Cranes,Trains, and Lease Rates

On a recent Tuesday in late february, DallasCEO  invited five top commercial real estate professionals from across a range of disciplines to discuss the state of the industry in Dallas currently and what they thought the rest of 2007 holds.

The players were Daryl Mullin, senior director at Cushman & Wakefield; Johnny Johnson, principal at CAPSTAR Commercial; Larry Blankenship, senior vice president for Younan Properties; Jeff Turner, senior vice president, Dallas Group for Duke Realty Corp.; and David Snyder, executive vice president, corporate business development for Constructors & Associates. The venue was Truluck’s Seafood, Steak, Crab House on McKinney Avenue, in the shadows of nearly a dozen construction cranes.

If there was one consistent theme, it’s that whatever the national economy holds for the future, the Dallas real estate market can weather it. Leasing activity is strong, rising construction costs have actually benefited developers by slowing the arrival of new properties, and outside investors find Dallas a particularly desirable real estate buy.

WISE GUYS: (from left to right) Larry Blankenship, Johnny Johnson, and Jeff Turner photography by Elizabeth Lavin

(from left to right) David Snyder and Daryl Mullin photography by Elizabeth Lavin

DallasCEO: So gentlemen, what is going on in Dallas right now?

Daryl Mullin, Cushman & Wakefield: At the end of 2006 we reported positive absorption of the office industry of over 4 million square feet, which was a pretty big year, comparatively speaking to other years. And we saw occupancy increase. We saw rates increase, which I think is probably an indicator of a relatively healthy market. I’ve kind of informally polled several other brokers in our operation and we’ve seen a little bit of slowing of activity. I’ve talked to some other folks who believe that there’s some shadow space out there that hasn’t shown on up on sublease rolls yet, but will probably come back at some point. So I think even though we’re coming off a very healthy year absorption-wise—absorption meaning more tenants moved in than moved out—I think that we’re cautiously optimistic. I think that we’ll still see positive absorption in 2007, but maybe not quite as much as we saw in 2006.

Johnny Johnson, CAPSTAR Commercial: A good barometer for us is we’re currently managing around 11 million square feet in Dallas. And a great barometer is just the growth, the internal growth we’re seeing in our buildings. We had an unprecedented year last year. Typically in our industry we see a bit of a slowdown in the holiday season. But this year the momentum carried right into 2007 on the heels of net absorption that was very positive. We’re already through February. We can already kind of see the first quarter coming to a close next month. At the end of the first quarter of this year, we will have done more leasing in the first quarter than we did in the last half of last year. We’ve all been in the industry a long time. … We’re always looking ahead thinking, Well, nothing’s forever. But at least for 2007 the investment side is very active. The office leasing growth is very active. We’re seeing new net construction. So we’re very optimistic.

Jeff Turner, Duke Realty Corp.: (Lease) rates never rise as fast as it seems like construction costs do. For instance, on the industrial side, one of the things we’ve tried to do is really figure out how to build buildings at a scale and scope on well-priced land that kind of offsets some of that. … On the office side what we’re doing is, in the suburbs we’ve tried to figure out how to really pay attention to what we call this new value-office product, which is basically a hybrid. It’s tilt construction, but we dress it up by putting it in a nice park and putting some nice stone accents on it. … I think on the industrial side and on the office side, 2007 actually will surpass 2006. Dallas on the industrial side is as well-situated as any place in the United States to capture a huge amount of big logistics business and big distribution business with the addition of the intermodal trade.

DallasCEO: That raises the question, what’s going on with South Dallas? Will it be a big part of that?

Turner: I think this is very exciting for Dallas. I mean, there was a time in 1993, let’s say, where we had a little over 300 million square feet in Dallas. As these companies look for distribution hubs across the United States, Dallas would every once in a while fall into a top-five hub or a top-three hub as far as the choice of user. Well today we’re almost always considered a top-five hub and almost always considered a top-three hub, which is huge. Somebody wants something on the East Coast, somebody wants something on the West Coast, and in Dallas. They’re flooding stuff by train into Dallas, by rail, and then it gets dispersed from here all up in the Northeast. So I think you’re going to see a big increase in the big boxes that get built in Dallas, although the land’s a problem. You might have to go out into the suburbs now, but that’s a huge driver for us in Dallas on the industrial side. I think we’ll end up being the biggest industrial market in the United States.

Johnson: You know, we haven’t talked a lot about just the dynamics of the investment activity on the office side. It’s really the world that we live in. But with all the buyers that have bought in Dallas, we’re seeing whole new faces of investors who have never bought in the city before. [If they’re from] either East Coast or West Coast, they’re having sticker shock on seeing just astronomical numbers on buildings. In New York, buildings in Midtown are trading for up to $1,000 a square foot, and on the West Coast the better submarkets go for as high as $800 per square foot. They’re coming into Dallas and seeing a real value perception play that they can buy a building for [far less.]

Larry Blankenship, Younan Properties: Prime example here. [Younan Properties is based in Los Angeles and has recently become one of the largest landlords in Dallas through aggressive acquisitions. —ed.] I’m sure that probably is the case. I don’t see anything in the immediate future that’s going to change it at all. Dallas represents the largest single city for us, from the standpoint of what we own. We have 6.2 (million square feet) here and we’ve got 200,000 in Houston. We’ll certainly try to grow more in Houston but we’ll also grow here in Dallas, as represented by the Thanksgiving Tower acquisition [in late February]. We love Dallas for a number of different reasons. First of all, we find the cap rates here to be very competitive, even though they did slip some this last year. In comparison, on a national basis, it’s still very competitive, and certainly on a cost-per-square-foot basis it would be difficult to find a better value across the nation than what you’re able to find here in Dallas for office space. We just see the fundamentals are here. We’ve certainly experienced it since our significant acquisition began in August 2005 here in Dallas. Since then, with all of our properties we’ve experienced positive absorption, and we’ve exceeded our leasing expectations from what we had in our pro-forma.
 
Turner: When things get like that it reminds me all of a sudden that things can also go the other way. And as bullish as we are—and I think this will be the best demand year we have and the best leasing year ever—it’s also about that time we start thinking about what’s around the corner. Because these cap rates are getting low you start to wonder, Well, gosh, how much risk is someone going to take for that low of a return?

DallasCEO: Are we at a peak right now?

Turner: If we’re not at a peak I can’t understand why we’re not. I’d like everybody’s insight on that. I mean, I still think we’ve got a little bit of fuel. Like I said, we’re not white-hot yet, but sometime in 2007 we hit something that you might turn white-hot and certainly in Dallas and other places when white-hot hits, you got to start thinking about battening down the hatches a little bit.

DallasCEO: Dallas’ economy looks strong, according to the Dallas Federal Reserve’s latest report. On the other hand, former Fed Chairman Alan Greenspan said that there’s about a one-third chance of a slowdown or even a recession at the national level by the end of the year. How does this affect your outlook?

Johnson: If we’re creating 80,000 to 100,000 new jobs a year and you translate that to real absorption and what it means in net absorption to the city, 80,000 to 100,000 new jobs a year equates to approximately 4 to 4.5 million square feet in net absorption in the office workforce. That’s a very healthy market. There have been times through the different cycles in our city where we’ve had greater absorption years, but it’s a very healthy market, given where we’ve come in the last 10 years. So again to Jeff’s point, you can’t believe the sky’s never going to fall again. We’re in a business that’s a very cyclical business and there’s going to be trends.

Mullin: I think that on the investment side, I’m hearing speculation you’re going to see maybe more domestic-based investors sell their properties. The United States is still a great place to invest in real estate, and the returns that the national community is able to achieve in our market and throughout the United States and in Texas and in Dallas is certainly a lot larger than what they can do outside the United States. It’s also a safe place to invest. So I think what we’re expecting is we’re going to start seeing more of the international community. We’re already seeing it. I think we’ll continue to see international funds flow into the United States for real estate investments.

Johnson: We’re working with a large German bank right now that, again, the cap rates are in the 6 to 6.5 range for a trophy asset. That looks pretty good to them. They’re not flinching because they’re benchmarking against other parts of the world where there’s been more cycles or there is more risk in a given city and particularly in Europe. Their long-term mentality is: We see there will be cycles, but we’ll feel good over the next 10 to 20 years. And that’s their horizon for which they’re willing to hold onto this real estate.

Mullin: Johnny made the statement a few minutes ago about you can overbuild a market.

Johnson: Our vacancy rate right now is 21 percent in the city and you would think that we’re in Manhattan where it’s 4 percent. This is when we start throwing up the cranes. Again it’s a mentality in Dallas that … we’re very pro-business. We’re very pro-growth. We have an exceptional real estate community here with a lot of bright people. It’s an industry here, and so they’re always going to figure out how to make a deal. We have people who want to make deals in this town whether it’s build buildings, expand an industrial, go outside a box, or create a market with this whole concept of intermodal play that’s happening.

Johnson: Dallas—and the rest of Texas—starts at kind of a low basis. It’s a good place to buy a big new home for a good price. It’s a good place to get a good piece of land compared to the Miamis of the world or the Californias. So our upside maybe does go a little bit longer … But as Johnny said, we’ve seen a couple of cycles too. We currently are building a lot of space in town in a lot of places at high construction numbers, and there’s going to have to be a lot of tenants come to take care of that.

David Snyder, Constructors & Associates: The thing is, we’ve gone through this before. We have a tendency to overdevelop in Dallas. One thing Dallas doesn’t have a shortage of is developers or contractors. We’ve got plenty of them, and like Johnny said, something dips below 10 percent occupancy [and] we start firing them up.

Blankenship: The other thing, too, is that for large corporations or even for companies like ours that own in global markets, again, it’s the overall growth. I mean we are purchasing a large number of assets in Chicago as well. We see Chicago very similar to this market. There is a great opportunity for upside and the ability to get in and purchase these assets at prices that we feel are competitive that will allow us to meet the leasing objectives that we’ve set for ourselves. We see this as very positive. So we’re really looking at it across the board.

Snyder: I’d love to hear what cities you all project. Which ones do you think are great cities other than Dallas? Phoenix has always been a hot market, and I hear less about Atlanta than I used to.

Blankenship: The three cities that we’re predominantly focused in right now are Chicago, Dallas, and Houston. And that is for a couple of different reasons. Number one is we love the Central time zone. We love being in the center. Also, these markets are experiencing significant increases and have been over the last eight quarters, and so we see that the opportunity for increased growth in these markets is there and of course obviously the economics of the buy is there. You got to get the buy right in these deals to make them worthwhile.

Now we are in fact moving out of other markets. We just recently last year sold the last assets that we had in Southern California. And that was predominantly because we really felt like we had gotten to a point to where these assets were going to trade at values that were significantly greater than what we had purchased them at. And the concern was how much higher could it go? And so because of that it became important to go ahead and trade those assets. But that also fuels additional buys. It’s what’s fueled more buys in Dallas, more buys in Chicago. I think that we’ll probably be seeing the exact same thing in Phoenix as well. We’ll probably begin to sell some of our assets in Phoenix and redeploy those funds into areas where we feel like the growth is more substantial than the three markets I’m talking about.

Johnson: We just witnessed a transaction with a national software company that was based in California. After the deal was completed, we asked what really were the top three reasons for moving: Why did you chose Dallas? What were the real driving factors for making your decision? We always think that it’s rent first and that it’s all about the rent. [But] the first reason was quality-of-life issues. Secondly, they wanted to be in an area that they knew in the long-term was going to support a good commuting pattern. So they wanted to be near an area that was really going to provide great access. Proximity to an airport was very important on the list. Also, quality of life once they’re in the building: the fact that we put in a health club, they wanted a conference center, and a shared conference center—all the amenities that their people will use or hope to use were very big. Then the efficiency of their space and all the basic elements were here but then about fifth on the list was occupancy cost.

Turner: I think sometimes we do put too much emphasis on sticks and bricks and cost and rent. At the end of the day, and you said something earlier, you know this town has the aura of this can-do city. Let’s get it done. Let’s make a deal. Let’s go make it happen. A buddy of mine called from Las Vegas the other night and said he ran into a guy that wants to move his company here from California. He can sell his building for five times what it’s worth, come out here, and get a great real estate deal. Overall, when people come here they get the sense that it’s a can-do kind of place. Where’s more of a can-do kind of place than Frisco right now? It seems even when things get tough in the bottom of the cycle, we’re always trying to figure out how to make a deal. With your relationships—brokers, developers, contractors, all the tenants you’ve grown to know over the years—you can figure out how it happens. It gets harder, but for some reason, Dallas figures out how to get it done in good times and bad.

Mullin: I think when you look at Johnny’s point in regards to why tenants want to come to Dallas … if you look at the top three of those five things, they’re focused upon the employee and the quality of life of the employee. The reason why is because retention is so critically important to corporate profits.

Snyder: I think that what you’ve seen is we’ve been fortunate to win some of the projects but the stuff that’s going into new buildings that are being built—the new class-A buildings—a lot of what that’s for is recruitment and retention. It’s to attract and retain these younger lawyers and accountants. They’re using their office space to develop their culture and to attract and retain employees.

Johnson: If you don’t make the upgrades, if you don’t do the right things to create a greater quality of life, you’re going to lose employees. You’re making a huge financial bet on the front end without anything guaranteed on the back end. But if you don’t do it, there’s the risk that you’re going to continue to fall further and further behind.

DallasCEO: Switching gears, but only slightly, you bring up quality of life. Increasingly, there seems to be an emphasis on sustainable design and environmentally friendly development. Is this just the latest trend or something here for the long haul?

Snyder: It’s here to stay. It’s here to grow for a couple reasons. One is, everybody is conscious of the environment—again attracting the workforce, the younger, new workforce that’s coming. They’re very conscious about the company they’re going to work for, what they’re doing to impact the environment. When you go for LEED [Leadership in Energy and Environmental Design] certification there’s a lot of different levels you can do, and if you do it in a planning stage at the very early part of the job, it’s not a whole lot more money. The payback is fairly soon. But as much as anything, I think everybody’s concerned about the environment and the impact we have. I mean we’re trying to contribute to the planet we’re on and help it sustain. So it’s all about sustainability. It is not a trend. You will see more and more of it. We’re getting ready to do a project in San Antonio right now and it’s an old Albertson’s store. It’s 80,000 square feet and it’s going to be a call center, and they want certification on it. That was something that we never would have thought about before.

Johnson: I think the awareness (about green building techniques and sustainable development) is growing. The city and the state are going to get really behind it, and the local developer and construction community is getting well ahead of it. At some point it’s going to almost be a mandate.

DallasCEO: But it’s not just about quality of life, it’s also energy costs, isn’t it?

Turner: We’re seeing tenants that are much more sensitized to not only the energy efficiency aspects of (sustainable development) but, as we’ve all said, quality of life issues. But they know that the market will see they’re a great corporate citizen, too. That has value.

DallasCEO: Back to the big question, and after hearing from your peers in other aspects of the industry, any last thoughts on where Dallas is headed?

Mullin: Back to my initial comment about cautious optimism in Dallas, one of the reasons I’m skewed in that direction is I’ve seen more mortgage companies and companies that are tied to the home-building industry that are kind of pulling their horns in. Centex gave back a floor. Countrywide’s put some of their expansion plans on hold. Bear Stearns, EMC Mortgage—those guys have downsized. So I think that that’s one of the reasons that I was saying that at the outset. I think that there are parts of our economy that we should continue to be very optimistic about. But that particular industry, that’s what I’m a little concerned about.

Snyder: I think we’re fortunate that we’re diversified. The medical industry right now is booming in Dallas. If the mortgage businesses aren’t doing well, or the lending dot-coms of the world, and some of these processing lending companies are slowing, it won’t have as large an impact. You turn around and there’s the energy and oil companies that are here and they’re all growing. We can’t get enough space to build them.

Blankenship: I think there are so many things downtown that are positive right now. Stop and think just about what it was like two years ago. And even in that short period of time, downtown has changed enormously. I think we’ll look back two years from now and we will have the same difference in change. And I think the change will be positive and hopefully will bring even more demand for space.