December 9, 2004
For Eastsiders, it's been the best recession ever
By ROBERT C. WALLACE
Because the Eastside's share of the regional economic pie has grown, its health affects us all.
The area generally defined as Renton to Bothell, east of Lake Washington, contains a disproportionately large share of the King County's jobs, job growth, personal income and household wealth. Since commercial real estate is so directly affected by and so directly affects the jobs, income and wealth of the entire region, it is instructive to know how that sector is doing.
In general, it's been a crummy few years. The post-boom years have seen increased vacancies and decreased rents in almost all sectors, but one could argue that this has been the best recession Eastside real estate has ever had. Thanks to a fairly diverse employment base (thank goodness for Microsoft) with relatively little participation in the hard-hit aerospace industry, employment was relatively stable.
Unlike in previous downturns, we didn't have the massive over-building, over-leveraging and high interest rates that were so lethal in the 1980s and 90s.
The office market
The boom-bust cycle has been most visible in the office market, perhaps best typified by the partially erected elevator core on Bellevue Way and the stalled excavation on 108th. Hundreds of millions of dollars worth of office projects throughout the Eastside came to a screeching halt, and the vacancy rate shot up from 3.5 percent in 1999 to more than 20 percent.
With virtually no new space constructed throughout the Eastside since 2001, area-wide vacancies have dropped to about 15 percent, led by a dramatic drop from about 18 percent to 11 percent in the Bellevue CBD. This remarkable improvement was due to some extremely aggressive leasing by major owners that brought large users into downtown from other Eastside locations: Symetra from Redmond; Drugstore.com from Interstate 90; Overlake Hospital from east of Interstate 405; Puget Sound Energy from throughout the region.
This stabilized rents in Bellevue, and they appear to have hit bottom throughout the region. But Bellevue's success will leave holes elsewhere, unless Microsoft or someone else snaps up the space.
With the likely departure of AT&T Wireless and regionwide anemic absorption, it does not appear rents will rise enough to spark significant new speculative development anytime soon.
While East King County only houses about a fifth of the industrial space that exists in the Kent Valley, there is almost as many square feet of industrial space as office space 21 million compared with 29 million.
Statistics for the industrial sector are similar: stabilizing rents, 14-15 percent vacancy, some uptick in demand and virtually no construction. Part of the reason is that land costs, traffic congestion, housing costs and labor costs have made traditional industrial uses relatively expensive east of the lake. But the fundamental problem is simply the recession, which appears to be waning.
The apartment market is the real enigma. Vacancy rates are up, rents are down and there has been (until recently) no job creation. Low interest rates continue to siphon the best renters into home ownership.
Despite the gloom and doom (vacancy rates ranging from 6 percent in Bellevue to 11 percent in Issaquah), builders have continued to pump out new units (albeit, at about a quarter the rate of the boom years) and investors are paying record prices.
With the possible exception of central Seattle, the Eastside has been the strongest apartment market in the state.
In-migration, pockets of job growth, the state's highest median income and traffic congestion that encourages people to live closer to their jobs have given strength to this sector.
Skyrocketing prices for houses and condos thanks in large measure to an excessively restrictive Growth Management Act and our Legislature's failure to address tort reform should continue to bolster demand for apartments. Forward-looking investors are making sub 6 percent cap rates and sale prices well over $100,000/unit are commonplace.
Retail continues to be the industry darling on the Eastside, as it is in Seattle. Eastside vacancy rates are only about 4 percent, and as low as 1.5 percent in downtown Bellevue and 0.6 percent in downtown Woodinville.
Other than expansions at or around existing centers, like the spectacular 400,000 square feet Kemper Development is building in the Bellevue CBD, there has been relatively little new development. Restrictive land use policies, high land costs and the fact that much of the close-in area is pretty well built out have constricted the supply of retail space.
Conversion of older retail spaces to new uses, such as an East Bellevue grocery store that has become an auto dealership, have compounded the shortage.
All that, coupled with the fact that even in recession people have to buy bread, has rendered retail occupancy rates fairly stable throughout the Eastside. The result has been continual upgrade of tenants, modest but consistent rent increases and fierce competition for good properties.
Two things that all sectors of the Eastside real estate industry share are record prices and extreme imbalance between demand and supply of investment properties.
Capitalization rates (yields) have been driven to unprecedented lows, with apartments (at 5.5-6.5 percent) and retail (at 6-7 percent) leading the way. I am aware of several multi-family and retail transactions at below 5 percent, and even the former dog of investment properties office is fetching sub 8 percent sales.
There are many reasons for this, and certainly low interest rates have been a major factor. Perhaps as important is real estate's attractiveness relative to other investments. A 6 percent yield isn't very exciting, but it beats earning 1.5 percent on cash. Many are more wary of the stock market than in previous recoveries, and with Greenspan tweaking interest rates repeatedly, the bond market should be even more scary.
Pension funds and other institutions have significantly increased their appetite for real estate, and the whole economy is awash in cash desperately trying to find a safe, respectable yield. Naturally, all this competition for a product that has a fairly finite supply is driving prices through the roof.
Other factors are also feeding the frenzy. There are a number of signs that we are emerging from the recession. Governor Locke, in a Nov. 19 speech, indicated that Washington had created as many new jobs as had been lost since 9/11. We are experiencing modest in-migration for the first time in several years, our population is growing and sales are increasing. There are also signs that our old friend inflation will be roaring back soon.
With rents still severely depressed (and generally well below rents that would enable significant new competition) and the ability to lock in low long-term mortgage rates, what better time to buy? And, of course, there's the fact that Eastside real estate is just fundamentally good real estate. Thanks to geography, previous development, restrictive land use policies, transportation corridors and demographics, there are few places in America that have more long-term potential. So, if you're waiting for prices to drop, it could be a long wait.
As we said, it's been a crummy recession on the Eastside, like everywhere else. But, it is the best recession we've ever had, and signs abound that indicate lower vacancies, higher rents and greater prosperity for those riding the Eastside real estate rollercoaster.
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