BMO Harris Bank: Midwest CRE to Improve in 2012

According to a new report by BMO Harris Bank, the Midwest is set for a recovery in its CRE markets during the rest of the year.

By Nicholas Ziegler, News Editor

Image courtesy Flickr user PunkToad

According to a new report by BMO Harris Bank, the Midwest is set for a recovery in its CRE markets during the rest of the year. The firm noted that the region “largely mirrored the broader national market” during slow ramp-up of 2011’s economic engine, and that stringent capital requirements and continuing unemployment were among the largest challenges. The company’s outlook was buoyed by the multi-family rental sector, which it called “characteristic of an early economic recovery,” and noted that the suburban general-purpose office and retail sectors will continue to lag behind.

Rental housing is the current shining star of commercial real estate. Homeownership rates have been on the decline since 2004, according to the U.S. Census Bureau. In fact, home ownership peaked at 69 percent of U.S. households in 2004 and recently has dropped closer to the historic norm of 62 percent. Interestingly, every 1 percent drop in home ownership creates approximately 1 million renters, and that demographic trend, while slowing down, is expected to continue over the next few years. According to commercial real estate market monitor Reis, U.S. apartment vacancies fell to a 10-year low in the fourth quarter of 2011. Midwest rental vacancy rates fell 1 percent in the third quarter of 2011 from the previous year.

Major Midwestern cities, including Indianapolis, Louisville, Cincinnati and Columbus, have recognized the need to add permanent residents in their urban cores. These cities and others have embraced this new urbanism and are attempting to attract more residents with urban-style redevelopment in their central business districts as well as close-in suburban communities. Many cities recognize that the permanent population encourages economic growth and reduces violent crime.

In many Midwestern markets, however, the window of multi-family development opportunity is already beginning to close. Recent rent level and occupancy gains in the sector have certainly been welcomed after years of competition with home builders. But the combination of higher apartment rental costs, low mortgage interest rates, falling home prices, and improving consumer confidence will again produce a more robust single family housing market. Competition from “for sale” will again be a major competitor for housing decisions, perhaps as early as 2013. A focus on infill suburban and urban sites will prove to be a winning formula for developers in this space. Nimble owners and developers can profit from the favorable market trends in this commercial real estate sector.

Modern bulk industrial space demand has seen a dramatic improvement over the past 12 months in many Midwestern markets. Bulk industrial space demand mirrors, and in many respects is a leading indicator of, optimism in the economy. In most Midwestern cities focusing on this sector, there is very limited availability of contiguous space of 500,000 square feet or greater. As bulk industrial development has historically been conducted on a speculative basis, the lack of capital has limited new supply since 2008. Now that a demand/supply equilibrium has been achieved in several markets, look for new speculative development in the sector.

“Industrial” as a commercial real estate category also includes owner-occupied office/warehouse buildings and manufacturing facilities. The Midwest is, in fact, still heavily reliant on manufacturing employment. In Indiana, for example, manufacturing accounted for 16.3 percent of the state’s jobs in 2009, according to the Bureau of Labor Statistics, and 27 percent of real GDP, according to the Bureau of Economic Analysis. Nonetheless, the Midwest continues to diversify away from manufacturing toward growth in areas such as clean energy, healthcare, engineering, and business services and will continue to do so.

As with so many facets of the U.S. economy, commercial real estate demand in the Midwest is driven primarily by job growth. Recent improvements in job growth have been welcomed, although the employment improvements have yet to affect market demand materially, especially for Midwestern suburban general office and retail space. Indeed, the sheer supply of suburban office and retail space in many Midwest markets is relegating these property types to commodity status and severely limiting property owner pricing power.

Many industry observers believe that the majority of Midwestern suburban office markets will not reach a supply/demand balance for the foreseeable future. Opportunistic purchases may be the only way for owners and developers to profit in the near term in this product sector.