Land, Ho!

Last year was a good one for commercial real estate. Next year looks to be even better.Here’s why.

 illustration by Anthony Freda
There are almost as many construction cranes in and around downtown Dallas right now as there were at any given time throughout all of Dallas in the heyday of the late-’90s building boom. Vacancies are dropping as fast as the North Texas unemployment rate. Rents, meanwhile, are growing by double-digit percentages. The biggest holdup for developers is the scarcity of skilled construction workers—they’re all out there working on other projects. And more commercial real estate has changed hands in 2006 in Dallas than in any other city except Chicago.

Oh yes, it’s been a very good year. That sound you hear, the cacophony of jackhammers, riveters, and heavy cranes, is the sound of Dallas’ real estate boom. A year ago at this time brokers were telling us everything was in place and they were just waiting for someone to declare it. Now they say the biggest trouble is calculating how high and how long the wave will last.

Skeptics kicked off 2006 warning about rising interest rates, energy prices hampering growth, and a seeming glut of still-vacant space even as new deliveries were scheduled quarter after quarter well past the horizon. The skeptics were wrong. At any given time as a real estate market, Dallas is almost unique in the variables that drive it. And the coming year, by the way, will offer even more variables that are as Dallas as a tuxedo and ropers.

As of this writing (the start of the fourth calendar quarter), Dallas is on track for the best leasing year since 2000, according to Delta Associates, which analyzes commercial real estate trends. Delta CEO Gregory Leisch says that the Dallas-Fort Worth office market has absorbed 3.7 million square feet year-to-date, and it’s on course to absorb 5 million. Marcus & Millichap, meanwhile, says it could be as much as 6 million square feet. The biggest gainers have been Frisco, Richardson, and the DFW International Airport submarkets.

And while there are 4.1 million square feet of construction going on, 46 percent of that is pre-leased. Through the end of the third quarter of 2006, 4 million square feet of office space were delivered—about 1.6 million square feet in the third quarter alone. Of that 4 million, 52 percent was leased by the time construction was completed. That pre-lease percentage is critical; it’s the sign that while construction is robust, overbuilding is unlikely. More than 1.2 million square feet of that is in the Plano/Allen submarket.

Steve Clay, managing director of TD Industries, one of the largest construction companies based in Dallas, said recently over drinks at a restaurant on Ross Avenue that the biggest problem builders are having is finding enough workers.

“And with all the projects in the works, it’s not going to get better,” Clay says.

Some would say that’s a good problem for a city to have.

Another threat to a slowdown would be a rise in interest rates. But the Fed has shown every sign of holding interest rates about where they are or at least keeping increases to a minimum, despite fears in some quarters about the rate of inflation. Jay Porterfield, senior vice president of Countrywide’s relatively new commercial real estate financing division, says he expects 2007’s activity to be on par with 2006.

“It all comes down to the interest rates,” Porterfield says. “And I’m definitely anticipating rates that are friendly to commercial real estate.”

Unemployment started the year 2006 at a four-year low of 5.2 percent and as of the end of September 2006, it had fallen further to 4.7 percent. Marcus & Millichap pegs the job growth for the Dallas area for 2006 at 2.7 percent, or about 75,000 jobs. Leisch’s firm, meanwhile, is projecting the Dallas-Fort Worth market will add a total of 85,000 jobs through the end of 2007. More numbers to consider: The overall office vacancy rate for the city started the year at 22 percent—at the end of the third quarter it was 18.1 percent. That sounds like a lot to the untrained ear, but historically for Dallas that’s on the low end.

Bottom line: More jobs are being created, vacancies are tightening even with all the new construction, and rents—oh, how they climb.

“All of the statistics we see indicate rents are going up a dollar a foot on average, but recent proposals I’ve seen show an average $2 a square foot increase, which is about a 10 percent rent growth,” says Elysia Holt Ragusa, president and chief operating officer of The Staubach Company, which specializes in tenant representation. “When you start seeing 10 percent growth, you’re coming into a landlord’s market.”

And then there are investment sales. With three quarters of 2006 in the books, sales have totaled $2.1 billion, with prices averaging $153 per square foot. If sales in the pipeline and the trends hold, Leisch says, the Dallas area will have made the $7 billion in sales mark for the second year in a row—about 20 percent above 2005. Ragusa says that puts Dallas—the eighth largest market in the United States—second only to Chicago in terms of sales. The last time we had this much commercial real estate changing ownership, Ragusa notes, was back when firms were buying back properties from the FDIC after the crash of the late 1980s and early 1990s.
In case you missed it, 2006 was a very good year.

A look at the numbers suggests 2007 could be even better. For one thing, job growth should continue. As Dr. Mark Dotzour, chief economist and director of research for the Real Estate Center at Texas A&M, says, Dallas’ employment growth should drive the commercial real estate market.

Dotzour believes that organic growth in local industries like air transportation and logistics, information and management consulting—all hard hit by the recession of 2001 and the economic impact of Sept. 11—are starting to fully rebound, and that they won’t be slowed by a cooling of the economy at large. Others agree.

“We are more optimistic now, more aggressive in our projections than we were last year at this time,” Leisch says.

Meanwhile, within the Dallas office market, the two biggest factors at play through 2007 will likely be the high volume of leases coming due and the changing face of who really owns Dallas. A large percentage of that projected $7 billion in sales in 2006 were to a new breed of owner in the Dallas market.

“We’re seeing a transition of ownership to more entrepreneurial owners,” says Robert Deptula, a principal with Transwestern Dallas. “Trizec is selling its whole portfolio. Renaissance Tower is on the market. Bank One Center is on the market. You have Younan Properties out of California, which wasn’t even in this market two years ago, and they’re the largest landlord in Dallas now. These are not the traditional institutions but owners who bring a different mindset and expect a different kind of return.”

Even longtime owners will be looking for changes as many leases expire in the next year or two. Almost 30 percent of all office leases in Dallas will be expiring—13.5 percent in 2007 and 15 percent in 2008.

“What you will have is owners who will be pushing for a lot higher renewal rates to meet their pro forma,” Ragusa says. “But despite that, even though it’s a landlord’s market, it won’t necessarily be that way for too long. That’s the thing about Dallas. We don’t have the land and permitting constraints other major cities do, so landlord markets are short-lived. When the numbers are right, the development community steps in and starts a new round of construction.

“That’s what’s going on in Uptown right now. Rents have jumped dramatically, and so you have another five major office projects announced, four of which have either broken ground or are about to,” she says. “Something will give there.”

Dallas is building a lot of space now, but it’s not overbuilding. And there is still space to absorb, although by Dallas standards it’s getting tight. We have 26 percent vacancy along LBJ Freeway, which has suffered mostly from Tollway envy and all the construction. The only submarket with a higher vacancy rate is along Stemmons, which is still considered the second tier despite some good space. Meanwhile prime properties on the Tollway have little left in the way of premium space.

“There’s a global perception that Dallas is such a free wheeling development environment and that we’re always in a state of overbuilding. That’s almost gospel in the real estate investment arena,” Dotzour says. “If Dallas and Texas outperform the national economy as I suspect they will in 2007, you’ll see developers from all over the country want to come into our market and build. There’s a tsunami of investment capital wanting to get into Dallas real estate.”


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