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STRATEGY

Outlook 2006: Real Estate

Blowing bubbles.
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The Challenge After the whiplash of the dot-com stock market fall, investors turned to real estate. Bricks. Mortar. Land. It all seemed so...solid. Low interest rates drew American buyers, while the weak dollar attracted foreign speculators (looking for condos, in particular). Recently, though, there has been talk of a dot-com-style bubble about to burst in real estate. "The concern is that amateur investors will try to get out at the first sign of a downturn," says Nick Florez, president of Nevada-based mortgage lender Meridias Capital. "And when they do, we may see a pullback in some areas."

Though several markets--particularly on the coasts--are overvalued, and prices could drop, good job growth and population growth mean nationwide demand probably won't slow drastically. Meanwhile, industry leaders expect areas with strong job markets and good income-tax receipts to continue to chug along, places such as Florida's Miami-Dade and Broward counties, Nevada's Clark County, and Arizona's Maricopa County.

Commercial real estate is based on different patterns and should continue upward. Job growth means employers need more space, and in markets such as Washington, D.C., and midtown Manhattan where there's not much room to build, that demand will shove lease rates higher. Eventually, high occupancy rates should create more supply by attracting developers in areas such as Dallas and Phoenix where there is room to build. "If you get into single-digit vacancy rates, generally speaking, you see speculative development activity coming back," says Kevin Hayes, head of CRESA Partners, an international real estate advisory firm. "And it is coming back, but it's coming back slowly."

Higher interest rates are pushing up development costs, as are the scarcity and price of construction materials. Katrina and Rita knocked out some supply--New Orleans-area cement factories, for example, accounted for 12% of U.S. supply in the first half of 2005--and high oil prices are raising prices for insulation, plastics, and roofing.

What You Can Do Plan for an increase in commercial rents. "I would predict that there will be several markets in 2006 that will reach all-time highs: almost all of southern California, Washington, D.C., and midtown New York," says Hayes. If you have a choice in where you're leasing, look for cities with job growth and lots of space. Dallas, Salt Lake City, Denver, San Diego, Atlanta, downtown New York, and Phoenix are considered good values.

The combination of rising interest rates and rising commercial rents will mean companies must rethink their real estate strategy. Growing companies usually sign operating leases, since they free up cash, but Hayes says variations on operating leases can be lucrative. Leases with a purchase option give you a strike price within a specified time frame; after buying, you can either flip the property or stay on as an owner (and replace the landlord). "Net profit interests" leases give the tenant a share in the landlord's profits and are often used when a developer needs to sign a tenant in order to get construction going. However, Hayes warns, it's becoming a landlord's market, and when occupancy rates are high, landlords usually force would-be tenants to buy outright or sign a strict operating lease--particularly with existing tenants. "The only way that a tenant is going to effectively secure a favorable transaction in a renewal circumstance is to convincingly threaten to leave," Hayes says.

What Insiders Watch

  • The National Association of Realtors tracks median sale prices for residential homes.
    www.realtor.org
  • The Mortgage Bankers Association forecasts mortage statistics.
    www.mortgagebankers.org
  • Torto Wheaton Research (www.twr.com) and the Real Estate Research Corp. (www.rerc.com) produce regular reports on commercial real estate.
  • Job growth (www.bls.gov) and population growth (www.census.gov) are also key drivers of the real estate market.



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