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Las Vegas Commercial Market
A Review and Outlook Report
by Brian R. Gordon
When analyzing commercial real estate markets, there is little
doubt when it comes to measuring the depth and breadth of the current
down cycle. A person need only to look at the consecutive quarters of
negative absorption, vacancy rates that reflect a tripling from their
all-time lows reported just three years ago and a construction sector
that is quickly coming to a halt. These conditions have rapidly
emerged in the Southern Nevada commercial office, industrial and retail
sectors, in stark contrast to the conditions that made the area among
the nation’s most prolific and profitable during the past decade. The
key question that remains is when recovery will take hold and how the
market will respond. The cycle can simply be characterized in three
key phases – recession, reality and recovery.
Recession
Beginning in December 2007, the national economy entered a
period of sustained contraction which has commonly been known as the
Great Recession, for good reason. The economic downturn during the
past two years has been the longest in the post-war era, confirmed by
contraction in gross domestic product, a staple in evaluating
recessions, but it also evident by a marked decline in the housing
market, softening in commercial markets, unprecedented layoffs, reduced
consumer spending and negative performances in nearly every leading
economic measure. It is also worth noting that by October 2008, the
global financial markets were near collapse and material government
intervention was ‘necessary,’ leaving the world in a much different
place from when the recession began.
Locally, market dynamics moved in a similar direction to
national trends, yet the high of the previous peak was the highest on
record, and the low that followed was also without comparison in modern
history. Under the axiom of the bigger they are, the harder they fall,
the drop from the “highest high” and “lowest low” has created a shock
that has rippled through the region’s growth-dependent environment.
This is clearly evident when viewed through the lens of the commercial
and industrial markets.
Office Market
From an office market perspective, the stage was set several years
ago as demand far exceeded historical norms while supply levels were
dictated by accelerating price appreciation and loose capital markets.
The perfect storm for record-setting development activity emerged and
nearly everyone participated to capture their piece of the pie. The
eight percent vacancy rate in the office sector witnessed in 2005
provided sufficient incentive to acquire additional land, design new
product and construct more buildings. The development timeline pushed
supply levels forward in 2006 and 2007 with 3.7 million square feet
coming on line each of those years, followed by another 2.8 million
square feet in 2008. With a market expansion of 10 million square feet
(27 percent of inventory) during that timeframe, even relatively robust
demand was outstripped by the amount of new supply. The result:
vacancies began their steady climb and the imbalance began to
negatively impact pricing.
By the close of 2009, office market inventory reached nearly 50
million square feet as another one million square feet of new product
came online during the year. In contrast, net absorption remained
negative for the year as nearly two million square feet vacated on a
net basis. The out-migration in office space is a function of a
2.1-percent decline in office-using employment through the third
quarter (September 2009 is the latest available data) and contraction
within key sub-sectors, including professional and business services
(down 5.9 percent), financial activities (down 4.0 percent),
information (down 5.6 percent) and government (down 1.0 percent).
These downturns were partially offset by a 4.2 percent increase in
education and health services, though this component has less of an
impact on the professional office segment.
Industrial Market
The industrial real estate market experienced similar pain as
the recession wore on. While the base of inventory now exceeds 100
million square feet, vacant product reached nearly 13 million square
feet, a quadrupling from the low of the current cycle reported at the
close of 2005. Complicating market conditions during the height of the
market’s run up, industrial development was actually moderated because
available industrial land was targeted for residential uses. That
said, from the low-point in vacancies (Q4 2005) through the close of
2008, the market expanded by a still notable 18 million square feet (21
percent of inventory), suggesting developers were able to gear up
operations to meet market demand. Similar to other segments, new
capacity ultimately outstripped demand, providing a sharp rise in
availability.
During 2009, market demand turned negative as nearly 3 million
square feet of net move-outs were reported through the first three
quarters of the year. The imbalance that emerged was driven by
slowdowns in the construction sector that previously demanded more
facility space, while retailers opted for lower levels of inventory
resulting in weaker demand for warehouse space.
Retail Market
As broad economic contraction prevailed and layoffs in the tourism
and construction industries mounted in 2009, consumer spending declined
precipitously. Incomes fell and confidence levels eroded. The impact
has been material to retailers in the Southern Nevada market. In a
sector that historically reported vacancies of 4 percent, retail
landlords have been faced with vacancies hovering in the 10 percent
range. Barring pre-leased anchor spaces that were negotiated 18 to 36
months ago, net absorption was negative during all of 2009. The
downturn was not only a function of local fundamentals but corporate
restructurings and liquidations of regional and national chains.
Storefront closures for companies like Circuit City and Linens N Things
contributed to an unusual operating environment for landlords.
Pricing edged down during the past year as the mix of properties
shifted and foot traffic levels at selected centers suffered. The
average asking rate dipped below $2.00 per square foot from a peak of
$2.20 nearly two years ago. In reality, prices dropped significantly
more and landlord concessions were reportedly at record levels.
Reality
Understanding the dynamic that emerged in the commercial and
industrial market is a difficult one. By late 2009 the reality of the
situation has taken hold for developers, owners, landlords and
financial institutions. That ‘reality’ resembles the feelings
experienced by those tied to the residential real estate market just
two years ago as foreclosure activity picked up and pricing declines
began to accelerate. The freefall was, in many instances, sharper than
the pricing run-ups witnessed in 2004 and 2005. With fewer
transactions taking place during the cycling down of the market,
volatility was also more pronounced. These images are now reflective
in non-residential sectors.
From an office market perspective, the fact that nearly one
quarter of all space is sitting vacant while an additional several
million square feet are under-utilized by those paying rent, suggests
that excess capacity equates to nearly 5 years of effective inventory
at historical demand averages. The impact of such an environment has
brought office market development activity to a halt with the ability
to count the number of projects actively under construction on one
hand. Speculative development is limited due to a lack of pre-leasing
demand and generally stricter lender underwriting criteria as a result.
Dynamics in the industrial sector have been similarly impacted.
As a result of weakening demand, few projects remain under
construction. The most notable project moving forward during late 2009
is the Freeman Warehouse Facility in the southwest submarket, which
totals over 400,000 square feet. The retail sector also witnessed
development activity slow with only a couple of projects actively
underway, including a Lowe’s-anchored center in the northwest and a
Glazier’s Marketplace in the southeast.
Recovery
The preceding provides a historical perspective and a snapshot
of the current realities in the marketplace. The summary is not
intended to cause people to jump out of buildings or raise white flags,
but what it does is set the stage for recovery. The timing and extent
of the recovery remains uncertain at best, but the fact that recovery
is inevitable provides light on an otherwise gloomy operating
environment.
The ultimate increase in demand, reduction in vacancies and
stabilization in pricing will not look like the upswing reported in the
earlier segments of this analysis; rather, the cycle will be founded in
fundamentals and sourced to intelligent business decision-making. The
ability to expand or relocate within Southern Nevada will be a question
of financial viability over the long-run, not a near-term arbitrage
strategy. Caution on the part of business owners and management will
result in a slightly lengthened return to normalcy, but to a ‘normal’
that is realistic and sustainable. The outlook for recovery varies by
sector, but all will ultimately find a new equilibrium.
The office market is expected to respond to a more stabilized
housing market by late 2010, which may have brokerage, mortgage,
insurance and title offices reporting increased demand with a lift from
the overcorrected employment levels today. Pricing will be a release
valve as tenants seek out more cost-effective options that may have
them finding comparable or superior space. Discounting by landlords
may also provide sufficient incentives to outweigh the cost of
relocation. Finally, bank workouts with building owners and
previously-foreclosed properties will be another factor to a resetting
of values and the stabilization of rental rates.
Vacancies are expected to peak by the close of 2010, while a slow
and methodical absorption rate will occur over the 2011 to 2013
timeframe, leaving vacancies in the mid-teens even at the end of this
cycle. The ability to sustain vacancies rates three to five points
below the national average is not expected to remerge during the next
decade. Price adjustments will have rents stabilizing 30 percent below
the peaks reported in the 2007/2008 window. The benefit will inure to
business operations that will be more efficient due to a lower cost
environment.
The industrial segment is expected to experience similar
trends. The recovery cycle will likely be quicker than its commercial
office counterpart as national and regional consumer demand prevails,
ultimately necessitating a need for industrial product. Some of those
gains will be offset by further deterioration in the construction
segment, while emerging industries like renewable energy and others
find Las Vegas to be a cost-effective place to do business.
Retail center construction activity will resume after consumer
spending improves and population begins to expand. Achieving both of
these factors may extend beyond 2010 while selected retailers will
enjoy top line revenue increases for at least two years before
expanding their operations, placing any material incremental tenant
demand in the 2012 to 2013 timeframe.
Consumers and business leaders are committing to hold the line
on expenditures as a shift in thought processes has taken hold. The
recovery locally, while likely to follow the broader economy in terms
of timing, will involve continued corrections in the commercial and
industrial sectors. Opportunistic transactions will continue to occur,
providing additional insight on valuations, while increasing sales
volumes will signal that a bottom to the cycle is in reach. And
finally, a belief that recovery is inevitable will have those directly
involved in the sector responding with motivation to continue deal flow
even at reduced pricing levels while key stakeholders share in the pain
in the short-term in order to regain a foothold in the market from
which they might again be able to climb upward.
Brian R. Gordon
Brian R. Gordon, CPA
Principal of Applied Analysis
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