I attended the 2016 Minneapolis/St. Paul Commercial Real Estate Valuation and Appraisal Forecast Summit held at the Golden Valley Country Club on Wednesday, January 20, 2016. Discussion centered on valuation trends for the retail, industrial, office and multi-family property sectors. This article details some key highlights from 2015 and expectations in 2016.
My Top Takeaways for the Four Property Types
Retail – Cap rates remained generally flat in 2015. Market rents are increasing.
Industrial – About 2.6 million square feet of speculative multi-tenant industrial space was delivered in 2016, of which about 74% is currently vacant. Slight compression in cap rates in 2015.
Office – Bifurcated submarkets exist in the Twin Cities. Some very strong submarkets with good rent growth and older Class B/C product remains challenged. Operating expenses are a concern of tenants.
Multi-Family – The urban core may be nearing a peak. Cap rates trended slightly lower in 2015. Some value-add opportunities remain.
Retail Trends
The direct capitalization income approach is the preferred method when analyzing single tenant, triple net leased properties. One observation or change noted over the past few years is an increase in tenant improvement dollars spent and leasing commissions for the retail space type. This is particularly applicable when appraising multi-tenant shopping centers using Discounted Cash Flow analysis. As appraisers, assumptions are required to project future tenant improvements and leasing commissions. Construction costs continue to increase and this contributes to higher TI costs.
One retail broker indicated the market is beginning to pay more for leasing commissions (upwards of $10.00/SF) for tenants signing longer lease terms. It’s also recognized retail leases for in-line spaces tend to be smaller (1,500 square feet, etc.) and this has upward influenced leasing commissions paid on a per square foot basis.
Construction costs continue to rise. One recent example was cited in southern Minnesota where hard costs were up about 10%-15% over the initial budget. This leads to more creativity when structuring new deals and at times, impacts entrepreneurial profit to complete projects.
Capitalization rates remain low and have remained generally flat over the past year. 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. Multi-tenant retail centers tend to be slightly higher in the range of about 7.0% to 8.0%, although some grocery anchored centers have traded below 7.0%. 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. All of the retail speakers agreed that no significant changes in retail cap rates are anticipated in 2016.
Market rents have returned or exceeded levels from the last peak. Some tenants seeking Grade-A locations with right-in, right-out access have been willing to pay rent upwards of $60 per square foot. With rents at these levels, future lease renewals present the greatest risk. 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 more investors are seeking to obtain in-store sales. However, sales data is not always readily available. Additionally, a big rent gap can exist between end cap tenants and in-line or interior corner locations within strip centers. This can depend on the strength of the tenants, etc.
All but three of the former Rainbow Foods grocery stores that were sold in 2014 have been filled by other grocers and users in the market including Cub Foods and Byerly’s. A few recent sales of vacant former grocery store big boxes at $78 and $90/SF suggest a significant increase from four to five years ago.
Land sales for most drug store sites such as Walgreens and CVS tend to trade at much higher prices than similar fee simple sites. This is due to the retailer’s motivation to be at that location and reflects a leased fee sale price as compared to fee simple.
Industrial Trends
Investment sales of industrial properties in 2015 were reported as a strong year with some cap rate compression. Cap rates are projected to remain generally flat in 2016. The typical cap rate range for the office showroom space type is about 7.75% to 8.50%.
According to CBRE data, the Minneapolis/St. Paul industrial market has posted five consecutive years of positive absorption. It was reported 11 build to suit projects were delivered in 2015 totaling approximately 1.6 million square feet. This does not include the 820,000 square foot building Amazon is constructing in Shakopee.
About 2.6 million square feet of speculative industrial development was delivered in 2015, of which a significant portion is located in the Northwest submarket. Most of this space has 32’ clear height and are predominantly office/warehouse or bulk warehouse buildings. Approximately 74% or 1.9 million square feet of this new speculative space is reportedly vacant. This represents a significant increase in new supply to the market and impacts the supply/demand equation.
With regard to value add industrial opportunities, brokers reported more calls are being received from coastal participants seeking to enter the market. A number of local development groups remain active in value add projects. One broker indicated industrial properties in the west metro suburbs tend to be more valuable than urban core locations. This is partly attributable to age of existing building supply.
With regard to investors seeking to acquire single tenant manufacturing properties, one broker stated their investment criteria centers on the company financials (strength of the tenant) and consideration of the existing building (how well it serves the company’s long term needs).
As a signal of the strength of the industrial market, the sale of the 585,200 square foot building leased to BAE was cited. The building was constructed in 1941, but features a long term lease. The sale prices was $48.5 million or $83/SF. The reported cap rate was 7.25%. Multiple national and international investors considered the property.
Office Trends
According to Jones Lang LaSalle (JLL), they track about 25 million square feet in downtown Minneapolis and 76 million total square feet in the Minneapolis/St. Paul office market. About 643,000 square feet of positive absorption took place in 2015. Several build-to-suit office projects have been delivered in the past few years and the absorption figures are impacted by these space additions as they are not included in the absorption figures. In the near future, Wells Fargo will be consolidating to their new Downtown East headquarters buildings currently under construction and this will impact the multi-tenant market.
With the looming vacant space coming to market due to the build-to-suit consolidations, one leasing broker recommended making deals with existing tenants is critical. It was noted the Southwest submarket has experienced positive absorption over the past few years and several tenants have made the choice to upgrade their quality of space. This continues to lead to a bifurcation among Class A, B and C office space types and individual submarkets. Some submarkets and office class types are not as strong.
A very strong submarket at present time is the North Loop neighborhood. It was reported the Tractor Works building recently achieved a $19.00/SF lease rate in the North Loop. On a personal note, our appraisal firm recently appraised a brick and timber North Loop office building and saw a similar rate for a lease renewal of an existing tenant. A recent study showed the North Loop submarket is experiencing some of the strongest job growth in the United States within the technology industry.
Tenants are concerned about gross rents, especially as operating expenses and real estate taxes increase. Operating expenses and real estate taxes are pushing $14-$16/SF in downtown Minneapolis.
The investment office market is very robust and healthy. With cap rate compression in coastal markets, more capital is flowing to the Twin Cities seeking higher yield. This local demand is supported by strong demographics, per capita income and diverse economy.
Fewer value-add opportunities are available in the office market at present time. The brokers on the panel stressed the importance of mitigating buyer’s expectations as it relates to lease-up cost assumptions. This includes higher TI allowances, leasing commissions and longer absorption time.
The office panel was asked to opine a range of cap rates for office properties. While dependent on tenant quality, occupancy and location, cap rates for Class A office were reported in the 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%.
Multi-Family Trends
The general consensus among the multi-family panel is that the urban core market is approaching a peak. A question that exists is how much room rents will be able to grow. Some opportunity exists in suburban locations as TIF money is sometimes available.
The Edina market will deliver 800 to 1,000 new units over a few years. It is expected the 55+ age bracket and baby boomers will be the main driver filling these units.
While new construction remains strong, it was reported by lenders underwriting current deals that developer’s pro-forma projections are generally pretty aggressive. Rents forecasted by appraisers tend to be somewhat less. Construction costs continue to rise and real estate taxes remain a big concern as assessments are resetting too much higher levels driven by the robust sales activity at significantly higher values.
Historically, real estate taxes in the Twin Cities have been approximately 20% of total operating expenses in apartments. As taxes rise to as much as $4,000+ per apartment unit in some cases, real estate taxes are approaching 40% to 50% of overall operating expenses.
The Class B/C apartment market remains predominantly owned by local operators, estimated at about 80%. Most local operators tend to prefer operating with slightly lower rents as this leads to lower vacancy and less tenant rollover. Thus, some value-add opportunities remain when long-time locally owned product comes to market.
The multi-family panel was asked to opine a range of cap rates for apartment properties. The consensus was cap rates have declined slightly over the past year. While dependent on building quality, occupancy and location, cap rates for urban core Class A apartments were reported in the range of 4.25% to 5.0% and 5.0% to 5.5% for suburban Class A product. Cap rates for stabilized Class B range from 6.0% to 6.5% and value add Class B apartments are trading about 50 to 75 basis points lower at 5.5% to 5.75%. Finally, cap rates for Class C properties are about 6.75% to 7.5% and 50 to 75 basis points lower for value add deals.
With current market fundamentals and considering the recent increase in interest rates, declining stock market and oil prices, what is your opinion for commercial real estate in 2016?
Mitchell Simonson, MAI is an expert commercial real estate appraiser and investor. Thank you for taking the time to read this article. If you have any valuation questions, please feel free to call at 612-618-3726 or email mitch@simonsonap.com.