships. And they’re taking a close look at the liquid assets of commercial loan applicants and their company’s principals. Until the bailout money starts to trickle down to individuals and specific projects, mortgage brokers expect to see more defaults. “There are going to be defaults. We just don’t know how much or when,” says Charles DuBose, managing director of Philips Realty Capital in Richmond. Another concern, he adds, is the large number of commercial mortgages that come due for refinancing in 2010. “Where is all that capital coming from? If there’s no money, there will be lots of workouts and defaults.” 

Economists expect the recession to continue at least through the middle of this year. So far in Virginia, the retail market has been the hardest hit among commercial real estate sectors.  As unemployment rises and consumers cut spending, 14 of the country’s major retail chains have sought bankruptcy protection in the last 12 months. Among them was Virginia’s Circuit City Stores Inc., the country’s No. 2 electronics retailer. When companies close stores, as Circuit City is doing, more space is dumped on the market, spiking vacancy rates and softening rents.

Despite the uncertainty and gloom, there are some bright spots for Virginia. Hampton Roads and Northern Virginia, traditionally insulated from economic downturns due to a stable anchor of government-related defense business, are still seeing vacancy rates for office and retail that are well below national levels.

Fredericksburg and Spotsylvania County continue to attract new development because of population and job growth associated with military base realignments.

The Richmond region has several projects in the pipeline including two major shopping centers and a Fortune 500 headquarters for MeadWestvaco.

Land sales, however, remain flat across the state. Still, the Washington metropolitan area, which includes Northern Virginia, is expected to rebound quickly. It was named as one of the top-five markets for real estate investment in 2009 by the Urban Land Institute. Above-average employment, access to an affluent population and proximity to the federal government all work in its favor. 

Other rays of light? Shopping centers anchored by grocery stores.  People have to eat, and these bread-and-butter properties generate income, says Ashby Hackney, a principal with River City Capital, a Richmond real estate investment company.  It just acquired a 133,000-square-foot property in Staunton for $10.9 million. Anchored by a Kroger, the center offers a mix of national and local tenants.

Hackney’s company purchased 10 grocery-anchored centers in 2008, including several in Virginia.  Equity for the deals, he says, came from high-net-worth individuals who want to invest in an income-producing real estate asset with a professionally managed partner. Going forward, the company plans to be very selective. “We think there will be some great deals out there. We’re going to do more and work harder in 2009 but for fewer deals.”

Hampton Roads
Commercial real estate executives say this region will power through a recession just fine, thanks to the area’s major economic drivers.  Hampton Roads’ strong military presence and its port have long provided a stable anchor for the region in lean times. Deborah K. Stearns doesn’t expect that to change in 2009.  In fact, Stearns, managing director of the Norfolk office of GVA Advantis, expects modest growth. She and a colleague even bought coffee mugs for the office that say “half full.”

“As we look forward to 2009, the region should remain stable,” says Stearns. In 2008, vacancy rates for office, industrial and retail typically were under 10 percent, she adds, well under the 15 to 18 percent rate that’s considered an oversupply.

Plus the state’s second-largest metropolitan area ended 2008 with good news. Northrop Grumman Shipbuilding and Areva plan to build a $360 million engineering and manufacturing facility for Newport News. The project will create hundreds of jobs while supplying components to the country’s growing nuclear-energy industry.

“We’re better off than other areas of the country,” says Craig Cope, regional manager for Liberty Property Trust in Hampton Roads.

Still, business is slower, he acknowledges, and Liberty plans no new projects this year. Nine office buildings are under construction in Hampton Roads and will add more than 800,000 square feet of space to the market. The largest is the Wachovia Center in downtown Norfolk, a 250,000-square-foot office tower that is nearly 50-percent preleased. Liberty recently delivered a 75,000-square-foot office building in Chesapeake. At year end, Cope had one tenant signed for 5,000 square feet. Despite the dismal economy, the Port of Hampton Roads in Norfolk continues to draw industrial warehouse development. Safco Products Inc. of Minnesota, a leading office products distributor, plans to build a 300,000-square-foot distribution center in Isle of Wight County because of its proximity to the port.
Overall, though, Cope looks for 2009 to be a year for focusing on existing clients. ”It’s back to the basics.” 

Northern Virginia/Washington, D.C.

Look for continued interest and opportunity in metropolitan Washington, D.C. Even in tough times, the business that flows from government agencies has kept the region on the lists of top 10 places to invest. 

Inside the beltway in places like Alexandria and Arlington County, vacancy rates were as low as 5 percent in the third quarter. Meanwhile, rents were as high as the low $40s. With Northern Virginia home to some of the most affluent counties in the country, retail has flourished, although this sector has cooled in recent months. 

“ … By virtue of the federal government being right here, we’ve still got, comparatively speaking, a strong job market,” says Carol Honigberg, who heads the real estate group in the Washington/Virginia region for the law firm of Reed Smith. “With the federal bailout and change of administration, there’s going to be new jobs created and new opportunities that will require real estate.”

Still, the region faces challenges. Some tenants are concerned that federal bailouts for the beleaguered financial services industry will mean fewer dollars for contractors. “What impact will the huge amount of spending on the government bailouts have on government contract spending in Northern Virginia?” wonders Paul Schweitzer, an executive vice president in suburban Washington for Studley. “More tenants are taking a wait-and–see attitude.” 

Plus, as the military shuffles operations as part of a base realignment program, office vacancies are expected to climb in some submarkets. The U.S. Army plans to move thousands of defense workers, most of them from office buildings in Arlington, to Fort Belvoir in Fairfax County. 

During the next six to eight years, the Arlington submarkets of Crystal City and neighboring Pentagon City will see more than 4 million square feet — or about 13 percent of its office space — become vacant as the military pulls out, according to a recent report from real estate company GVA Advantis. 

Traditionally, the region’s big downside has been notorious traffic congestion. So the recent endorsement by the Federal Transit Administration of its share of a long planned extension of the Metrorail came as welcome news. The extensions would put four new metro stations at Tysons Corner and eventually extend service to Washington Dulles International Airport.

No doubt Tysons Corner will tout this development as it embarks on a major transformation that relies more heavily on public transit. Only one new building is scheduled to deliver at Tysons this year, the region’s largest commercial center, and it plans a pedestrian connection to one of the future Metro stations. Construction workers topped out Towers Crescent Plaza this fall, a 13-story, 295,000-square-foot tower. In December, no tenants had signed leases in the speculative building.   

Later this month the na-tion’s capital re­­­­­­­­­­­­-gion will bask in the spotlight of international exposure with the inauguration of the country’s first African-American president. Weeks before the gala, the Obama inauguration already had filled the region’s more than 4,000 hotel rooms. The jury is out on what effect his administration will have on the rest of the market.

Richmond region
Signs of stress are evident in Richmond’s economy, and it’s affecting the office and retail sectors.  Brokers expect the buyout of Wachovia by Wells Fargo and bankruptcy filings by Circuit City Stores and LandAmerica Financial Group to put space back on the market as these companies reorganize. 

Innsbrook, the dominant office market for the Richmond region for more than a decade, already has seen a large block empty with the departure of some Wachovia offices. “Innsbrook is going to have some big holes to fill,” says Sutton, of CB Richard Ellis in Richmond.

On the plus side for Richmond as Virginia’s capital city is the reliability of the state as a major tenant. It recently purchased three buildings in the heart of the city’s financial district. While this development will push out some existing tenants, new projects are going up downtown.

For instance, the Williams Mullen law firm will leave the James Center, freeing up existing space, when it moves into a new 15-story, $60 million office tower at 10th and Canal Streets.  MeadWestvaco’s new corporate headquarters is going up on the banks of the James River and should be ready by fall of this year.  The global packaging company now leases about 250,000 square feet of office space at Innsbrook in the Henrico County suburbs.

Richmond continues to draw interest from developers. Highwoods Properties, a Raleigh-based REIT (real estate investment trust) with a Richmond office, recently proposed two new major projects for the North Boulevard and Shockoe Bottom areas. The proposal includes $60 million for a new baseball stadium in the Bottom, part of a $363 million development that would include a black history museum. Envisioned for North Boulevard is a $422 million town-center development and public-works complex that would replace the existing ballpark, The Diamond. The city, which would serve as a public partner and provide some funding, has yet to sign off on the project. 

On the retail front, Richmond also has several major projects under construction.

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