Spillover effect

Spillover effect

Commercial real estate by Jean Gruss | Editor/Lee-Collier

Commercial real estate experts are looking over their shoulder at their residential cousins and worry whether a commercial downturn is around the corner.

The commercial real estate sector is starting to feel the drag of the residential slowdown.

Banks are scrutinizing new and existing projects, land sales have slowed, investors aren't counting on rapid appreciation, rental rates have stopped rising, landlords are helping tenants with insurance and tax spikes and vacancies are starting to rise.

Experts who gathered at the CCIM Real Estate Outlook Conference in Fort Myers suggested these are the first indications that the commercial real estate boom of the last few years is slowing.

Typically, the economic cycle of commercial real estate lags the residential sector by two or three years. With the start of the residential downturn now into a full year, there are indications commercial real estate may be starting to feel the effects now. Florida economist Hank Fishkind told the gathering that retail and office space are going to be two property types that will be impacted by the residential slowdown.

Certainly, all is not gloom and doom in the Sunshine State. Population growth continues apace, the unemployment rate is below 3%, capital continues to be available, and the pace of business is now on par with the solid growth prior to the boom.

"There's more good than evil out there," says James Boback of Boback Commercial Group in Fort Myers.

Slower retail growth

Population growth, low unemployment, rising incomes and increases in tourism will continue to fuel construction and leasing of shops in Southwest Florida.

In particular, Lee County has reached the benchmark of 500,000 people that attracts large national companies seeking to enter new markets. "The nationals have discovered Southwest Florida and they continue to drive into our market," says Bruce Preble, a broker with Welsh Companies Florida in Naples.

But the rush to build new shops is making lenders hesitant about how much space tenants will fill and at what cost. "The projects not under construction will be delayed," Preble says.

In 2006, there was two million square feet of empty space in strip malls and shopping centers, especially in Bonita Springs and Estero in South Lee County. Rents in that part of the county average $26 per square foot, versus $19 in Fort Myers, Preble says. Meanwhile, two new shopping malls in South Lee County added three million square feet of shops.

"Rental rates are going to stabilize," Preble says.

It's about time things cooled off. From 2003 to 2006, the average cost to buy shopping-center space rose from $70 to $147 per square foot. For strip malls, the average cost rose from $89 per square foot in 2003 to $194 in 2006, according to Preble's data.

Land values for retail space rose from between $10 and $14 per square foot in 2003 to between $20 and $25 in 2006. During that same period, the average value of improvements to retail properties rose from between $32 and $37 per square foot to between $68 and $83.

The rapid escalation in prices for land on which to build industrial buildings seems to have reached a plateau. "Ten dollars [per square foot] seems to be the price point at the high end," says Boback.

Some of that may be attributable to weakening demand. Boback says he has seen demand weaken for flex space, which is warehouse space that includes a small office. Prices paid for smaller flex spaces have topped out at around $150 to $175 per square foot. "The prices are not escalating daily," he says.

Still, Boback says there's rising demand for larger spaces exceeding 20,000 square feet. That's because there's an increase in regional distributors looking for space in Southwest Florida and large blocks of space are rare.

Meanwhile, speculators and investors are less likely to be buyers of industrial space because banks have become more cautious about lending and they're requiring more preleasing. "It's now more of a user than an investor market," Boback says.

Despite overall industrial space vacancies below 3%, taxes and insurance will likely slow development. For example, Lee County raised taxes on the construction of new commercial buildings starting Jan. 31. That means a developer will now have to pay the county an additional $30,290 to build a 10,000-square-foot building.

Insurance is now a big part of the maintenance costs, especially for older buildings. Boback says he recently helped an owner of a 13,650-square-foot building find insurance. The cost jumped form $7,314 per year to $28,000 and the new policy now excludes wind-related damage.

Offices for sale

Rising interest rates will play a significant role in the office market because many businesses purchased office space using adjustable-rate loans, says Ryan Leffler of Leffler and Associates in Fort Myers.

In 2004 and 2005, when interest rates were historically very low, those who purchased offices for top dollar tended to be the ones who used it. By contrast, investors realized prices were rising too high and for the most part avoided buying space.

As these loans readjust to higher interest rates, some owners could face mortgage payments that are as much as 25% higher than they are today and will be forced to sell. "You're likely to see a lot more properties come on the market this year," Leffler says.

Adding to the pain, rising insurance and taxes will continue to hurt landlords and tenants. Even if a tenant has agreed in advance to pay these costs in addition to the rent, a 50% increase in maintenance costs usually will force the landlord to absorb some of these costs to retain the tenant.

Further, tenants in older buildings are demanding landlords upgrade telecommunications equipment such as high-speed Internet access. This is likely to add to the cost of ownership.

To offset some of these rising costs, landlords are increasingly signing tenants to shorter leases of three years or less, giving them the flexibility to increase rents sooner. In addition, some owners are turning their office space into executive suites, renting out offices to multiple tenants who share the common area. Income from executive suites can be 30% to 45% higher than leasing traditional office space.

Review summary

Industry. Commercial real estate

Trend. Rents and prices will stabilize this year.

Key. Experts worry how the residential downturn will slow commercial activity.

Commercial real estate: Outlook and Trends in 2007

Commercial real estate landlords and tenants know 2007 won't likely resemble the speculative frenzy of the last few years. Here's what experts at the CCIM Real Estate Outlook Conference in Fort Myers recently had to say about the trends they see this year in each sector throughout Southwest Florida.

Sector: Retail space

Expert: Bruce Preble, Welsh Companies Florida

• Rental rates are going to stabilize as new shopping centers are built, putting pressure on rents.

• It's questionable whether land will continue to appreciate at the rapid rate it has in the last few years.

• Retail construction projects that have not started construction will likely be delayed as developers wait for new and existing space to be absorbed. Banks are telling developers to hold off on new retail projects.

• National companies have discovered Southwest Florida's rapid population growth and will continue to push into the market.

• Not all shops will be geared to retirees. Children's stores will grow as will those geared to sportsmen and tourists.

Sector: Industrial space

Expert: James Boback, Boback Commercial Group

• There is rising demand for larger industrial spaces exceeding 20,000 square feet and an acute shortage of large contiguous blocks of space.

• More national and regional distributors want to establish satellite distribution in Southwest Florida.

• Freestanding buildings with outside yard storage are in extremely high demand and command premium rents or sale prices.

• Buyers increasingly are users of space instead of investors as prices escalate.

• Absorption is slowing, especially for smaller flex spaces that combine office and warehouse. There is an oversupply of flex space, leading to softening sales and leases.

• Less construction will take place in 2007 and 2008 as space gets absorbed.

• Banks are toughening lending standards and will emphasize more preleasing.

• Tenants will demand leases with shorter time frames, as they are reluctant to lock in for longer periods due to the uncertainty in the housing market.

• Rising insurance and tax expenses will keep base rents from increasing.

Sector: Office space

Expert: Ryan Leffler, Leffler and Associates

• Rising interest rates will dramatically affect property owners with adjustable mortgages. Rising rates could bump up mortgage payments by as much as 25%, forcing owners to try to sell their properties.

• Landlords will continue to have difficulty passing along costs for fast-rising property taxes, insurance and other expenses. In some cases, landlords will have to help the tenants pay for expenses that can increase as much as 50% in one year. Landlords should consider writing shorter-term leases or make the tenants pay those variable costs when drafting a new lease or a renewal.

• Tenants will demand landlords keep pace with changes in telecommunications, including greater bandwidths to accommodate sending large amounts of data.

• Some office tenants are choosing industrial flex space, which includes a combination of warehouse and office space. That's because flex space is less expensive to lease than office space.

•Landlords should consider converting office space into executive suites. In this type of space, companies lease individual offices within a suite and cater to startup companies and independent salesmen. Executive suites command rents that are as much as 30% to 45% higher than traditional office space.