The expanding economy is pulling commercial real estate along with it, creating strong demand for space, and institutional investors are returning to the market, according to a commercial market update and forecast from the National Association of Realtors.

David Lereah, NAR’s chief economist, said the market fundamentals are improving. “Commercial real estate vacancy rates are falling and rents are rising as the economy expands and jobs are created,” he said. “Growth in the Gross Domestic Product is fairly strong and consumer spending remains healthy. Business spending is on the rebound, and the completion of new commercial buildings has shown positive growth over the last two years.”

Government spending is providing support to the commercial sector, increasing over 2 percent in the first quarter of the year. Strong corporate profits mean businesses are in the position to expand, wages are growing and 2 million jobs have been created in the last year. Imports and exports remain at high levels, fueling port business and industrial activity.

“Unemployment is near a ‘natural’ rate for the U.S. economy, so it doesn’t get a lot better than this in terms of factors that drive the commercial real estate market,” Lereah said.

Several factors could curtail growth: Oil prices are exerting inflationary pressure, interest rates have been rising and construction costs are increasing. “The Consumer Price Index has been trending up over the last two years with relatively higher inflation,” Lereah said. “As a consequence, the Fed has had to raise interest rates to keep inflation in check. Fortunately, it appears the Fed is near the end of its cycle of raising interest rates.”

Construction costs have been rising faster than the rate of inflation due to global economic expansion. “It really gets down to the law of supply and demand, and right now, construction materials are in high demand in Asian and other overseas markets,” Lereah said.

On the upside, capital is continuing to flow into commercial real estate at strong levels, and delinquencies have fallen. The hospitality sector is the best it’s been since Sept. 11, 2001. With the exception of retail space, new supply is being held in check.

According to the Mortgage Bankers Association, commercial mortgage originations totaled $201.7 billion in 2005, which is a 48.2 percent increase over 2004. Much of the funds, 35.8 percent, flowed into the multifamily sector; this was followed by office real estate, 24.1 percent; retail, 16.5 percent; industrial, 7.4 percent; and hotel, 6.4 percent.

Data from the Federal Reserve shows commercial loan delinquency rates have trended down since peaking around 1.9 percent in 2001 and now are close to 1 percent.

Since bottoming-out in the first quarter of 2002, the rate of return on commercial property had trended up and is now in excess of 5 percent, according to Haver Analytics and NCREIF (National Council of Real Estate Investment Fiduciaries). The apartment, industrial, office and retail sectors are converging, with the rate of return varying about 1 percent.

In terms of the overall commercial market, Lereah said migration patterns affect demand. “Migration favors warm weather and low taxes, so states with the biggest net migration are seeing commercial growth,” he said. These include Florida, Arizona, Nevada, Georgia and North Carolina.

NAR projections for five major commercial sectors, including the office, industrial, retail, multifamily and hospitality markets, are based on data provided by Torto Wheaton Research and Real Capital Analytics.

Office Market

Office vacancy rates are the lowest since 2001, with rent gaining traction in almost every major market. Investment volume in office real estate grew by 34 percent in 2005 to $99.7 billion, and institutional investors have returned to office acquisition.

Approximately 350,000 office jobs will be created in 2006. Net absorption of office space in 56 markets tracked, including the lease of new space coming on the market as well as space in existing properties, is projected at 22 million square feet in the first quarter of this year. For all of 2006, NAR expects 90 million to 95 million square feet will be absorbed.

Vacancy rates in the first quarter should average 12.6 percent; two years ago office vacancies were close to 17 percent. Overall office rents are expected to rise 5 percent this year.

Industrial Market

Trade and distribution are driving the industrial market, with greater demand in the West and Southeast, and institutions have increased investment in industrial property — up 65 percent in 2005 to $34.5 billion. There is strong build-to-suit activity, and urban industrial properties are being redeveloped for mixed-use and residential purposes.

With a low inventory-to-sales ratio, businesses need to restock and add space. There is a similar pattern with wholesale inventories, and orders for durable goods have risen strongly — up about 18 percent from a year ago.

Net absorption of industrial space in 54 markets tracked is forecast at about 51 million square feet in the first quarter. For all of this year, net absorption is likely to be 265 million to 270 million square feet.

Industrial vacancy rates are projected to drop to 9.1 percent in the first quarter of 2006; two years ago the rate was 11.7 percent. Industrial rents should grow an average of 3.8 percent.

Retail Market

The retail sector has an abundance of space in areas such as Indianapolis, Cincinnati and St. Louis, but drastic shortages existing in other markets like San Francisco and Las Vegas. Los Angeles topped the list of attractive retail markets for investors last year.

Consumer confidence appears to be a bit “iffy,” but retail sales have risen about 7.5 percent. On the downside, savings rates have turned slightly negative this year.

Net absorption of retail space is seen at 30 to 32 million square feet this year. Retail rents in 54 tracked markets are forecast to increase to an average of 4.0 percent in 2006.

Multifamily Market

The apartment rental market — multifamily housing — has benefited from rising mortgage interest rates, which are boosting renter demand. Job growth and in-migration are driving demand, primarily in the West and Southeast. Conversion of apartments into condos is waning.

Multifamily net absorption is expected to be about 80,000 units in 59 tracked metro areas during the first quarter, while vacancy rates are likely to ease to 5 percent. For all of 2006, NAR projects a net absorption of 285,000 to 290,000 units. Rent growth is seen at 5.3 percent this year.

Hospitality Market

Hotel occupancies are projected at 68.7 percent by the end the year, the highest since Sept. 11, 2001. Markets such as Honolulu and New York City have occupancies greater than 80 percent. Revenue per available room (RevPAR) should be $76 this year — an increase of 6.3 percent from 2005. The greatest increase in RevPAR is expected in Atlanta and Houston.

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