Gradual Improvement

CRE Pricing Recovery Continues With September Rebound

Third-Quarter CoStar Sales Data Reflects Less Distress, Firmer Retail Pricing and Broadening Strength Across the Spectrum of CRE Properties

By Randyl Drummer

November 16, 2011

Commercial Real Estate prices resumed their steady if modest rise in September following a pause the previous month, helping lift the CoStar National Composite Index to a nearly 1% gain in pricing for the third quarter of 2011 over the previous three months.

Two main factors, the ongoing decline in distressed sales activity and the recovery in pricing of retail and multifamily sales -- drove the 0.9% increase for the quarter and the modest 0.4% bump, according to the latest release of the CoStar Commercial Repeat Sale Index (CCRSI).

CoStar counted 825 sales pairs for September, 682 general property purchases and 143 investment grade deals, in slightly lower transaction activity from the previous month. By comparison, only 385 transactions were recorded in January 2009, the bottom of the last downturn, and the September figure is within the historical range of the real estate boom period from 2004 to 2008.

Total deal dollar volume declined slightly in September by 1.2% from its six-month average, chiefly reflected in the general property index, which fell 5.9%, while investment grade volume remained at about par with its six-month average.

Distress sales accounted for 25% of repeat-sale transactions in September and have declined steadily as a percentage of total sales from a peak of 35.4% in March 2011. While distress sales have drifted down over the past six months, the overall level remains high, suggesting that distress continues to be a significant factor in CRE pricing.

Both the investment-grade and general commercial property indices rose about a half-percentage point in September - further evidence that the pricing bifurcation between high-quality and lesser-quality assets is starting to level out. The fifth consecutive monthly increase pushed the general property index to a 1.6% gain during the third quarter over the prior three months, the second straight quarter of positive price growth. The Investment Grade Index edged down 1.4% in the third quarter, reflecting the August softening in pricing.

Sales of non-distressed property sales posted solid quarterly price increases of 2.3% for general properties and 1.9% for all commercial properties. Distressed property sales continued their gradual decline.

The CCRSI Multifamily Index posted a 2.1% pricing gain following the strong 7.3% increase in the second quarter. The multifamily index has jumped 12.3% and outperformed all the other property indices since bottoming out in the second quarter of 2010.

The Retail Index posted the highest gain, rising an impressive 5% over last quarter. However, retail has a lot of ground to make up and was still 3.9% below the same period last year, and 32.8% below its peak.

"Despite great uncertainties in current economic conditions, the commercial real estate market recovery continued, albeit slowly and at a bumpy pace. The steady and solid recovery of the General Commercial Index also indicated broad interest in commercial real estate among investors," according to the monthly CoStar report.

Still, many challenges remain. While overall U.S. retail and multifamily prices advanced in the third quarter, office and industrial prices retreated, and pricing for everything except apartments continues to oscillate in 2011, with the lack of a clear upward trend reflecting the uneven recovery for those sectors in the volatile economy.

Despite the gradual strengthening in pricing of higher-end properties, the investment-grade repeat sales index remained 35.8% below its August 2007 peak, with the composite and general property indices both down from last year and nearly 34% below their peak.

The Office Index fell by 5.1% in the third quarter after posting a strong 15.5% gain in the previous three months. Office is 38.5% below its second-quarter 2008 peak, the largest decline among the four property types. Similarly, the Industrial Index fell by 3.6% in the third quarter, with prices presently 9.3% below the same period last year and 33.1% below their early 2008 peak.

The latest CCRSI results reflect trends noted by CoStar analysts during the recent round of third-quarter market reviews for the office, industrial, retail and apartment sectors.

"The demand for real estate in terms of capital is returning. There is tremendous pressure on investment managers to place money, principally because real estate looks cheap relative to other asset types," said Walter Page, director of research and office specialist for Property & Portfolio Research (PPR), CoStar’s forecasting and analytics subsidiary, during the third-quarter office review last month.

While continuing to struggle, general property transaction activity is showing some improvement of late. While the office market is seeing the lowest level of pricing among the property types by historical numbers, high-quality assets that have traded at premium prices have fueled recent improvements on that front, said Jay Spivey, CoStar director of analytics.

While still prevalent , distress is not as deep in real estate markets as some had expected. The recent Operation Twist move by the Federal Reserve to lower interest rates may have slowed the momentum of distressed sales by flattening the yield curve for banks, Senior Real Estate Strategist Suzanne Mulvee said during the CoStar’s retail outlook.

The Northeast, which saw the smallest pricing losses during the recession, recorded an increase of 2%, the largest quarterly price increase among the CCRSI’s four regional indices. The Northeast Index was only 19.8% below its peak value at the end of the third quarter. By comparison, pricing was 34.8% below peak value in the South, and down 36.4% and 40.1% in the West and Midwest, respectively.

Further color on the quarterly CCRSI regional results includes the following:

• All property types in the Northeast except retail showed price increases, led by office at 2.1%, multifamily (1.3%) and industrial, barely, at 0.1%. The Northeast retail index declined by 3.34%.

• In the West, the composite index posted a 1.36% quarterly increase, offsetting declines over the same period last year. Retail led all gainers at 10.1%, followed by multifamily at 0.2%. However, a 3.7% decline in office prices wiped out gains made in the region since the third quarter of 2010. The West’s industrial index continued its two-year decline, falling another 1.7% in the third quarter.

• The composite index edged up slightly by 0.5% in the South during the quarter, but is still 2.6% below the same time last year. Price gains were mainly in retail (8.9%) and industrial (6.7%). But a big quarterly decline of 6.4% in office mostly offset those gains.•

• Of the four regions, the Midwest is still waiting for prices to reach bottom, with the Midwest Composite Index declining by another 0.8% in the third quarter and currently 9.8% below the same period last year. Prices for all property types except for office continued to fall in the quarter and overall, the Midwest’s prices are 40.4% below their peak -- the largest decline among the four regions.




Good News for Chicagoland Industrial Market

BRIGHT SPOT: Investor Appetite For Warehouse Property Continues to Grow

Improving Fundamentals And Reliable Returns -- Especially For Well-Located Big Boxes -- Lure Institutional Capital Back to Industrial Market

By Randyl Drummer

October 26, 2011

While the economy is volatile and leasing is healthy but not exactly stellar, investment sales of warehouse properties continued to strengthen in the third quarter, with a number of large transactions underscoring the growing demand for this historically safe and reliable sector of commercial real estate.

Trading activity increased across the board in the third quarter, with investors particularly interested in large industrial portfolios in solid markets and a shrinking supply of vacant mega-big-box warehouses in the nation’s key distribution portals, according to Hans Nordby, managing director of Property and Portfolio Research, CoStar’s analytics and forecasting division.

Unlike the top-flight office and apartment markets where prices for core properties have been bid up dramatically over the last couple of years, investors haven’t "backed up the truck" and loaded up on warehouse assets. The industrial sector, however, is the next stop on the investment capital train, said Nordby, who co-presented CoStar’s Third-Quarter 2011 Industrial Outlook and Review with senior real estate economist Shaw Lupton.

Four of the five markets with the largest year-to-date investment sales totals are among the country’s largest distribution hubs, led by Chicago with $2 billion in sales; the San Francisco Bay Area and Los Angeles, each $1.6 billion; Atlanta, $1.3 billion and the nation’s hottest distribution leasing market, Southern California’s Inland Empire, with $1.1 billion in sales.

Ripples from heightened retail and wholesale sales that started 18 months ago, combined with a near freeze in the construction of new warehouses, is resulting in a very rapid turnaround in occupancy rates in super-big boxes of 500,000 square feet or more -- and investors are taking notice, Nordby said.

Granted, not all metros are sharing equally in this sharpening appetite for distribution buildings. Rustbelt markets with the highest exposure to manufacturing and the U.S. auto industry are still seeing weak overall sales, including Western Michigan, Cleveland, Cincinnati, Milwaukee and Detroit.

The strength of industrial real estate is reflected in its comparative lack of distress. Distressed sales, which barely rose above 20% of total warehouse transactions during the worst of the down market, have fallen to about 15%, where they’re likely to stay for at least the next year to 18 months. That compares to 35%-40% distress among hotels, Nordby said.

Despite unspectacular internal rates of return, returns on less flashy warehouse investments are relatively predictable, just the ticket for life insurance companies and other institutional investors who are seeking respite from the rising prices for the best office and apartment assets.

"Slow and steady wins the race. Dull is good," the PPR managing director said.

Some of the top trades of the third quarter illustrate the draw of investors toward big boxes, well-performing portfolios and smaller properties in solid markets.

• In the coveted Washington, D.C. market, Washington Real Estate Investment Trust (NYSE: WRIT) sold 40 buildings totaling 2.06 million square feet for $235.8 million to AREA Property Partners and Adler Realty Services in a deal that closed late last summer.

• ProLogis (NYSE: PLD), in its continuing portfolio realignment following the merger with AMB Property (NYSE: AMB) sold 13 buildings in functional markets in Utah, Texas, California, Ohio, Georgia, Arizona and Indiana totaling 2.8 million square feet for $118 million to Clarion Partners . The 91% occupied portfolio sold at a healthy capitalization rate of about 7%. ProLogis, encouraged by the investor reception, is now said to be marketing a second portfolio that could fetch up to $250 million.

• The quarter also saw triple-net transactions such as the sale of the 1 million-square-foot PetSmart Distribution Center in Ottawa, IL, by Inland Western Real Estate Trust to American Realty Capital Trust for $48.6 million. In Orange County, the 415,000-square-foot warehouse at 17871 Von Karman in Irvine sold to Menlo Equities for $47 million.

Steady leasing fundamentals should continue to fuel investor confidence for the next couple of years, especially in national hubs such as the Inland Empire, Dallas, Atlanta and Indianapolis.

"We think the intermodal demand story -- of goods coming in through major sea ports and traveling inland via rail -- will continue to be an important demand driver into the future," Lupton said.

The third quarter was the sixth straight quarter of positive warehouse absorption at 29 million square feet, for a total of about 80 million square feet year to date. The top five markets of Inland Empire, Dallas-Fort Worth, Detroit, Chicago and Atlanta accounted for half of that total. More than three-quarters of the 210 warehouse markets tracked by CoStar have seen positive absorption in 2011.

Space under construction, restricted mostly to large build to suit projects, is a mere one-tenth of 1% of total inventory, compared to 1.5% during the boom years. Developers, however, are cautiously starting to make moves in certain tightening markets such as the Inland Empire, where occupancy in the largest buildings now hovers at around 97%.

"If I’m a tenant needing more than 500,000 square feet in the Inland Empire, I’m either going to build my own building or move to Phoenix, where occupancy in the largest buildings is only 82%," Lupton noted.

Demand is also starting to pick up for smaller-bay buildings serving local markets in Seattle and other West Coast and Sunbelt metros where the housing market is finally starting to recover.

The national warehouse vacancy rate has now dropped about 70 basis points from its 2009 peak of about 10.4%, with about 1,300 of the 1,900 industrial submarkets tracked by CoStar seeing vacancy declines. The narrowing spread between falling availability and vacancy rates is a sign that quoted rents may soon see renewed growth, Lupton said.

Willis Tower starts to shed terror fears after 10 years

A decade after terrorism fears made Sears Tower a no-go zone for tenants, the Western Hemisphere's tallest office building is showing signs of recovery.

Leasing plunged nearly 20% after Sept. 11, as rumors swirled that the 110-story building was next on terrorists' target list. Major tenants Goldman Sachs Group Inc. and Ernst & Young U.S. LLP defected, and real estate brokers struggled to persuade others to even consider the 1,450-foot-tall tower at 233 S. Wacker Drive.

Currently 82.8% leased, the building is still far from its pre-Sept. 11 peak of nearly 98%. But brokers say they're noticing a change in attitudes toward the recently renamed Willis Tower. Some aggressive rent offers, along with the headline-grabbing 2009 decision by United Airlines to rent more than 600,000 square feet, gave the building a boost. These days, tenants are at least willing to consider moving there.

“People look at it today more favorably than they did right after 9/11,” says David Matthews, a Jones Lang LaSalle Inc. executive vice-president who represented United Continental Holdings Inc. in its move there. “People don't talk about it in terms of 9/11 anymore. They see it as a prominent building in downtown Chicago.”

Willis Tower matters to all of Chicago because of its impact on business, real estate, tourism and the city's image. A struggling, lightly occupied Willis Tower could depress leasing rates throughout downtown.

The tower's owners, Skokie-based American Landmark Properties Ltd. and New York investors Joseph Chetrit and Joseph Moinan, are ready to cash in on the building's improving image. They've listed it for sale at $1.5 billion, nearly twice what they paid in 2004. Real estate experts say they'd be lucky to get $1 billion.

BIG NUMBERS

Every weekday, 8,000 to 10,000 people work in the tower, and 1.4 million visitors are expected on the 103rd-floor Skydeck this year. That would be a 40% boost since the Ledge, a set of glass balconies with a view 1,353 feet straight down, was added in 2009.

Willis Tower was 97.6% leased at the end of 2000 but bottomed out at 78.5% in late 2006. The nearly 3.8 million rentable square feet was 93% leased at the end of 2009 and ended 2010 at 87.5%.

The key challenge is to lease the 315,000 square feet vacated by investment bank Goldman Sachs in 2005. No large-scale leases expire in the next three years, says Michael Kazmierczak, a senior vice-president at leasing agent U.S. Equities Realty LLC.

The biggest new tenant in years, United Continental, is moving 3,800 employees into 650,000 square feet on 12 floors by mid-2012. In doing so, United is absorbing much of the 387,000 square feet accounting firm Ernst & Young vacated in 2010. Brokers note the symbolism of an airline moving in.

“When United committed to move in, I think a lot of people thought, if they're moving in there, the security must be resolved,” says Rick Schuham, a executive vice-president at New York-based Studley Inc. who represents tenants. “I think that was a game-changer for them.”

Other big leases extending into the mid-2020s are London-based Willis Group Holdings PLC, which obtained naming rights in a 2009 deal for 140,000 square feet, and law firm Schiff Hardin LLP, an original tenant, with 217,000 square feet.

BELOW-AVERAGE

The tower's 82.8% occupancy rate is the worst since 2008, when the recession and real estate collapse sent commercial office vacancies soaring across the country. The Class A office occupancy rate downtown is 83.7%, according to Washington, D.C.-based real estate data firm CoStar Group Inc.'s mid-year office market report.

Inking new deals has required lower rents and other concessions, including a nearly $36-million subsidy from the city of Chicago for United. Long-term leases are now $15 to $20 per square foot, with the building offering $50 to $80 a foot in improvements and about a month of free rent for every year on the lease—all fairly standard, brokers say.

“I am still not sure the story would be as positive without the incentives that have been provided to tenants such as United,” says Thomas Volini, an executive vice-president at London-based Colliers International who represents tenants.

Read more: http://www.chicagobusiness.com/article/20110903/ISSUE01/309039974/willis-tower-starts-to-shed-terror-fears-10-years-after-sept-11#ixzz1XBRhEhvY
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Industrial demand falls in second quarter | Trend Of The Week | Crain's Chicago Business

Industrial demand falls in second quarter | Trend Of The Week | Crain's Chicago Business

Willis Towers Owners Seek Investors

(Reuters) — The owners of North America's tallest building, formerly known as the Sears Tower , are looking for a buyer or an investor to help recapitalize the building that is a staple in the Chicago skyline, two sources familiar with the situation said on Wednesday.

The Willis Tower , the 110-story, 4 million square-foot building on Chicago's South Wacker Drive, carries $780 million of debt on it, said two sources, who asked not to be identified because they were not authorized to speak publicly about the matter.

A group that includes Chicago-based American Landmark Properties Ltd and New York developers Joseph Moinian of the Moinian Group and Joseph Chetrit of the Chetrit Group bought the tower in 2004 for about $900 million.

Representatives of those investors were not available for comment.

Many investors who bought U.S. commercial real estate during the boom years of 2003 through 2007 have needed a loan modification or an infusion of capital to hold on to properties because rents or occupancy did not go as planned.

A recapitalization gives a new investor a percentage of ownership in the building in exchange for the investment. As U.S. capital and investment interest has waned and prices have declined, investors from China, the Middle East and Canada have stepped up as new investors and buyers in U.S. commercial real estate.



Read more: http://www.chicagorealestatedaily.com/article/20110601/CRED03/110609981/willis-tower-owners-seek-investor-or-sale#ixzz1O42AzBpZ
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Investment-Grade Properties See Largest Year-Over-Year Gain Since 2006

CoStar's index tracking repeat sales of investment-grade commercial properties jumped 10.6% in January over the same period last year, the largest year-over-year gain since the height of the real estate boom in 2006.

The increase in the index for higher-quality properties hit a five-year high for January despite dipping slightly from December, a reflection of how hard the index fell a year ago and how strongly it has recovered within 12 months.

"Pricing is all relative," said Chris Macke, CoStar senior real estate strategist. "The fact that January's reading was negative on a monthly basis but the largest gain since 2006 on a year-over-year basis indicates how fast the index was falling a year ago -- and how much it has improved since then."

The volume of investment-grade repeat sales transactions rose 54% in January from a year ago, a significant increase that reflects the appetite of buyers for trophy office, apartment, retail and hotel properties. Sales pairs of general grade properties, which reflect sales of non-investment grade buildings, declined 1% over the year-ago level.

The differences between changes in general sales versus investment-grade sales transaction counts and volumes are significant, Macke said.

"The investment grade pair count volume increase of 54% and the 1% general grade increase reflects the split in the market, which is caused by available financing to a large degree," he said.

Sale pair counts for investment and general grade property likely will both increase slightly when additional closings are recorded.

Meanwhile, the general grade index was down 11.3% in January versus the same period last year, even though general real estate index edged up slightly by 0.4% during the first month of 2011.

After being down 2.4% for the past three months and down 11.3% for the past year, the smaller property index may be approaching the market bottom for the first time in the past three years.

The CoStar National Composite Index, an equal-weighted analysis of both the investment grade and general grade indices reflecting the broad overall market, was flat in the first month of 2011. The composite is down 2.6% and 6.6% for the past three and 12 months, respectively, and down 30.7% from its August 2007 peak.

The March report of the CoStar Commercial Repeat Sales Indices (CCRSI) includes data through January. The CCRSI, a comprehensive and accurate measure of U.S. commercial real estate prices, includes a total of 32 sub-indices in addition to the monthly national composite index, including breakdowns by property sector, region, transaction size and quality, and market size.

CoStar tracked more than $211 billion in total sale transactions in 2010, a 79% increase over 2009. However, sales transaction volume remains 63% below peak market levels, despite the clear recovery taking hold in real estate markets.

In January 2011, CoStar recorded 483 pair sales compared to 434 in the same month of 2010, an increase of 11%. CoStar expects to see pair volume running closer to 20% ahead of January 2010 once additional sales from that period are confirmed and added to the database, in line with the 22% higher volume observed in December 2010 versus December 2009.

Distress sales as a percent of total sales increased in each of the four quarters of 2010, with an increase of just over 20% in the fourth quarter and an increase of 18.5% for all of 2010. By property type, the highest percentage of distress in the fourth quarter was found in the hospitality sector at 36%, followed by multifamily (24%), office (21%) and industrial and retail (both near 19%).

By transaction count, General Grade Index sales accounted for 68% of total transactions in January. By volume, Investment Grade Index sales represented 78% of the total. The average investment grade deal size was $10.5 million in January -- down from nearly $16 million in December but more in line with long-term averages. The average dollar size for general real estate was $1.4 million in January, compared to $1.6 million in December.

Also in the March release, CoStar announced a one-time change in the index methodology effective this month. The monthly numbers are now based on a two-stage/frequency-conversion of rotating quarter procedure, which roughly means the monthly changes will now be anchored to quarterly changes, which results in slightly less noise in changes and movements compared with direct monthly estimates. The quarterly indices methodology and approach have not changed.

Health Care Real Estate Mega Deals Show Rebound in Seniors Care Property Sector

Blockbuster transactions this week for seniors housing, skilled nursing and other post-acute care assets by Ventas Inc. and Healthcare REIT Inc. underscore the expansion and growth potential of health-care REITs. The deals also demonstrate that investment in the seniors care subsector has picked up as public companies deploy hundreds of millions in equity capital raised over the last 12-18 months.

Senior care facilities suffered more pain than other health-care properties during the recession as older Americans postponed decisions to move into retirement housing. The sector also endured uncertainty in 2008 and 2009 over the future of government health care legislation and reduced Medicare and Medicaid reimbursements. As baby boomers begin to enter retirement and the population of 85+ -year-old Americans grows, cash-flush real estate investment trusts have scrambled to acquire a diminishing supply of available seniors housing, assisted-living and post-acute facilities.

These factors, combined with a change in REIT tax law that allows health care REITs to own third-party operators to manage and collect income from their facilities similar to hotels, have helped fuel a number of large transactions in recent months, including the two huge deals announced on Monday. As CoStar Group reported last week, . industry executives predict more mergers and acquisitions between both public and private companies.

"These large transactions are a very good sign for the senior housing industry," said Chris Macke, senior real estate strategist for CoStar Group. "It shows that the market, and specifically, health care REITs, is both confident in and capable of transactions that 18 months ago would have been unthinkable. The M&A activity we're seeing is due both to the strong performance of REIT stocks, which provides advantageous capital to acquirers, and the lack of available direct property acquisition opportunities."

Ventas (NYSE: VTN) announced an agreement to acquire Nationwide Health Properties (NYSE:NHP) for $5.8 billion in stock and $1.6 billion in assumed debt, a deal scheduled to close in the third quarter that would make Ventas -- already the largest owner of seniors care property -- the largest health care REIT, with a pro forma value of $17 billion. It's the second massive transaction in the last few months for Chicago-based Ventas, which agreed in October to acquire operator Atria Senior Living Group in a deal valued at $3.1 billion.

"The combination of Ventas and NHP increases the scale and diversification of the combined company, the strength and flexibility of the company's balance sheet and the quality and geography of the assets," said Ventas chairman and CEO Debra A. Cafaro. "With Ventas's successful track record of value-creating transactions and NHP's longstanding history of regional, asset-level acquisitions, taken together with one of the strongest balance sheets in the REIT industry, the combined company will have a unique opportunity for continued external growth."

In the second major deal Monday, privately owned JER Partners and Formation Capital LLC agreed to sell the real estate of Genesis Healthcare, a Kennett Square, PA-based provider of short-term post-acute, rehabilitation, assisted living and long-term care services, to Healthcare REIT Inc. (NYSE: HCN). In the $2.4 billion deal, HCN will acquire 147 facilities in 11 North Atlantic and Northeast states from Genesis, which will continue to operate the senior living facilities through a triple-net lease. In its fourth-quarter 2010 earnings call, HCN announced $2.2 billion of new investments in senior housing assets, on top of $600 million in investment in 19 senior housing facilities, which will continue to be operated by Brandywine Senior Living through a triple net lease.

HCN will have the right to acquire certain facilities at a fixed price that Genesis currently leases from third-party landlords, as well as any facilities that Genesis acquires or develops during the initial 15-year term of the lease. HCN further has the option to acquire a 9.9% ownership interest in Genesis for $47 million throughout the initial lease term. The option will enable HCN to share in the future growth of Genesis, HCN said.

The growth spurt also casts light on a law that went into effect in 2008 allowing health care REITs to both receive rents as landlords and profits from operators through partnership arrangements with operators, under tax treatments similar to hotels. HCN is investing another $1.6 billion in 61 senior housing facilities with Benchmark Senior Living, Silverado Senior Living and Senior Star Living structured as taxable subsidiaries under the law, called the REIT Investment Diversification and Empowerment Act (RIDEA).

Healthcare REIT launched the first RIDEA transaction in the seniors housing industry last year when it announced an $817 million partnership with Merrill Gardens to own and operate 38 seniors housing communities totaling about 4,300 units. The four RIDEA partnerships would boost HCN's senior housing portfolio to 22% of its total portfolio investment. The Genesis deal isn't formed under RIDEA, but HCN hasn't ruled out the possibility of converting it at a later date, said George L. Chapman, HCN chairman, CEO and president, in a conference call discussing the Genesis transaction.

While RIDEAs offer increased operating income, they're also exposed to the economy and property operations turn sour, a risk acknowledged by Chapman.
"We looked hard at whether or not there would be too much exposure given the rewards we would get from engaging in our RIDEA structure," he said. "I think there is some caution. But I could see as we get more color, more clarity on just what exposure there is, going back and talking further with the sellers Formation and JER about perhaps converting into a RIDEA structure. So we’re not against it at all. And the closer we can align without undue risk, the better we feel about it."

Pent-Up Shopping Demand Fuels Surge In Retail Leasing

Mirroring the rebound in other commercial property sectors, leasing and occupancy of U.S. malls and shopping centers continued to improve across the country in fourth-quarter 2010, and CoStar Group economists expect demand to accelerate for the next two years as shoppers open their wallets and the economy adds jobs, leading to renewed demand for retail space.

With the very low amount of new supply of retail space and a strengthening economy, retail vacancy rates are expected to continue to decline through mid-2013.

Absorption of retail space, which has been positive for six consecutive quarters, should continue to be positive through at least mid-2012, CoStar Group forecast this week in its Year-End 2010 Retail Review and Outlook. CoStar Real Estate Strategist Suzanne Mulvee co-presented the retail market report with Real Estate Strategist Kevin White.

"Retail real estate fundamentals have closely followed retail sales, which are now looking quite positive. Retail sales turned positive in 2009 and between early 2009 and today, have eclipsed their pre-recession high," Mulvee said. "We're moving in the right direction from a fundamentals standpoint. Recovery is in motion."

Over the last few months, fears of a double-dip recession have eased and GDP growth, now at around 3%, will continue to be strong through this year and into 2012, White said. Consumer spending, which has improved for the last 18 months, ramped up a strong 4.4% in the fourth quarter, the best since 2006. Retail sales are growing at a healthy 7% clip, levels not seen since the housing boom, White said. Household finances have recovered to a reasonably healthy level, and pent-up demand for consumer durables is solid. Spending on health care and personal care are up 14% while food/beverage spending has increased 5% and general merchandise is up 4%.

But the outlook isn't without risk or potential problems, which could cast a shadow over the longer-term outlook later in CoStar’s forecast during 2013-14, White cautioned. Housing remains locked in a double-dip downturn. State and local government cutbacks will continue to be a drag, especially in state capitals and other metros dominated by government. The federal deficit is expected to hit a record $1.5 trillion this year, leaving a 70% debt-to-GDP ratio that could drive up interest rates.

"We're not expecting consumers to lead this recovery by any means, but we also don't expect them to be the huge drag on the recovery that some of the more pessimistic economists expect them to be," White said. The economy should get a boost from pent-up demand for cars, clothing and electronics.

"American consumers went on a buyer's strike during the recession. Finally, they're loosening up the purse strings and there's a lot of pent up demand that will continue to play out over the next year."

Stepped up leasing activity resulted in 13 million square feet of positive absorption in the fourth quarter nationally -- the sixth straight quarterly improvement - with most individual metros seeing a net gain in leased space, including Houston (3.8 million square feet), Washington, D.C. (3.04 million square feet), Philadelphia (2.87 million SF), Boston (2.28 million) and Long Island, NY, (1.87 million) rounding out the top 5 metros that are concentrated in healthier segments of the economy, including energy, government, and health care and education sectors.

The direct vacancy and availability rates declined again in the fourth quarter and appear to have turned a corner, although they remain well above their five-year averages.

Retail construction, like most other commercial categories, remained stifled, with developers delivering a record low of less than 50 million square feet in 2010. Very new supply is in the pipeline, with starts totaling only 23 million square feet in 2010, including just 3 million square feet in the fourth quarter. That compares with 176 million square feet started during the market peak in 2007.

Very few large centers are under construction and projects have especially plummeted for grocery-anchored centers, which are exposed to the weak housing market, as big-box value retailers like Sam's Club and Costco have competed for the dollars of thrifty shoppers.

"We've not yet at the bottom for deliveries of new construction, we're still probably a year away," Mulvee said.

Quoted rents continue to fall and their recovery will trail improvements in fundamentals. With profits rising quickly, matching their 2006-07 levels, retailers are under less pressure to cut occupancy costs.

All told, CoStar forecasts a strong recovery in the retail sector. Deliveries will rise gradually, hitting 40 million square feet by fourth-quarter 2014. Absorption will peak and vacancies will bottom in the first half of 2012, with a gradual decline in absorption through 2014 paired with a rise in vacancy rates as the supply pipeline reopens.