A few weeks ago I had the honor of attending the national Institute of Real Estate Management (IREM) Forecast Breakfast. As luck would have it, the meeting was located here in Portland where I was fortunate to rub shoulders with 800 other real estate practitioners, attorneys, property managers and owners, and to get the latest scoop from the front lines. Now it's not like our gut doesn't already give us indicators (i.e. the phone rings less, or deals are harder to make), but it is nice to know that it is happening to everyone across markets.

Financial Markets

Wally Harding, Senior Vice President of Norris Beggs and Simpson, led off the discussion with an overview of the financial markets. He saw the following issues having an impact on the financing market:

• The potential for inflation

• Energy price increases

• The real estate bubble (fueled by low interest rates and stagnant stock market)

• Likely interest rate increases

• Slowing economy

• Federal deficit spending (I added this one)

His perception is that the cost of long term real estate capital will stay relatively low through 2006. Short term rates, on the other hand, will be increasing. He expects that longer term conduit-style financing will move from the upper 5 to upper 6 percent range and bank financing for similar projects will exceed 7 percent.

Harding expects CAP rates to increase along side an increase in interest rates. What is holding the CAP rates down is too much available money to lend, and significant product demand.

Harding sees the first quarter of 2006 as a good time to borrow and make deals. He encourages us to fix the rate for as long as possible, and to negotiate a secondary financing provision into loans to enable a harvest of equity at a later date. He also suggested that now was the time to move from adjustable rate mortgages to fixed rate mortgages.

Industrial

Lindsay Gordon, the Regional Director of Trammell Crow Company, gave us the industrial overview.

He pointed out that industrial vacancy rates have been reduced from 15 percent to close to 11 percent at the end of 2004.

Gordon also pointed out that it is getting very expensive to build. According to his very detailed figures, the cost of labor and materials for the construction of industrial buildings (mostly distribution style warehouses) has increased from about $20 per square foot for the shell, to about $30 per square foot for the shell -- or close to 48 percent. The cost of labor has increased about 10 percent, and the cost of materials a whopping 61 percent. Rents, on the other hand, have not increased as fast.

Gordon indicated that he expects vacancy rates to drop and rents to increase as existing space is absorbed. He pointed out that historically (1983-2005 Costar statistics), the Portland/Vancouver marketplace has absorbed 2,000,000 square feet per year, but that in the last few years we have only brought an average of 1 million square feet into the marketplace.

Gordon sees a steady stream of distribution and industrial users coming into our marketplace. As in other real estate investments, the CAP rates in industrial also lowered from the 8's to 6's over the past few years as a result of higher demand and lower interest rates. He expects rents to improve to overcome the increases of construction costs and lack of inventory. The only concern that he has is the lack of land available for projects over 200,000 square feet that require a minimum of 5 acres.

Retail

Fred Brunning, President of Center Oak and CenterCal Properties (and co-developer of the very successful Bridgeport Village Project in Tualatin), emphasized that Oregon is one of the least retailed states in the nation. He expects the successes of the recent Bridgeport Village and Tanasbourne properties to increase Oregon's visibility with retail stores and developers. The Crate and Barrel store, which was hesitantly developed by Crate and Barrel at Bridgeport, is one of the most successful stores in the whole chain, outperforming even many of their California Stores.

Brunning is involved in the future development of the 830,000 square foot Cascade Station Project at the airport which will be anchored by IKEA. He expects that store to be one of the nation's highest grossing stores.

The development of non-mall retail space (called 'lifestyle retail') has been very successful nationwide, and will continue to grow in Oregon. It has encouraged the larger malls to renovate and expand to stay young and fresh, such as the Washington Square expansion, and remodel as well as the Clackamas Town Center and Lloyd Center remodels. Vacancy rates are low and in some areas asking rates for strip retail exceeds $30 per foot for shell space. Brunning expects this energy to carry into downtown Portland for redevelopment of existing buildings. CAP rates are very aggressive for retail properties.

Apartments

The good news in the presentation from Jerald Johnson of Johnson Gardner Co. was that he expects vacancy rates to drop to about 4 percent in 2006. This should give owners of apartment properties an opportunity to increase rents. In the last 10 years, net apartment absorption has averaged less than 2900 units per year.

Many apartment tenants attacked low interest rates and purchased homes which drove vacancy rates into the 15 percent range last year. At that rate many owners were fighting for tenants with up to two and three months of free rent specials. That seems to have changed as the short term interest rates have increased.

There are many major ingredients that affect the apartment market:

• Over the past few years, over 4000 units have been pulled out of the apartment market to be sold as condominiums

• Apartment developers kept themselves going by building low income, tax credit apartments

• There is a lack of inventory of land -- especially for larger projects of 100 units and over

• Vacancy rates have been high

• Rents have been low

• Construction costs have increased significantly

• Apartment developers make more money building condominiums than apartments

• The condo market will need to be overbuilt before developers look at building more apartments

Finally, Johnson expects that rents will have to increase 10 percent before builders will be able to justify more apartment building.

Downtown

• UNICO is planning the Lovejoy block with rents in the high $20 to low $30 per square foot due 2007

• Equity Office is planning a building at 1st and Main. Moderate rate increases will reduce the numbers of office numbers and office building owner/buyers and increase the number of business owners that will want to lease space. Because there is a current lack of small buildings available to buy, commercial condominiums will have an opportunity to take hold in the Portland market place.

Summary

In general, low interest rates will keep the marketplace humming into 2006. As population continues to increase, there will be greater demand for space in all categories. Unless there is a major world crisis, 2006 should be a good year for real estate investors.

Buyers do not have much inventory to chose from, and as a result of this tight inventory, sellers will need to decide if they will enter into a 1031 exchange or pay long term capital gains taxes. Congress is deciding on whether to extend the federal 15 percent capital gains tax into 2009 and 2010.

Published: January 12, 2006

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Clifford A. Hockley is the President of Bluestone & Hockley Real Estate Services, one of the larger brokerage and property management companies in Portland, Oregon. Mr. Hockley holds an MBA Willamette University and a B.S. in Political Science from Claremont McKenna College. He is a Certified Property Manager and Bluestone & Hockley Real Estate Services is an Accredited Management Organization (AMO) by the Institute of Real Estate Management (IREM). Mr.Hockley serves as member at large on the Portland IREM board. He has twice been named Certified Property Manager of the Year (2001 and 2003) by the Institute of Real Estate Management and is a frequent contributor to industry newsletters.