I attended the 2017 Minneapolis/St. Paul Commercial Real Estate Valuation and Appraisal Forecast Summit held at the Golden Valley Country Club on Friday, January 20, 2017. Topics centered on valuation trends for the retail, industrial, office and multi-family property sectors. This article looks back on some key highlights from 2016 and expectations in 2017.
My Top Takeaways for the Four Property Types
Retail – Cap rates initially compressed in early 2016 then stabilized and have ticked up slightly in the past 30 to 90 days.
Industrial – Continued growth of ecommerce is helping fuel industrial development and change space need requirements. Limited supply exists for owner user buildings less than 25,000 square feet.
Office – Bifurcated submarkets continue to exist in the Twin Cities. Some very strong submarkets and buildings with good rent growth and other markets or buildings remain challenged.
Multi-Family – About a $1,000 rent spread exists in some submarkets for high-end Class A properties compared to Class B/C assets. Cap rates for Class A properties were pretty flat in 2016. Cap rate compression continued for Class B and C properties, particularly with the wider rent spread.
Retail Market
Rental rates for existing retail properties Minneapolis/St. Paul metropolitan area saw minimal growth over the past 12 months. New construction costs are higher, causing rental rates to increase for new developments. It’s common for rental rates for new construction, single tenant retail buildings to be in the $40 to $65 per square foot, net range. Overall occupancy costs will continue to rise as CAM and taxes increase.
Health ratios or total cost of occupancy/gross sales can vary among retail tenants from 5%-20%. This is a vital metric in determining the long-term viability of tenants and important for investors to try obtain in-store sales. However, sales data is not always readily available. Restaurants want lower ratios near 8%, whereas quick lube facilities net rents are often 12% to 16% of gross sales.
Cap rates trends were mixed over the past year as they initially compressed in early 2016, then stabilized and have ticked up slightly in the past 30 to 90 days. The main factor contributing to the increase in cap rates for retail properties is the rise of treasury rates. During 4th Quarter 2016, the 10-year Treasury Yield increased 82 basis points to 2.45, up from 1.62 at the start of the quarter. Spreads for interest rates are currently about 160 to 210 basis points above 10- year treasury.
The cap rate range for retail properties in the Twin Cities is generally 4% to 8%. The low end of the range reflects ground leases with tenants such as McDonalds. Often times, they will lease the land and construct their own building. This has a lower level of risk to the owner of the real estate because they receive a steady income stream from a strong credit company, and at the end of the lease term, would retain the building if the tenant vacates.
For strong credit, triple net tenants, cap rates are about 5.0% to 6.0% and about 6.0% to 7.0% for moderate credit tenants. The Walgreens merger with Rite Aid has slowed transaction volume in the drug store sector due to uncertainty among investors about future store closures, etc. CVS stores are now trading at a slight premium over Walgreens due to added Walgreens/Rite Aid supply to the market and changing lease terms.
Multi-tenant retail centers cap rates tend to be slightly higher in the range of about 7.0% to 8.5%. Class C properties, particularly in outstate MN exhibit a wide cap rate range and can approach 10% or higher, depending on the tenant mix, location, etc.
According to the Net Lease Market Report, 4th Quarter 2016, the expectation is there will likely be upward movement in cap rates moving forward. As part of the Net Lease Report, The Boulder Group conducted a national survey and the vast majority of active net lease participants expect cap rates to rise in 2017. The largest segment of net lease participants expect cap rates to increase between 25 and 49 basis points by the end of 2017.
Industrial Market
From manufacturing to service industries, e-commerce continues to change industrial trends with delivery times an important factor. This continues to drive demand for distribution centers, with cubic volume a major consideration as buildings with 32 to 36 foot clear heights are being built. It’s interesting how building and design trends change over time. In the not too distance past, high ceiling heights often resulted in some degree of functional obsolescence as they tended to be designed for special purpose uses.
One panel member cited an interesting statistic tied to the changing industrial demand needs for retailers. Reportedly, a traditional brick and mortar retail company with $1 billion in sales needs about 300,000 square feet of warehouse space as they also use their stores for storage. This compares to 1.2 million square feet of industrial space needed for an online retailer doing $1 billion in sales.
The story in 2016 was positive absorption, particularly the speculative industrial development that was delivered in 2015. About 2.6 million square feet of speculative industrial development was delivered in 2015, of which about 80% was located in the Northwest and Southwest submarkets. About 1.9 million square feet of this speculative space was reportedly vacant 12 months ago. Brokers indicated approximately 60% to 65% of the spec space was absorbed in 2016 and about 1.5 million square feet of build-to-suit space was absorbed. According to Colliers International, about 2.63 million square feet was absorbed in 2016. This is lower than the 2015 peak of 2.96 million square feet, but still well above the 10-year average. The panel indicated a lot of organic absorption occurred with tenants upgrading to newer, more efficient space.
Much of the new construction added in prior years was in outer ring suburbs such as Rogers, Dayton, and Shakopee. As of 4Q2016, Colliers International Industrial Report stated 32% of the vacancy in the entire bulk warehouse market was located in Rogers and Dayton, which comprise just 5.3% of the bulk warehouse inventory. Developers are looking for infill sites as companies seek amenities to accommodate employees. With some new product still vacant, developers are cautiously optimistic heading into 2017 and a little less bullish. Overall, the industrial panel members held a mostly optimistic view for the industrial market.
Owner user buildings in the 10,000 to 20,000 square foot range are in limited supply. Most buildings receive multiple offers when listed for sale.
Office Market
The panelists expressed optimism the capital markets will remain strong in 2017 and into 2018. Buyers are looking for Class A office buildings and even B and C buildings as several Class A buildings have traded in recent years. Cap rates for Class A office are in the approximate range of 6.0% to 8.0%, Class B at 7.0% to 8.5% and suburban Class C cap rates are about 8.0% to 10.0%.
One panel member discussed how historically, rents at the high end of the market topped out around $35.00/SF, gross. This has changed more recently as some upper floor lease rates in buildings such as the IDS Center have seen deals near $40/SF, gross. As some longer term office owners have sold and moved out of the market, newer institutional owners haven’t been afraid to push rates. Of course, the strength of the local economy is a contributing factor as well.
The trend of smaller, specific submarkets outperforming the broader office market has continued. Submarkets and buildings that are able to create unique opportunities include areas such as the North Loop, I-394 Corridor in the West Submarket, France Avenue in Edina and Class A buildings in downtown Minneapolis. These markets have been able to push rental rates higher and vacancy rates are lower. The cost of and availability of parking in the North Loop neighborhood is a concern. Recent proposed office developments in the North Loop area incorporate needed parking spaces.
It was reported much of the sublease space available on the market from about 2012 to 2015 has been backfilled. Absorption was down in 2016, compared to the past few years. This is partly attributable to Wells Fargo vacating out of a few buildings and moving to their new headquarters in Downtown East totaling 1.1 million square feet. Absorption is also affected by other build-to-suit owner user completions. Long-term, the commitment by larger corporations based in the Twin Cities to invest in new space is beneficial as it helps maintain and create jobs and business opportunities.
Multi Family Market
About $1.5 billion in total sales volume was reported for 2016 which is another record year for the Minneapolis/St. Paul metropolitan area. This increased sales activity has led to more competition from more parties, including national investors and is more difficult for some buyers to pencil out the deals. Given the extended strength of the market in terms of rent growth for several years, this has pushed up values and led more buyers to pursue tertiary markets and lower quality units.
Value-add opportunities continue to exist. One panel member discussed how the rent spread between Class A to B properties historically was closer to $150 to $200 per unit, per month in the Twin Cities. As new Class A building have been built with extensive amenities, about a $1,000 per month rent spread is present when comparing top Class A units to Class B/C units. This creates two multi-family markets, those who want and can afford Class A units and those who cannot afford or don’t to pay the higher rents settle for Class B and C units.
The multifamily panel agreed that it is difficult in the current market to forecast stabilized real estate taxes. This is a concern for investors and lenders. Some buyers are 1031 buyers or buying for tax shelter purposes which creates different motivations and can result in higher sale prices. With the continued trend of higher sale prices, assessed values and real estate taxes continue to escalate.
There was discussion among the panel about pressure or challenges for landlords to find adequate maintenance staff for mechanical repairs, etc. with the current tight labor market. In some instances, this has impacted maintenance/payroll expenses. On the flip side, more tenants are starting to be charged back for utilities in Class B/C apartment units which help lower operating expenses and increases NOI.
With challenges in terms of new rent growth, higher vacancy and some concessions, capitalization rates for newer, Class A multi-family product held relatively flat in 2016. Additionally, lenders are scrutinizing new construction projects more closely and investors are selective with location, size and completion timelines. While dependent on building quality, occupancy and location, cap rates for urban core Class A apartments have been in the approximate range of 4.5% to 5.0% and 5.0% to 5.5% for suburban Class A product.
Cap rate compression continued in 2016 for Class B and C product with the value-add opportunities and ability to raise rents. Cap rates for stabilized Class B range from about 5.5% to 6.25%. Finally, cap rates for Class C properties saw even more compression and are about 6.0% to 6.75%, with some dipping below 6%. Cap rates are down about 50 to 75 basis points from 2014/2015.
What challenges or growth opportunities do you see for 2017?
Mitchell Simonson, MAI is an expert commercial real estate appraiser and investor. If you have a market related question, please feel free to call at 612-618-3726 or email mitch@simonsonap.com.
Mitchell Simonson 