While uncertainty clouds the overall outlook in many sectors of our economy, the Boston commercial real estate market shows no sign of a downturn in 2008. The question now becomes, “How long can this last?”
The Boston office market will continue to be strong well into the upcoming year, albeit with more moderate rent increases than in 2007. Private equity funds’ dramatic foray into the Boston market in 2007 placed tremendous upward pressure on rents. The new owners recognized untapped upside in rents and, perhaps more importantly, are positioned to push aggressive rent increases because they are willing and able to accept more vacancy risk than traditional REITs. Average asking rents for Class A space in the central business district in 2007 were approximately 40 percent higher than in 2006 and are reaching a historical high of more than $65-per-square-foot at year end. With vacancy rates remaining low (at about 8 percent), it is unlikely that we have seen the apex of rental rates. However, as much of the upside has already been squeezed out of the market, and as 2007’s growth rate certainly is not sustainable over the long, rent growth will be far more moderate in 2008.
In the longer term, a major issue for the Boston office market will be the projected supply-and-demand balance. Forecasts vary by source but the consensus is that Massachusetts’ and Boston’s economic growth will be moderate. Based on economic growth projections, The Concord Group, a Newport Beach, Calif.-based real estate consultancy firm, forecasts demand for 1.9 million square feet of new office space in the CBD over the next five years. Currently, there are over 7 million square feet of new office space in planning in the CBD, of which The Concord Group predicts approximately 3.7 million square feet is likely to be delivered in the next five years. Although deliveries would outpace new demand, the impact on vacancy in the CBD (an area with approximately 80 million square feet of existing office space) would be manageable, with vacancy remaining below 10 percent – a very healthy rate in most major metropolitan markets.
In the wake of the subprime mortgage market collapse, the commercial real estate sector must contend with significantly tightened capital markets. With stricter lending standards, the cost of capital has increased 25 basis points to 50 basis points, non-recourse debt transactions are no longer prevalent, and loan-to-cost ratios have decreased 20 percent to 25 percent. Furthermore, increasingly cautious lenders are highly unlikely to provide financing for commercial developments built on speculation. These capital markets trends have contributed to delays in the progress of major new office developments in the Seaport district and elsewhere.
However, despite the overall tightening of lending standards, sufficient capital will continue to be available – and financing decisions ultimately will be regulated by demand and supply fundamentals. Investors, encouraged by moderately strong conditions, remain confident in commercial real estate markets and will look to maintain or increase their investment in the sector. A recent survey of 1,000 institutional and private real estate investors conducted by national brokerage firm Marcus & Millichap indicates that most are seeking to increase their investments in the commercial real estate sector in 2008.
This bodes well for Boston’s strong commercial real estate sector. Attractive rent and vacancy dynamics, coupled with positive demand conditions, will continue to support investor confidence. Quality commercial projects – those in prime locations with strategic tenant commitments – will find funding.
Mind the Gap
Growth creates opportunity, but opportunity exists even where growth is slow. Development and investment in the retail sector will be based more on underserved niches and existing market gaps than on near term economic and household growth. Employment growth, though steady over the past few years, will continue to lag faster growing metro areas such as Miami and Washington, D.C. The Boston area’s household base is likely to increase slowly – by less than 1 percent per year over the next few years. Considering these dynamics along with a slowing national economy and declining consumer confidence, retail opportunities will be based not on a “rising tide” but on underserved niches and existing market gaps.
Boston and Cambridge, a combined market area with roughly 285,000 households, is growing at 0.3 percent per year. Those 850 annual new households would support only about 15,000 square feet of new retail space (assuming average per household annual retail expenditures of $11,000 and average sales of $600 per square foot of retail space). This is hardly the type of volume to attract major development and investment activity. However, these slow growth projections belie the pent up demand that exists in the market.
The area has long been a difficult market in which to entitle and deliver new commercial space, and supply historically has not kept up with demand. Very low vacancy rates – consistently under 4 percent – reflect the health of the market for those who hold commercial assets. Furthermore, underserved categories such as electronics, home goods, and sporting goods represent pent up demand for hundreds of thousands of square feet of new retail development.
In recent years, several major local players have been successful by paying attention to these niches. The strategy worked well for The Abbey Group when The Landmark Center brought much-needed retail categories – including home goods, outdoor/sporting gear, and office products – in a convenient transit oriented location. More recently, Boston Residential Group repositioned struggling retail space at 360 Newbury to a viable outlet with Best Buy.
Major national and international big-box retailers will continue to show strong interest in entering the Boston market. This dynamic is part of a national trend as big box retailers, having saturated the suburban and rural markets, view downtown as the next (last?) frontier for growth.
Retailers like Home Depot, Wal-Mart, Target and others known for large, freestanding, single story, automobile- and freeway-oriented design have in recent years made a strong push into mixed use urban locations. Notable examples include: a two-level Home Depot in Chicago’s Lincoln Park neighborhood, which opened in 2003; two Home Depot locations that opened in Manhattan since 2004; a Target store, which opened in 2001 in downtown Minneapolis; and a Wal-Mart in a 9-story building in downtown White Plains, N.Y. that opened in 2006.
There is significant opportunity for a strategically located, transit-oriented, modified big-box development in the Boston/Cambridge market, and interest among major retailers is high. Target, a national leader in the urban big-box trend, would fill an underserved market niche and is known to be actively seeking space in the market. Wal-Mart remains interested in an urban Boston location after bowing to strong and widespread opposition to a potential Downtown Crossing store.
The adaptation of big-box retail for urban settings has myriad implications in both the private and public realms. As a relatively new and distinct format, the urban big box will require a collaborative approach that incorporates and blends disciplines including, but certainly not limited to, planning, entitlement, architecture, finance, and merchandising.
In early 2008, the Boston District Council of the Urban Land Institute will host a panel discussion focused on unique challenges and opportunities of big box retail in the urban setting.
