From 1998 through 2001, the Raleigh-Durham, North Carolina, metropolitan statistical area (MSA) saw nearly 3 million square feet of office and flex space built per year, taking the office market from 28 million to 40 million square feet. The majority of the consumption was by telecom- or Internet-related companies. Expanding service businesses, fed by telecom and Internet companies, also contributed to absorption.

In all product types except retail, the Raleigh-Durham MSA commercial real estate market has been in a steady state of decline from late 2000 to the present. With 20/20 hindsight, one can now see that peak valuations for most commercial properties were achieved in 1999 and vacancy rates actually began to climb in 2000, as the “tech wreck” chain reaction dominoed through the marketplace. In the late 1990s, the supply problem began through over-leasing, but later became overbuilding, based upon expectations of continued growth in the technology sector.

Negative absorption of office, flex and industrial space started in late 2000 and has yet to stop. The good news? Closures, layoffs and bankruptcies are slowing significantly. The bad news? There has been no meaningful increase in demand in the face of this unprecedented supply. Unfortunately, several of the area’s largest employers face potential bankruptcy, with Spectrasite and MCI already in reorganization.

Several major market influences will significantly affect the next 2 years:
w Job Growth: Employment trends are still negative in all but the retail sector and education. There will not be any meaningful change in job growth until mid-2003. Most of the area’s “old economy” jobs went overseas, and the government will be downsizing for the next 2 years. Healthcare and academic institutions should lead, as should biotech and some financial services. Low wage retail jobs are growing. The Triangle needs some new employers, as no one expects that the big job generators of the late 1990s (IBM, Nortel, Ericsson, etc.) are going to grow anytime soon.
w Sublease Factor: Landlords will feel the most pain in 2003 and 2004. Subleases are deflating rental rates significantly as word spreads about $12 per square foot, full service, Class A rents, including furniture. Much of the 3.5 million square feet of office and flex sublease space that is still available will expire in the next 2 years. To underscore the seriousness of the sublease problem, consider that 8 percent of all office space in Raleigh-Durham is available for sublease, the highest percentage AnthonyAllenton knows of in any market in the United States.
w Valuations Are Headed Down: Low interest rates have taken some of the sting out of low vacancies, but when rents drop, eventually so do property values. Highly leveraged, non-recourse loans will default when paper equity losses are preferred by owners to negative cash flows. High-priced conduit deals of 1998 through 2000 are the most at risk for default.
w REIT Factor: Office real estate investment trusts (REITS) were the most active developers of office space and are most responsible for overbuilding nationally and locally. They will feel the pain in their stock prices as funds from operations (FFO) decline over the next 2 years. The question is, how low will they cut rents to fill their buildings? Will they sell assets to prop up FFO and therefore their stock prices? REITS have sold appreciated assets to generate cash flow and profits in 2001 and 2002, but can they continue to harvest gains in a declining valuation environment? The response of the two big, local REITS, Highwoods Properties and Duke Realty Corporation, to their challenges will largely determine the course of the local office and flex market.
w New Construction: Thankfully, with the exception of retail, speculative development has almost stopped, but not quite. It needs to completely stop for 3 to 4 years to accelerate a recovery in rents.

Office and Flex

As the overall market “bellweather,” the office market warrants first review. Jobs that fill office buildings drive nearly all other aspects of Raleigh-Durham’s economy, as there are few real manufacturers left in the Triangle area.

As noted earlier, over 2 years of negative commercial absorption is stressing the office market. Of the 8 million square feet of office space available in the MSA, 40 percent is sublease space. This is the highest percentage in the U.S., topping even the San Francisco Bay area, which is at 35 percent. The Raleigh-Durham MSA overall market vacancy rate, including sublease availabilities, is approximately 24 percent — again, one of the highest in the U.S.

The market area most challenged is the Research Triangle Park/Interstate 40 submarket, where most of the new construction of the last decade occurred. The vacancy rate in that market is now over 35 percent in primarily institutionally or REIT-owned projects. Rental rates are dropping, both on face and effective rates. Class A buildings that used to lease for $21 are now fortunate to get $17 to $18, and subleases in those same buildings are capturing a growing share of tenants throughout the market, with 35 to 45 percent discounts for as-is, short-term tenants.

There are no new significant office projects expected to break ground this year, with one notable exception: Progress Energy plans to start a large mixed-use project with 350,000 square feet of office, 20,000 square feet of retail and 80 residential condos in downtown Raleigh to consolidate its office space. When the consolidation is completed, the downtown Raleigh office market will suffer, as nearly 200,000 square feet of space could be vacated, in addition to possible surplus space contained in the Progress Energy project.

Investment sales activity in office and flex property has slowed significantly, but there were two buyers that actually closed office deals in 2002. Craig Davis Properties’ development in North Carolina State University’s Centennial Campus was sold to General Electric’s Pension Trust for $55 million, and Anthony Dilweg’s syndication paid Principal Financial $132 per square foot for the 111,000-square-foot Trinity Place project in west Raleigh.

Industrial

The Triangle has lost many technology tenants that used distribution space, and vacancy rates reflect that fact. Thankfully, small tenant spaces (10,000 square feet and less) have remained fairly stable, but large blocks (50,000+ square feet) are now waging war with one another. Effective rents for large distribution space are well below $3 per square foot, with very few deals being completed at all. Three large industrial deals were completed in 2002: a 70,000-square-foot expansion at a building on Chin Page Road, developed by Panattoni and sold to Property Reserve; 105,000 square feet on Weck Drive that AnthonyAllenton brokered in a building owned by HSA Read of Chicago; and the sale of a new 325,000-square-foot Panattoni warehouse for well below cost ($25 per square foot) to an owner/user that vacated a 90,000-square-foot space at Research TriCenter. Negative absorption is continuing in this property category in all submarkets in the MSA.

Retail

While only eight opened nationwide, the Triangle area saw two regional malls of more than 1.2 million square feet open in 2002. SouthPoint Mall in south Durham on I-40 and Triangle Town Center at U.S. 1 North and Interstate 540 in northeast Raleigh. Urban Retail developed SouthPoint and sold it to The Rouse Company, while The Richard E. Jacobs Group developed Triangle Town Center, which is rumored to be for sale. Both projects are drawing significant adjacent retail development in the form of power centers.

Also in north Raleigh is the mixed-use redevelopment of North Hills Mall. This project, led by John Kane of Kane Realty Corporation, will include JC Penney, Target, cinemas, a hotel, outparcels and many small shops in a long-awaited project across from Kane’s makeover of North Hills Plaza, known as The Lassiter, one of the finest retail makeovers in eastern North Carolina.

One of 2001’s largest retail redevelopments was Falls Village, which BVT of Atlanta recently sold to a Steven D. Bell Company syndication for $25 million. This was another of the year’s largest investment transactions. Grocery-anchored shopping centers have traded for as high as $175 per square foot in the Raleigh area, as retail investments continue to be highly sought.

Wal-Mart, BJ’s Wholesale Club, Costco, Kohl’s and Target have been aggressively building out superstores as well as conventional stores. Most insiders expect big fallout among the discount retailers in the near future. Bi-Lo considered a major expansion into the market, but cancelled its plans in 2002. Walgreens is now rolling out stores, as are Eckerd, CVS/pharmacy and Kerr, which are trying to retain market share.

Multifamily

2002 was a difficult year for multifamily developers and owners in the Triangle as none met projected income goals. Rents continued their deterioration through the year as vacancy rates rose. The combination of renters moving to ownership, job losses and delivery of new units pushed vacancy rates up. The good news is that although there were fewer transactions, sales prices held up. The drop in capitalization rates and the high demand for quality, multifamily product combined to support resale prices.

The largest sale of 2002 was the 552-unit Cumberland Cove in north Raleigh. Berkshire Realty sold the property to Realty Investment Corporation. Frank Quinn of AnthonyAllenton handled the $38.5 million sale. In addition, The Hanover Company of Houston sold 400 units at SouthPoint Mall in Durham, and Keystone Development sold the 270-unit Four Seasons in west Raleigh for $75,000 per unit.
Construction of multifamily is slowing as lenders shy away from new development, but appetite is strong for existing product.
Student housing projects are hot if and when land can be found. Numerous developers are seeking sites near UNC, NCSU and other eastern North Carolina colleges.

Overall, market vacancies stand in the low- to mid-teens (13 to 16 percent), but economic vacancy is in the low- to mid-20s. There are pockets of great strength, however, where the land supply is constrained, such as inside the beltline in Raleigh where Crosland is planning a 400-unit mid-rise project, and near Duke University, all with construction starting this year.

Hospitality

Hotel/motel construction was stopped in the Triangle area in 1999. That was merciful timing for the industry, given the aftermath of the tech wreck and September 11. Average daily room rates and occupancy levels have fallen for 2 consecutive years in the Triangle. A couple of older hotels have closed and/or been demolished to make way for new developments. This has been a small bit of light for an industry that has been struggling to find balance. Except for projects near Duke University and NCSU, it will probably be years before any significant new hotel/motel development is attempted in the Triangle area.

The Raleigh-Durham market is being challenged as never before. But, just as the late 1980s and early 1990s bottom led to dramatic growth, we believe the future remains bright for Raleigh-Durham. The area still has the unique combination of great education, geography, climate, location and human capital that puts it on nearly every relocation target list. Raleigh-Durham now has abundant inexpensive space and labor for the first time in 10 years.

Jim Anthony is president and CEO of AnthonyAllenton.


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