Sacramento Business Review

Real Estate Trends in the Sacramento Region - 2009 Mid-Year Update

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Office
■ Regional vacancy increased from 16% to 21% since the beginning of the year, which is significant because it is the first time in Sacramento’s history that office vacancy has exceeded 20%. The submarkets hit the hardest are the “new growth” areas of Elk Grove and Roseville/Rocklin with vacancy rates of 39% and 34% respectively.

■ Commercial REO (real estate owned by banks) activity is just now beginning to occur and, together with other types of distressed assets, will represent a large portion of the sales activity going forward. However, banks are having difficulty understanding the assets they have and what to do with them, which is prolonging the REO process. As a result, it is taking longer for distressed assets to become available for sale, pushing out the correction by several months. Although we will see REO offerings during the second half of this year, we expect the bulk of REO sales across all commercial sectors will occur in 2010.

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Ross, M., Thakur, S.K., "Real Estate Trends in the Sacramento Region", Sacramento Business Review, Volume 1, Issue 1, January 2009

What began a few years ago as a correction to an inflated residential market has now become an industry-wide infirmity transcending all sectors of real estate. Everyone in the region has been touched in one way or another.

Consumers have seen their shopping and dining options reduced with the flurry of restaurant closings and surge of retailers declaring bankruptcy. Real estate owners of all property types have watched their balance sheets suffer. Management companies have had to focus much more of their attention on tenant retention as fewer tenants are out looking for space and competition for those that are has intensified (often even within their own building as the amount of sublease space rises). Odds are even the casual observer knows someone who has lost their home, with over 19,000 regional residential foreclosures this past year and nearly 29,000 since the beginning of 2007.

The composition of our economy has dramatically changed as well. As the engine of regional growth for many years, employment in the real estate industry peaked as a proportion of all employment in 2005. By the end of 2005 - coinciding with the peak of the residential market - 26% of all jobs in the region were real estate related. Since that time the real estate sector has steadily lost jobs and now represents only 22% of overall employment.

Figure 1 Real Estate Employment as a Percentage of Sacramento Total Employment

When will the correction end and the healing begin?

While even the most optimistic real estate experts are hesitant to predict any meaningful recovery in 2009, we believe it will likely bring us to or near the bottom of the cycle.  Whether we reach the bottom soon and how long we remain there is primarily dependant on two things: 1) the depth and duration of the current economic recession, and 2) the return of a functioning credit market.  If local employers continue to shed jobs and the lending environment remains in its current paralysis, prices and transaction volume will continue to decline, likely into 2010.  Conversely, if the recession is short-lived and the credit markets return to normalcy, we expect to see a bottoming out of pricing by year-end.

On balance, we believe the Sacramento real estate market is further along in the cycle than many other markets, having already incurred a significant correction in pricing.  Further, the large presence of state government will temper the regional impact of the economic recession, as it has in previous downturns, providing for some relative stability.

Bear markets are difficult to stomach, but for the long-term investor, they provide immense opportunity.  Given the breadth of this real estate downturn and the concomitant economic weakness, it is easy to get overwhelmed with pessimism.  However, for those investors waiting on the sidelines with capital to deploy, we anticipate the next 12 to 18 months will provide abundant, excellent long-term investment opportunities at very attractive prices.  Let’s not forget that strong population growth, relative affordability, quality schools, job diversities, cultural sophistication, endless recreational activities, and proximity to several world-renowned destinations continue to make Sacramento’s long-term outlook very bright!

Retail

While all sectors of commercial real estate are facing a headwind today, the retail sector is particularly challenged due to its relatively high dependence on a healthy residential market.  With home equity diminishing and new residential construction at a standstill, most national retailers have postponed or pulled out of new development deals.  Also, new franchisees and other would-be “mom & pop” retailers do not have the capital to start a business or expand.  As a result, several notable projects have been put on hold this year including the partially built Elk Grove Promenade, a 1.1 million square foot open-air mall, and The Landing, a 439,700 square foot retail and theater complex scheduled to replace the drive-in movie theater just west of Rancho Cordova. 

Figure 2 Retail Vacancy vs. Net Absorption | Sacramento MSA

Owners of existing complexes are also feeling pressure.  With bankruptcy filings of small retail businesses on the rise and fewer tenants looking for space, tenant retention has become a priority for landlords.  To retain tenants, landlords are offering increasing incentives on renewals and, in some cases, are even renegotiating existing leases - agreeing to more favorable terms for their tenants.  With abundant competition for new creditworthy tenants, landlords are offering generous tenant improvement allowances (in multiples of what were offered just a few years ago) and aggressive concessions (in some cases up to a year of free rent).   

The region has seen its share of notable casualties this past year, including:

• Mervyns filed bankruptcy, forcing the closure of all 9 stores in the region
• Starbucks announced the closing of 600 stores nationally, including 5 in the region, with rumors of another round of cuts
• Linens & Things filed bankruptcy and is closing all 4 stores in the region
• Shoe Pavilion filed bankruptcy, forcing the closure of both stores in the region
• High-profile restaurant closings: Melting Pot (Rocklin), 55 Degrees (Downtown), Masque Ristorante (El Dorado Hills), Rusty Duck (Natomas), Fins Market & Grill (Midtown & Davis), Macaroni Grill (Arden-Arcade), Elk Grove Brewery (Elk Grove), Islands (Elk Grove) 
• Fourteen car dealerships have closed - some with multiple franchises.  Greater Sacramento’s new-car franchises have closed at two-and-a-half times the national average

Additionally, we anticipate more bankruptcy announcements and store closings during the first quarter of 2009 as retailers, hoping the holiday shopping season will save them, realize they do not have the financial wherewithal to keep their doors open.  

Figure 3 Retail Growth Area Asking Rents | 4th Quarter, 2008 | Sacramento MSA

However, despite the daily pounding of negative news in the media, there remain bright spots. As consumers focus more on necessities, the value-oriented retailers are benefiting with strong sales and many are expanding locally (Goodwill, Big Lots, Ross, Winco, Dollar Tree, 99 Cents).  Drug stores Rite Aid, Walgreen’s, and CVS continue to expand in the region.  BevMo, Autozone, and several fast food restaurants are also still actively looking for new locations.  Further, Fresh & Easy, a U.K. based neighborhood grocer, is aggressively expanding in the region with approximately 20 store sites identified.  The first wave of stores is expected to open next spring and they are continuing to search for more sites.

Overall we think the retail sector will largely remain weak until the residential market rebounds.

Office
The State of California’s large and active local presence is once again buoying the Sacramento office market during an economic slowdown.  While a significant decline in the private sector has caused overall leasing activity to fall nearly 30% in 2008, the government sector has remained very active.  The state currently lists 44 active requirements totaling 1.1 million square feet of space, roughly a quarter of which will represent growth in state-leased space. However, it is unknown at this time what impacts the state’s much publicized budget problems may have on these requirements.

The most active private sector leasing activity is in the health care, engineering and software related technology industries.  The most common leasing activity today is lease renewals.  With the scarcity of tenants seeking new space, tenant retention has become an increasing priority for landlords.  When possible, landlords are renewing leases with existing tenants well before their leases expire, offering greater concessions including longer periods of free rent and right-to-cancel-early clauses.  Feeling more uncertain about the future, tenants are favoring shorter lease terms (12 – 24 months) so that they can reevaluate where the economy and their businesses are going before making long-term commitments. 

Since the mortgage meltdown and ensuing economic crisis began just over a year ago, many companies related to the financial and real estate sectors have downsized or left the market altogether.  This has created a surge of office space in which the tenant has vacated but continues to pay rent, called sublease or “shadow” space.  Over the past year, roughly 775,000 square feet of shadow space has been created, though it is not included in vacancy calculations since the tenant continues to pay rent. 

With slower than average leasing activity this year, much of the shadow space being offered for sublease remains empty and is converting to vacancy as those leases expire.  This turnover of shadow space, along with significant speculative development and a large number of tenants contracting caused vacancy to increase from 13% to over 16% since the beginning of the year.

Despite an increase in vacancy, concessions, and competition for tenants, landlords remain reluctant to reduce rental rates.  However, we see rents softening next year, along with a continued increase in vacancy and heightened competition to attract and retain tenants.

Industrial
While Sacramento is known to have a resilient industrial market, recent months have proven it is not entirely immune to a struggling economy.  After a relatively strong first half of the year, the region experienced over 250,000 square feet of negative net absorption during the third quarter, the first time in over six years net absorption in Sacramento was negative.  

The vacancy rate moved up 0.3% during 2008, though it remains fairly low at 8.4%.  The availability rate, perhaps a more meaningful measure of market health in that it also takes into account sublease space, is currently at 10.7%.  The amount of sublease space, which continues to grow, is giving tenants more bargaining power as sublessors become more aggressive in their attempt to fill space.

Interestingly, asking lease rates are not falling, an indication that many landlords are reluctant to lock in lower rental rates long-term.  Instead, they are choosing to attract tenants by offering concessions such as free rent and/or a generous tenant improvement allowance.  That being said, short-term leases, in the 12-18 month range, can be made below the asking rate.  Many tenants, nervous about the economy and therefore reluctant to commit to a long-term renewal/lease, seem to favor this.

When the market does improve, there will not be much competition from new buildings.  With a shortage of entitled or industrial zoned land, rising fees, more difficulty in obtaining financing, and modest rent growth projections near-term, it is becoming increasingly difficult to financially justify new construction.  While nearly 300,000 square feet of industrial space was completed last quarter, the development pipeline is virtually empty for the foreseeable future. 

We expect “more of the same” in 2009, with flat rental rate growth, a slight increase in vacancy, and virtually no new construction. 

Figure 6 Industrial Vacancy vs. Net Absorption | Sacramento MSA

Figure 7 Industrial Average Asking Lease Rents | Sacramento MSA

Figure 8 Industrial Construction Activity | Sacramento MSA

Investments
The regional real estate investment market is currently in a transitional period, with pronouncedly slower moving transactions, lower transaction volume, and general downward pressure on pricing. 

Concerned with uncertainties at every level of the economy, commercial real estate buyers have become more cautious and are gravitating towards what they historically know to be safe – well-located, primarily single-tenant investments with creditworthy long-term leases.  Viewed as having more risk, multi-tenant properties with short or mid-term leases (shorter than 10 years), particularly in peripheral areas, are having more difficulty selling as buyers require increasingly higher rates of return.  Value-added commercial properties are also having difficulty clearing the market unless discounted to reflect the challenged leasing fundamentals and the difficulties associated with obtaining new financing for these types of properties. 

The multi-housing market, by comparison, is experiencing fairly solid rental fundamentals.  Many single-family home owners/residents, displaced by the wave of foreclosures, have moved into apartments.  However, general economic uncertainties have also caused a “flight to quality” in the multi-housing investment market, with a distinct buyer preference for newer, stabilized class A or class B value-add properties in quality locations.  Rates of return for these investments have remained fairly stable with only a slight drift upwards.  Sales activity for older class C properties has slowed considerably as only those sellers with extraordinary motivation have dropped pricing to the point necessary to clear the market.  Required rates of return for these lower quality assets have fluxed upward much more aggressively.

Adding to the slowdown in transactional time frames and transaction volume is the added scrutiny placed on buyers by lenders, both commercial and multi-housing alike.  Lenders are requiring larger down payments while lending options have become fewer.  Those lender options that remain have tightened underwriting standards, thereby reducing leverage thresholds.  As buyers commit more capital, more attention is being focused on underlying fundamentals and more consideration is placed on every step in a transaction.

There is a sense among the buying public that a bottom has not yet been reached, causing some pause in buyer activity.  However, opportunistic buyers, many of whom sat on the sidelines during the recent boom, have begun to emerge once again – a signal pricing has become more appealing and that a renewal of transaction activity may not be far away.  We see the regional market staying in a “wait-and-see” mode until early next year, when we believe an increase in the availability of capital (once the debt market settles), coupled with a return of value-added purchasers (as opportunistic buys become more plentiful), will foster an increase in the number of transactions.  The long-term investment fundamentals of the Sacramento region remain very strong.

Residential 

As we prepare to enter our fourth year in housing downturn there remains no imminent recovery on the horizon.  The fledgling residential market, initially driven down almost exclusively by the implosion of “funny money” financing, now faces an economic recession, potentially extending the days of high foreclosure rates and delaying a recovery due to increasing unemployment and financial hardship. 

The median sale price in the Sacramento region has been on a steady decline since the end of 2005, falling nearly 46% through October.  While there are homes that have dropped in value by that amount (and more), this statistic is also influenced by a change in the type of homes being sold.  Progressively more inexpensive homes, driven largely by REOs, are dominating the sales market.  In late 2005, now considered to be the peak of the market, REOs represented just 0.2% of all sales in the region.  During the past three years the number of REOs has grown to become the driving force in sales activity today, representing over half of all sales. 

One glimmer of good news is that sales activity is up.  After bottoming out in the first quarter of this year, sales on both a monthly and year-over-year basis have been slowly but steadily rising.  This upward trend of sales activity after a prolonged slump is typically the first sign of an impending recovery.  Could this mean the market is stabilizing?  It certainly suggests that pricing has become attractive enough to lure more investors and entry-level home buyers off the sidelines.  However, the moderate renewal in activity is confined mostly to the lowest price segment and does not represent broad market stabilization across all price segments.

Further, we still face an elevated foreclosure rate.  What began as a wave of foreclosures caused by the fallout of bad sub-prime loans is now also being fueled by rising unemployment.  Changes to the state’s formal foreclosure process and lender efforts to modify loans have resulted in a drop in foreclosures during the 4th quarter.  However, we believe these efforts are largely delaying the inevitable and, with continued job losses, we will see the trend of rising foreclosures resume in early 2009. 

While a recovery is at least a year (or two) away, it is likely we will reach or approach the bottom of the downturn by the end of 2009.  The local residential market is further along in the cycle than most the rest of the country, having already incurred a significant correction in pricing.  As such, we expect the Sacramento region to be one of the first markets to recover.  However, whether we reach the bottom soon and how long we remain there is dependent on how quickly the credit markets thaw and the depth and duration of the current economic recession.  One thing is for certain, everyone will be watching closely as a healthy residential market is a key precursor for the rest of the real estate sectors to recover.  

Figure 11 Industrial Vacancy vs. Net Absorption | Sacramento MSA

Figure 12 Industrial Average Asking Lease Rents | Sacramento MSA

Figure 13 Industrial Construction Activity | Sacramento MSA