Where will real estate take investors next? Will it avoid capital losses by riding net operating income (NOI) growth out of the low yield basin; or will it drag investors through a correction, undermining values as yields rise? The answer is in the formula, yield (y) + growth (g) = r (total return). With the yields being what they are, the focus is on underlying growth, or the “g.” And, in fact, as long as growth in NOI meets or exceeds the percentage rise in yields, investors will avoid capital losses. So, the challenge is finding the “g” in 2006 and beyond. Let’s explore the outlook for four main sectors.

Multifamily: Great Growth Story but Pricing and Condos are Big Risks

Good News: The rise of the 80 million echo boomers portend strong demand over the next decade as they enter the prime renting cohort, especially as housing prices remain high. On top of this, condo converters purchased more than 115,000 units in 2005 (through the third quarter) for conversion. This represents approximately 1 percent of the total stock for the 54 markets covered by Portfolio & Property Research. The reduced supply and growing demand will push vacancies down strongly in 2006.
Bad News: In markets where condo conversion and new construction is focused, if the slowdown in the housing market means all those condos don’t get sold, they spill back into the market as “repartments” competing with existing supply. Furthermore, condo converters are buying properties at low cap rates, helping push pricing to the max. In terms of historical spreads over the 10-year Treasury, the apartment sector’s spread is near the bottom of its band.
The Bottom Line: As concessions burn off, vacancy declines and rent gains are seen in the short term, the sector can expect strong NOI growth, which will make apartments a fantastic growth story in 2006. However, a condo bubble pop in certain markets in 2006 will undermine growth in 2007 and 2008. Compared to other sectors it will still be attractive, but the big question is whether that growth will be enough to offset cap rate increases. Our forecasts for NOI growth and cap rate increases says it is unlikely in 2007 and 2008, although 2006 should be safe. Picking up the pieces in 2007 or 2008 may be the answer.

Office: Poor 2006 but a Recovery Play over the Forecast

Good News: Office-using job growth is strong, and a continued steady economy promises at least one more year of solid demand. Vacancies will drop 60 basis points or more over 2006, allowing landlords to fill vacant space for a nice NOI pop before market rents start to reach in-place levels around the end of 2006. Supply is also reasonably constrained, with 2005 being the fifth-consecutive year of declines in completions. Outside of trophy towers in CBDs, pricing is relatively attractive as cap rates are well above Treasuries.
Bad News: The U.S. economy has most likely peaked with a 3.1 percent annual GDP growth forecast between 2007 and 2009. Leasing is ahead of hiring in areas like Boston, San Francisco and Northern New Jersey. What this means is the holes need filling before more space is absorbed in 2006.
The Bottom Line: The prospects for this sector are solid in 2006, with a continuing recovery and strong rent growth, at 4.3 percent. However, unless you are buying vacancy or near-term lease risk, the good news does not seep into NOIs until 2007 and 2008. Metro areas where market rents are most quickly exceeding in-place rents are investors’ best bets, including Orange County, San Diego, Denver, Orlando and Ft. Lauderdale. The strength for this sector is its relatively attractive going-in yields. Compression of cap rates is still viable over another 6 months to a year, and by then robust NOI growth will stave off capital losses (not including fully-leased trophies that cannot take advantage of improving conditions).

Retail: A Market Darling is Losing Steam

Good News: The U.S. consumer keeps on chugging. Retail sales growth is coming off a high, but what a high it was—we have not seen growth near 10 percent since the ’90s. Supply until now was moderate with 102 million square feet delivered in 2005, 21 percent below 2000 levels.
Bad News: Retail is facing a demographic headwind as the Gen Xers (a relatively small generation in terms of numbers) will start to dominate the 35 to 54 age cohort of prime-spenders in 2008. The sector attracted feverish investor interest during the recession in the early 2000s, so pricing is next in line after pricey apartment levels. Also, no other property type has seen as large an increase in planned construction as retail.
The Bottom Line: The consumer has jumped from lily pad to lily pad over the last five years, riding first the stock market and then the housing market to elevated levels of confidence and consumption. The next big thing, wage growth, will not be strong enough to keep retail sales growth at the same level. This year will be a last hurrah with the second-highest NOI growth, at 2.9 percent. Low going-in yields and weaker growth after means capital losses as NOI growth fails to keep up with cap rate increases in 2007 and 2008.

Industrial: Trailing Off but Still Safe

Good News: The sector’s demand drivers, including wholesale inventory growth and retail sales, are slowing but are still at healthy levels. Supply is still moderate at 104 million square feet delivered in 2005. Pricing on the private side is attractive with NCREIF yields of 7.2 percent, and spreads over the 10-Year Treasury are within their historical band.
Bad News: The demand drivers are slowing, and planned construction is picking up. More construction and slower demand will keep rent and NOI growth performance moderate—as is usually the case with industrial.
The Bottom Line: This is a slowing but steady sector. NOI growth will not be fantastic through 2008, but attractive going-in yields, the highest among the four sectors, will minimize cap rate increases, in turn limiting the potential for capital losses. With institutional interest, and therefore planned construction, focused on the major centers (Northern New Jersey, Chicago, Los Angeles), look for development opportunities in secondary markets where population growth will prop up demand—Nashville, Memphis, Atlanta, Phoenix, Savannah and Norfolk.

Conclusion: Finding Growth

As investors search for growth in the coming years, they will find some encouraging signs in each of the four sectors discussed. In 2006, the residential sector is expected to post sizeable growth (before capital losses kick in), and retail is primed for one last hurrah. Moving into 2007 and beyond, the office sector will find its legs providing not only the highest average NOI growth, but also capital appreciation. Industrial is a fantastic growth story, but its additions to the NOI line will not be enough to counter cap rate increases.

Michael Hudgins is a research strategist with Property & Portfolio Research, Inc.