6 Commercial Real Estate MegaTrends Identified At 17th Annual Washington, D.C. TrendLines®

WASHINGTON, Feb. 7, 2014 /PRNewswire/ -- Transwestern, along with its research affiliate, Delta Associates, and their sponsors, Baker Tilly and PNC Real Estate, today announced they held their 17^th annual Washington, D.C. TrendLines^® event on Feb. 6 at the Ronald Reagan Building and International Trade Center. As part of the event, Greg Leisch, CEO of Delta Associates, gave a presentation highlighting opportunities in the Washington, D.C. commercial real estate market. Guests of the event also received a copy of the 17^th edition of the TrendLines^® publication, Trends in Washington, D.C. Commercial Real Estate – A New Playbook, which distills the trends of 2013 and sheds light on pivotal forces and issues that Delta Associates believes will affect the region's economy and commercial real estate in 2014 and beyond.

"I believe for the foreseeable future we face not just a more competitive market in certain asset types, but pressure on our industry to respond to a myriad of trends," said Leisch. "A response that requires a new playbook – a focus as much on transforming our existing portfolio of assets as on creating new product."

Delta's presentation on the state of the market addressed six key themes for investors to consider in 2014. The following is a summary of these "MegaTrends."

#1: Uncertainty in 2013, Less in 2014
During 2013, uncertainty plagued the regional economy as sequestration went into effect in March and the federal budget dominated discussions in the months following. However, despite soft footing, the Washington metro area economy progressed with several major projects that provided economic stimulus. Now that a two-year budget deal has been passed by Congress and signed by the president, Delta Associates expects this uncertainty to lessen in 2014, which will further propel the economy forward. Although the budget deal will alleviate only some of the sequestration cuts, Delta Associates believes that because Congress was able to come to an agreement – particularly after so much discord – local businesses and consumers will gain confidence, which will translate into greater spending that will boost the region's economy in 2014.

MAJOR PROJECTS AND FACTORS AFFECTING THE WASHINGTON ECONOMY IN 2013

• DC United deal struck with the District for a stadium.
• Prince George's County became a player with casino and hospital. Also, a possible FBI deal.
• Trump invested in the Old Post Office.
• Walmart and Costco opened stores in the District.
• Tech hub 1776 opened – a start-up incubator.
• Record pricing paid for apartments.
• The Bipartisan Budget Act of 2013 passed in December, re-establishing much funding previously cut by sequestration.

#2: National Economic Recovery is Gaining Momentum
As with the Washington-area economy, Delta Associates expects improving conditions at the national level during 2014. Several indicators speak to this trend. Despite the uncertainty caused by the federal government, 2013 was a year of record corporate profits; soaring stock prices; sturdy, if not impressive job gains; robust housing market growth and rising consumer confidence and spending. These indicators point to stronger conditions for both consumers and businesses in 2014. Although conditions will remain muted compared to past recovery cycles, and challenges to the national economy remain, Delta Associates expects economic progress in 2014 to be better than in 2013.

#3: Capital Flows in Washington Vary from Nation
The third MegaTrend reveals a challenge facing Washington's commercial real estate market. There is a dichotomy in the real estate investment market between national capital flows and flows into Washington-area assets. Nationally, capital flows into commercial real estate are robust, with private equity ramping up its commitment to the asset class. Locally, capital flows into Washington have ebbed, a reflection of weaker property performance metrics here in 2013, the political gamesmanship on Capitol Hill and higher returns available in secondary markets.

As of August 2013, U.S.-focused private real estate fund managers had an aggregate $98 billion in equity available to invest in new opportunities. That figure compared with $79 billion just eight months earlier. Similarly, those same funds invested almost as much in 2012 – $67 billion in equity – as the $68 billion deployed in 2007, the peak of the market. In fact, as of December 2012, private equity's commercial real estate assets under management had reached $335 billion, an all-time high. Nationally, commercial real estate is a favored asset class.

One reason investors, especially institutions, have been so committed to commercial real estate is that the huge run-up in stocks – the S&P 500 rose 32.4 percent in 2013 – has led to portfolios that are over-weighted in equities relative to their stated risk profile. In particular, institutions with a mission to protect value – such as pension funds – need to rebalance their portfolios away from equities. Real estate, which also represents a hedge against potential increases in inflation, is a good place for them to park resources. After all, even following the robust gains equities made in 2013, real estate still beats stocks on a 10-year return – an 8.66 percent annualized return for NCREIF's Property Index (NPI) versus 7.56 percent for the S&P 500 (as of September 2013, the most recent NPI data available at this writing).

While capital flows into real estate remain strong nationally, they have ebbed in Washington. Part of the reason is that returns in 2013 did not hold up as well here as in peer cities. For example, the 12-month total return on apartment product as of September 2013 was 7.42 percent for Washington compared with 10.77 percent for the nation – a gap of 335 basis points. For office assets the gap was even larger; Washington's return was 5.67 percent as of September 2013 compared with 9.68 percent for the U.S. as a whole – a difference of 401 basis points. Washington's performance was ahead of the curve earlier in this cycle. Now, other major metros are providing a better yield, as Washington's pricing remains high but market fundamentals are not allowing for apartment or office rent growth.

#4: Rising Interest Rates Mark End of Cap Rate Compression
"Interest rates are going to rise – it's only a question of when." This has been the mantra of investors for several years now, and while long-term rates did rise modestly in 2013, they remain low by historical standards.

As of early January 2014, the 10-year Treasury yield was 2.88 percent. This compares with 1.91 percent a year earlier, but a long-term average of 6.55 percent. Observers who said long-term interest rates would edge higher in 2013 were correct, including Delta Associates, which predicted steady to slightly rising rates in last year's TrendLines^® report. But the more important question is when will rate increases accelerate to the point that access to financing becomes materially more expensive and changes the decision calculus for investors?

Delta Associates believes 2013 marked a clear increase in long-term interest rates that will gradually, but meaningfully, affect investors' decision-making in 2014. With the national economy showing signs of more significant traction during the second half of 2013 (notwithstanding December's weak jobs report), and the Fed making it clear that tapering of its bond-buying program will proceed in 2014, long-term interest rates are likely to continue their ascent. Wells Fargo's forecasting unit predicts a 10-year Treasury yield of 3.20 percent as of year-end 2014 and 3.50 percent as of year-end 2015. Delta Associates thinks these rate predictions are low and rates are likely to move at least that much or more, given recent economic indicators. J.P. Morgan forecasts 10-year Treasury yields stabilizing at 4.5 to 5.0 percent in 2018, with a 200 to 300 basis points spread for core real estate. That would equate to commercial mortgage rates of perhaps 7.25 percent in 2018. Delta Associates thinks this is sensible for planning purposes.

The overall economic picture in Washington is improving, with substantial reason for optimism, but the recovery will proceed slowly. The competitive environment here will remain, and investors will need their properties to stand out in order to attract buyers' interest and raise valuations.

#5: The Changing Nature of Space – Driven by Tenant Demand
While market conditions across all property types are likely to improve in Washington in 2014, investors face a significant challenge in responding to the changing demands of tenants. This is no more evident than in the office market, but it is seen in all property types.

The "densification" trend, the reduction in square feet leased per worker, is combined with the changing nature of how tenants are using space. Demographic shifts and the rise in technology have not only put downward pressure on the amount of office space tenants need, but it has also begun to impact how tenants use a smaller space. Driven by tenant demand, the changing nature of space heavily weighs efficiency, layout and design. The question is no longer, "How much space do you need?" but rather "How do you plan to use the space you have?"

For Office
Tenant densification is not a new trend, but its use has ramped up in recent years as companies implement alternative workplace strategies to save on occupancy costs. With the federal government's "Freeze the Footprint" mandate in effect and the private sector looking for ways to reduce spending as a result of uncertain economic conditions, average square feet allocated to each worker continues to trend downward. Tenants are acclimating to less space and learning how to operate efficiently within those confines by reconfiguring layouts, using new design elements and integrating technology. Based on a Delta Associates survey, the average amount of square feet leased per office worker will decline from 197 square feet in 2000 to 178 square feet in 2017, a 10 percent decline. For some industries, the reduction is substantially greater.

For Flex/Industrial
Flex/industrial demand has been increasing over the past several years due to structural shifts in the regional market. Cloud computing increases demand for data centers and space that supports technological changes in how we compute, access and store information. Retailing has also resulted in greater demand for industrial space as e-commerce heats up and same-day delivery of online purchases becomes a reality, sourced from local warehouses.

In the Washington/Baltimore region, demand was robust in 2013. Notably, construction started on a 1.2 million-square-foot Amazon fulfillment center. Large retailers like Amazon are increasing their warehouse and distribution space to keep up with the demand produced by e-commerce. Much like the changing use of space for other product types, warehouse space must be efficiently designed. Delta Associates expects retailers to follow this strategy of placing large distribution centers near higher income metros, such as Washington, which has the highest median household income in the country. Data centers supporting cloud computing should have renewable and redundant energy sources, efficient cooling and innovative building layouts. Given the growing use of data, Delta Associates expects data center demand to continue.

For Multifamily
Demographic changes in the Washington metro area from 2006 to 2011 caused a shift, adding more renters than single-family homeowners. During this period, the relocation of 25- to 34-year-olds to the Washington metro area – many in search of a job – intensified. While the region lost 5 percent of its 25- to 34-year-olds from 2000 to 2006, it gained 21 percent in that cohort from 2006 to 2011. As a less uncertain economy surfaces, many Millennials who moved in with their parents during the downturn will begin to look for alternative housing options, bringing an influx of potential renters to the Washington metro area.

Prospective renters in the younger age brackets, an estimated 9.1 million nationally from 2011 to 2015, are expected to drive apartment demand as they join the workforce. Given the hefty pipeline of apartment units in the Washington metro area, the market is prepared and already responding to the needs and wants of Millennials via changes in design.

Class A, high-rise apartment unit size in the District of Columbia is trending downward over time, similar to office densification. For reference, in 2000, the average size of a Class A, high-rise apartment unit was 878 square feet. By 2010 this figure had declined to 851 square feet. Notably, over the past three years the average unit size has declined another 9.4 percent, to 771 square feet, reflecting a more aggressive trend toward smaller, more efficient units.

For Retail
In the age of technology, retailers must be creative to attract customer spending, especially to brick-and-mortar stores. E-commerce sales are on the rise and expected to continue, reaching $434 billion by 2017. The booming e-commerce market and access to technology does not bode well overall for traditional retailers. Shoppers can buy online or easily check prices on cell phones in order to get the best deal. This is putting pressure on traditional retailers as foot traffic is reduced and prices have to remain in check in order to compete. All of this puts pressure on margins.

Many stores are unable to compete with the growing amount of e-commerce sales. During 2013, big names like Barnes & Noble, Sears and Best Buy reported closing retail stores due to an increase in e-commerce. Some of these retailers, such as Best Buy, Target and Walmart, are reducing floor plates in order to fit in high-demand urban areas. Retailers are finding the growing population of young shoppers in the urban core is a market worthy of tapping, and they are becoming more willing to change store structure in order to compete. Notably, Walmart created an urban format which opened in the District of Columbia in 2013. Big box stores are figuring out how to transform into an urban concept and still be successful.

#6: Demographic Shifts Impact Commercial Real Estate
Notable demographic shifts are occurring nationally. Generation Y, also known as Millennials, has become the largest demographic in terms of population. This generation currently accounts for 86 million people, or 27 percent of the U.S. population. It has now surpassed the Baby Boomer generation, which accounts for 80.3 million people, or 25 percent of the U.S. population. The Millennial cohort ranges from age 18 to the mid-30s (definitions vary). Due to the population size and different preferences compared to other generations, the life and work choices this generation makes are having a notable impact on the commercial real estate market.

The demographic shifts are occurring at the national level are also occurring in the Washington metro area. From 2009 to 2012, the Washington area was the top metro in the U.S. for in-migration of young adults, with over 12,000 new residents aged 25-34.

The Millennial generation has different preferences compared to other generations. According to the 2013 ULI/BRS National Survey, this group has a greater preference for city living, as 39 percent currently live in a medium-sized or large city, and 40 percent want to live in a medium-sized or large city in five years. This generation also is transient, as 53 percent have changed residences in the last five years and 63 percent expect to move again within the next five years. According to the survey, this generation prefers mixed-use communities with access to public transportation.

There are substantial challenges facing the Washington area, including stress on the Metrorail and school systems, a lack of sufficient housing in the right places and at the right prices, shortages of qualified labor for certain fields and the erosion of the General Services Administration as an office market driver. Yet, despite these challenges, Delta Associates expects the good news arriving with 2014 – and the evolution of our economy and commercial markets – to support growth and prosperity in the years ahead.

Following the market overview presentation, Transwestern, Delta Associates and their sponsors, Baker Tilly and PNC Real Estate, honored three individuals who have made unique and innovative contributions to the commercial real estate industry as a whole and to the Washington, D.C. region in particular. This year, they paid tribute to Capital Riverfront Business Improvement District (BID) President, Michael Stevens and StonebridgeCarras' Founding Principals, George Carras and Doug Firstenberg, as "TrendSetters of the Year" for 2014.

Since founding the Capitol Riverfront BID in 2006, Stevens has led the transformation of an underutilized industrial area five blocks south of the U.S. Capitol into one of Washington, D.C.'s most dynamic and fastest-growing urban neighborhoods. Already home to a mixed-use community of 35,000 daytime employees, more than 3,000 residential units and a growing roster of retail, hospitality and entertainment venues, the Capitol Riverfront now has an additional $6.5 billion of projects planned or under construction.

Serving as a central point of coordination for everything from urban planning and infrastructure improvements to retail openings and cultural events, Stevens has been instrumental in the branding, development and marketing of the Capitol Riverfront.  He has built an organization that is viewed as effective, innovative and compassionate by the community, as well as the public and private sectors.  For his dedicated and steadfast leadership in spearheading the resurgence of this 500-acre urban neighborhood, we are very pleased to honor Stevens as this year's Public Sector TrendSetter of the Year.

Over the past 20 years, the principals of StonebridgeCarras have been involved in real estate transactions in the Washington area exceeding $5 billion in value. With a present focus on high-quality, transit-oriented, mixed-use developments, the firm has delivered a spate of noteworthy projects that have been extraordinarily well-received by their partners, lenders, tenants and neighbors – leaving a lasting legacy of superior results and enhanced communities. 

As founding principals, George Carras and Doug Firstenberg have overseen StonebridgeCarras' ascendance to the pinnacle of Washington's real estate community. After the completion of the award-winning 200 Eye St., SE in 2012 and being selected by Montgomery County to lead transformational redevelopment projects in Wheaton and Bethesda in 2013, StonebridgeCarras is poised to remain at the forefront of trends in our industry. For their decades of leadership and distinguished records of accomplishment, we are very pleased to honor Carras and Firstenberg as our Private Sector TrendSetters of the Year.

ABOUT DELTA ASSOCIATES
Delta Associates, the research affiliate of Transwestern, is a firm of experienced professionals which has been providing consulting and subscription data services to the commercial real estate industry for more than 30 years. For more information, please visit www.DeltaAssociates.com.

ABOUT TRANSWESTERN
Transwestern is a privately held real estate firm specializing in agency leasing, property and facilities management, tenant advisory, capital markets, development, research and sustainability. The fully integrated global enterprise leverages competencies in office, industrial, retail, multifamily and healthcare properties to add value for investors, owners and occupiers of real estate. Transwestern facilitates better decision-making for clients by combining penetrating local market intelligence and macro-market research through its affiliate, Delta Associates. Transwestern has 34 U.S. offices and assists clients through more than 181 offices in 40 countries as part of a strategic alliance with Paris-based BNP Paribas Real Estate. For more information, please visit www.transwestern.com and follow us on Twitter: @Transwestern.

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SOURCE Transwestern