Recapping the Third Quarter — and Taking a Look Ahead

By Robert Bach, Grubb & Ellis Co.
The office, industrial and retail markets all recorded a very modest drop of 10 basis points in their third-quarter vacancy rates. Asking rental rates typically lag vacancy, and at this early stage of the recovery cycle, landlords have little pricing power with the exception of some apartments and selected high-quality office and retail properties in primary markets.

As we edge up toward the end of the year, let’s take a look at the market in the third quarter – and provide some predictions for the future.

Leasing market conditions improved in the third quarter at a pace ranging from barely detectable to brisk. The apartment market fit the latter description as the vacancy rate fell to 7.1 percent from 7.8 percent in the second quarter, one of the sharpest drops on record according to data-provider Reis. The office, industrial and retail markets all recorded a very modest drop of 10 basis points in their third-quarter vacancy rates. Asking rental rates typically lag vacancy, and at this early stage of the recovery cycle, landlords have little pricing power with the exception of some apartments and selected high-quality office and retail properties in primary markets.

Soft tenant demand for most types of commercial real estate is not holding back investors. Year-to-date sales transactions totaled $60.4 billion of apartment, industrial, office and retail properties valued at $5 million and up – 82 percent above the same period in 2009 according to data-provider Real Capital Analytics. Transaction volume has picked up every quarter this year on a sequential and year-ago basis. Compared with a year ago, volume was up 49 percent in the first quarter, 85 percent in the second quarter and 105 percent in the third quarter. Investors are focused on the upper end of the quality spectrum – core properties in primary markets. This is evident in the average deal size of $21.3 million year-to-date versus $14.1 million during the same period in 2009. Although the dollar volume of transactions has risen by 82 percent this year, the number of transactions is up by just 20 percent.

Very low interest rates and disappointing returns on other asset classes are fueling investor demand for commercial real estate despite the weak economy. The potential for higher inflation down the road also seems to be a plus for real estate, which is viewed as an inflation hedge.

Expect the leasing market recovery to be slow and uneven until the labor market picks up. Job growth could be disappointing in 2011, perhaps in the range of 1.5 to 2.0 million – which would leave a remaining deficit of around 6 million and a year-end unemployment rate of around 8 to 8.5 percent.

Expect the investment market to continue gaining momentum in 2011 unless interest rates rise unexpectedly. Federal Reserve officials and many economists think this is unlikely because there is so much slack in the labor market, real estate, factory utilization, etc. But there is a small chance – perhaps 10 percent – that bond investors could pull back from United States Treasuries due to their meager returns, the weak dollar and huge increases in supply, which could cause a spike in inflation and interest rates.