CITY HIGHLIGHT, JANUARY 2005

RALEIGH-DURHAM COUNTING ON TECH INDUSTRY

Despite stronger absorption in 2004 than in recent years in the Raleigh-Durham, North Carolina, real estate market, real estate professionals’ crystal balls remain clouded with apprehension as the effects of the economic downturn of the past 3 years remain fresh in everyone’s mind. Forecasters may err on the side of caution when projecting the end of the Triangle’s woes and the beginning of a significant recovery.

During the first three quarters of 2004, true office vacancy rates decreased by approximately 2 percentage points to yield the lowest vacancy rate since the first quarter of 2002. At 17.3 percent, the Triangle’s true vacancy rate reflected a net absorption of approximately 1.8 million square feet in the first three quarters of 2004, which is the most robust since 2000. Last year revealed an increase in new deliveries totaling nearly 1.4 million square feet, with more than 600,000 square feet still under construction. Strong pre-leasing aided in combating any negative impact of the increase in supply-side pressures in the market. Last year’s largest new construction project, American Tobacco Complex in downtown Durham, delivered 465,000 square feet of office space at 77 percent occupancy. In the third quarter, Two Progress Plaza in downtown Raleigh delivered 365,000 square feet of office space at 100 percent occupancy.

However, the real estate industry remains wary in its outlook for 2005. Conflicting economic factors could delay further recovery in the short term. According to the Bureau of Labor Statistics, the local unemployment rate dipped to 3 percent in September 2004, the lowest since May 2001, but ultimately reflects fewer people actively seeking employment. However, job growth did not fair as well. Between September 2003 and September 2004, a mere 8,436 jobs were created in the Triangle, resulting in anemic growth of a mere 1.2 percent. According to the Milken Institute, the Raleigh-Durham metropolitan statistical area ranked 113 out of the nation’s 200 largest metros in job growth between 2002 and 2003. In the Milken Institute’s annual ranking of Best Performing Cities, the Raleigh-Durham MSA ranking declined from 12th in 2003 to 34th in 2004.

With 6 million square feet of office product available as direct or sublet space, owners and lenders are expected to remain conservative with their real estate decisions until stronger economic indicators prevail. With Raleigh-Durham having been recognized as one of the nation’s fastest growing markets in the late 1990s, owners continue to strive toward maintaining relatively stable rental rates for the foreseeable future, while awaiting economic recovery. However, certain projects can be expected to be under pressure to compete with steeply discounted sublease opportunities.

— Caroline Miller, research director, Advantis Real Estate Services Company

Retail

The Triangle area retail development activity is trending more toward planned unit development (PUD)-based development. Developers are finding that within the PUD context they have the greatest latitude to craft a successful retail strategy. Examples of PUD-based retail development include Wakefield Plantation (North Raleigh/ US1 corridor), Brier Creek (west Raleigh) and The Heritage at Wake Forest.

Retail development activity accelerated in the Triangle region during a period of time (third quarter 2001 to third quarter 2004) when office and warehouse development came to a near halt. While vacancies soared in these two sectors, the retail vacancy rate has only fluctuated slightly from a low of about 5.5 percent to a high of 6.4 percent. Current market vacancy is at 5.9 percent in spite of nearly 2 million square feet being added to the market over the past 12 months and more than 8 million square feet in the past 3 years.

The areas that have seen the greatest acceleration of retail development have been southern Durham, northeast Raleigh (US70/Glenwood corridor) and northeastern Wake County (and Wake Forest). Multiple centers have been added in all of these markets during the past 2 years. In addition, the North Hills Mall at Six Forks was razed and is being redeveloped by Kane Realty. The retail portion of the project entails 560,000 square feet. They recently opened several stores including a SuperTarget.

The submarkets that have experienced the greatest growth in recent years have been viewed as attractive for the following reasons:

• strong demographics

• improving to excellent access

• sufficient land available

• reasonable municipal oversight

In contrast, Raleigh’s largest submarket, Cary, experienced very little increase in available retail space since 2000 when the Centrum Center (380,000 square feet) came on line. Cary, which has more than 5 million leasable square feet, saw its vacancies drop to just 2.84 percent in the third quarter of 2004.

Raleigh’s new interstate (I-540), which runs from I-40 on the west to US1/Capital Boulevard on the northeast, has been the catalyst for unlocking the northern part of Wake County and eastern Durham County. This great “enabler” has spurred development throughout the region and is going to continue on to Knightdale (eastern Wake County) by early 2006.

Some of the most active developers in the area include Faison & Associates, the redeveloper of South Square Mall into a power center and Alexander Place (across from Brier Creek). It was recently sold to Inland. Crosland is developing Poyner Place (475,000 square feet) located adjacent to Triangle Town Center. The Weingarten Group is developing multiple neighborhood centers. American Asset Corporation is entering the next phase of Brier Creek with office and hotel development added on to existing retail. JDH Capital is developing multiple neighborhood centers and single-tenant, net-leased properties. Lincoln Harris and Kane Realty are also active in the area.

The retail sector has increased in size by 24 percent (25 million to 33.1 million) in the past 3 years while the vacancy rate has remained steady. Rental rates range from a low of $14 to $15 per square foot (gross) in unanchored retail to the mid $20s per square foot for new power center and regional mall space.

Over the past 12 months, $269 million worth of transactions occurred in the retail (strip center) product type. The 13 transactions, which occurred during the past 12 months, went at an average price of $114 per square foot and an average cap rate of 9.4 percent. Cap rates have steadily risen in this product type from a low of 7.5 percent in first quarter 2003 to a third quarter 2004 high of 10.5 percent. Fifty-eight percent of the buyers were REITs and 31 percent were private, compared with the southeast region, where 30 percent were REITs and 50 percent were private investors. (Source: Real Capital Analytics – 11/1/2004)

— Gary Lyons and Rob Cohen, Sperry Van Ness/AIM

Industrial

There is currently little to no significant new industrial development in the Raleigh-Durham area, and absorption of the current developed space is slow.

There are two developments in northeast Raleigh-Durham: Angela Bobbitt Design is developing 2.38 acres of industrial/flex space on Garvey Road, and Nominee Realty Trust is developing 10 acres on Yonkers Road.

Three development sites in southeast Raleigh-Durham include two by Harold Bagwell: 83.87 acres at Headwinds at Auburn Church Road and 6.6 acres at Crosswinds Industrial Park on Centurion Drive. Blair Stiffs is developing a project called Just Inspections on 4.24 acres on New Bern Avenue.

In southwest Raleigh-Durham, Bobbitt Design Build is developing an industrial/flex project on 1.99 acres on Chapel Hill Road and Algie Stephens is developing 1.83 acres at Hammond Industrial Park on Chapanoke Road.

In the North Hills area of Raleigh-Durham, Lee Singleton is developing 3.12 acres on Tarheel Drive.

The Blount Street redevelopment project is something to watch next year. The redevelopment involves 30 acres of mixed-use, state-owned land. Fifteen of the top local and national players expressed interest in the project, and in October 2004 it was narrowed to five companies — Lennar, Crosland, First Oakland Properties, a partnership between long-time local developers, and an alliance between a developer and private equity fund. They have until February of this year to advance a detailed plan for the site and purchase price. Asking price is between $15 million and $25 million for approximately 21 acres. The project may take up to 10 years to complete.

— Thomas McMahon, Sperry Van Ness/ McMahon & Associates

Multifamily

The Raleigh-Durham-Chapel Hill (Triangle) multifamily market in eastern North Carolina has approximately 84,000 apartment units spread throughout Wake, Durham and Orange counties, which make up the MSA. Research Triangle Park, which is strategically located in the middle of the three-county area, is the private economic engine of the region, and North Carolina’s state capitol in Raleigh that anchors the economy.

The Triangle apartment market is divided into 11 submarkets. Wake County is the most populous of the three counties and has 64 percent of the region’s apartment inventory and four of the five largest submarkets in the region. Durham County has a 25 percent share and Orange County carries the balance of approximately 11 percent.

Over the last 10 years the Triangle has earned numerous accolades as the country’s “Best Places to Live and Work.” With three major universities, a world-class research and development park, and a private-sector economy with unlimited potential that is based on information technology, communications technology and biotechnology, it’s no wonder that population and job growth have outpaced most other areas of the country. New development met the demand, but couldn’t be turned off fast enough when the tech bubble burst in 2000 and the economy declined following 9/11. Apartment vacancies jumped quickly from 5.7 percent in 2000 to 13 percent in 2002. Even worse, effective rents fell by more than 20 percent and still remain at their lowest level since their peak in September of 2001.

In 2001, 5,692 units were under construction when it became evident the market was headed down. New construction dropped sharply to the low of 1,700 units in June of 2003. This represents the most significant development trend of the last several years, namely that multifamily developers have maintained restraint and limited the delivery of new product to the market. This, combined with modest gains in net demand, appears to be the most significant factors in improving the Triangle’s vacancy rate to 7.9 percent in September 2004.

Developers are anxious to get going at full speed again, and the number of units under construction quickly spiked 35 percent to 2,918 units in late 2003 following the 4 percent decline in the area’s vacancy rate from 12.6 percent to 8.6 percent that was reported in September of 2003. Today, new construction has risen to 3,919 units under construction with 4,174 units proposed.

Predictably, the majority of new development has occurred in Wake and Durham counties. Statistics provided by Karnes Research and the Triangle Apartment Association (Karnes/ TAA) in their jointly published Triangle Apartment Reports show that 78.3 percent of the new apartment completions over the past 12 months were in Wake County and 21.5 percent were in Durham County. Over the last 2 years, the development was divided 62.5 percent in Wake County, 37.3 percent in Durham County and only 0.2 percent in Orange County. Community activism and the governmental regulations they have achieved are almost entirely responsible for the lack of development in Orange County.

It is also interesting to note that because Research Triangle Park is the private economic engine of the Triangle, almost 50 percent of the new apartment completions in the last 2 years have been in the Cary/Morrisville/ Apex, Northwest Wake and South Durham submarkets, which surround the Park. Likewise, proposed new construction is concentrated around the Park, with more than 60 percent of the new units planned situated in these submarkets. Continued development focus is expected in these areas as the local technology economy rebounds and employment by Research Triangle Park employers and their suppliers and strategic partners grows.

Another interesting trend that appears to have moderated is the growth of new apartment units in the Northeast Wake County submarket. Northeast Wake was projected to be Wake County’s fastest growing area due to an abundance of affordable land, and it has lived up to its billing. In the last year, 46.6 percent of new apartment construction has occurred in Northeast Wake, and 42.4 percent over the last 2 years. Presently, however, only 6.5 percent of the units under construction are situated in Northeast Wake County, and only 11.9 percent of the planned units. It appears that Northeast Wake is saturated for the near future.

The apartments being built are looking more and more like condominium and townhome communities that are for sale, with more attention to detail and significant upscale amenities. The nicer finishes that are common in projects for sale are being built into the new communities. Upgraded cabinets, lighting, moldings, and hard surface flooring in foyers, kitchens and baths are common features, as is high-speed Internet. Further, new communities are often park-like with fitness trail paths and tot lots, and courtyard gathering spaces. The pools, decks and clubhouses are becoming more resort-like, and communities often include fitness centers, business centers and other amenities designed to distinguish the project from its competition.

With few exceptions, these projects are tailored for renters who don’t mind paying the attendant higher rents that are necessary to deliver these projects to the market. Average weighted rents as reported by Karnes/TAA are $653 per month for one-bedroom apartments; $890 for two-bedroom apartments; $1,161 for three-bedroom apartments; and $834 for all new apartments. This latter number is down 15.8 percent from the average rent reported 1 year ago, which is consistent with the market as a whole. In comparison, the average one-bedroom unit in the Triangle rents for $667 per month, two bedrooms rent for $798 per month and three bedrooms for $1,009 per month. On average, the new one-bedroom units are slightly smaller — 3 percent smaller than the market average — and the new two- and three-bedroom units are approximately 8 percent larger than those existing in the market. On average, the units in new apartment communities are approximately 10 percent larger than the average unit size across the Triangle.

Beyond new development, the Triangle apartment market has been exceptionally hot relative to its size and classification as a secondary market. Since the first of the year, 15 different major apartment communities (each more than 100 units) comprising a total of 3,782 units have sold at an average price of $66,969 per unit. What is even more astonishing, and which attests to the area’s popularity among investors, is that they sold at an average cap rate of 6.34 percent — from a high of 7.58 percent to a low of 5.44 percent. As a result, properties being brought to the market are being priced more aggressively than ever. Presently there are 13 major communities on the market for sale comprising 3,139 units at an average price of $65,992 per unit and an average cap rate of 5.1 percent. These are more like a California, Florida or northeastern cap rates. This is perplexing for many out-of-area investors who have read the Triangle’s accolades and come searching for a “better deal” because it is a secondary market. Part of the answer lies in the fact that effective rental rates are approximately 20 percent lower than they were in 2001, and certain to recover, which also explains why sellers and brokers emphasize “proforma” operating numbers in their sales packages. On the other side of the coin, though, is the fact that the Triangle has thousands of acres of undeveloped land, and few barriers to entry. New development in part caused the decline in occupancy and rental rates and the increase in concessions, and its potential must be considered in making the investment decision.

In conclusion, the Triangle is destined for continued growth because of its technology-based economy and quality of life. No doubt this will spell increased multifamily development, especially as job growth continues and record low interest rates increase. The questions, though, are how much longer will it be before rents and occupancies recover; how long will the demand continue to sustain the record low cap rates we are seeing; and will the market continue to apply those record-low cap rates to non-depressed NOI’s when rents recover?

— James Scofield, senior advisor, Sperry Van Ness

©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.