Investors Take Upbeat View Of Twin Cities
Commercial Real Estate Markets

• Strong demand, lower yield expectations spark increased sales activity

• Real estate TICs make an appearance in Twin Cities

• 2004 set to be a banner year for Twin Cities commercial real estate sales

Investors are underwriting the recovery in the Twin Cities commercial real estate market, to the point that prices for in-demand properties are trending higher. Premier properties within all categories are commanding substantial price increases, especially properties with good credit tenants and longer lease terms.

Market conditions this half favored large institutional investors with access to lower-cost capital structures, fueled by an interest rate decline that began in the summer of 2003. But investors of all types have shown increasing interest in allocating larger portions of their investment portfolios to commercial real estate. This helps them balance against the more volatile equity markets – and as yields on fixed income assets have fallen. Even with the impressive gains registered by the stock market in 2003, investors are still steering more capital into commercial real estate. Some observers speculate that the interest in real estate is permanent, especially since the industry proved to be financially stable throughout the roughest economic downturn in more than a decade.

Retail, particularly grocery-anchored centers, remains most in favor among investors in the Twin Cities.  However, while many grocery-anchored sales were in play at the end of the year, the largest investment sales transaction this year was for Opus’ The Shoppes at Arbor Lakes, the only lifestyle retail center in the area. Prudential paid  $87 million only a few months after the 411,000 sq. ft. center’s opening.

Investor Interest On The Rise For
Broader Range Of Properties

Multifamily rental properties are a strong second to retail, while industrial properties, particularly bulk warehouse and office warehouse, continue to be in demand. Stabilized office buildings, with good credit tenants, high occupancy levels and a strong rent roll schedule, are also commanding top investor interest – and top dollars, in some properties. Interest is also increasing, particularly among institutional investors, in a broader array of property types such as unanchored retail shopping centers and office and industrial properties with higher than average vacancies, non-credit tenants, deferred maintenance issues and the like.

In response to the increased competition for commercial real estate, some investors are expanding their criteria to properties in the redevelopment or mixed-use category.  Great consideration is being given to office buildings with substantial challenges, such as significant vacancy levels and higher capital costs, although even those properties are in short supply. 

As has been the case throughout the past couple of years, investor interest in the most in-demand types of real estate continues to exceed the supply of such properties on the market. As a result, investors are growing increasingly creative in their use of alternative investment strategies.

Private Investors Are Adding Dollars to The Pool Of
 Available Investment Capital

The overall pool of available capital for investment in commercial real estate continues to grow, even as other types of asset categories – the equity markets in particular – register healthy gains. Much of the increase in investment capital is coming from individual investors eager to participate in the stability and anticipated cash returns of 8 to 10 percent available from commercial real estate holdings.

Among the many types of investment vehicles tapped by individual investors are private real estate investment trusts (REITs), which are very active in the Twin Cities commercial real estate markets for properties fitting their specific criteria. Private REITs, in return, are able to leverage their access to lower-priced capital to outbid other investors for choice properties. For example, Wells Real Estate Funds’ purchase of the U.S. Bancorp Center in downtown Minneapolis in May of 2003 was a private REIT transaction – and the largest office property transaction in the Twin Cities in 2003. Wells typically pursues Class A office buildings with high occupancy and long-term leases in markets across the country.

Publicly traded REITs, on the other hand, were net sellers of commercial real estate in the Twin Cities in 2003. The public REITs are taking advantage of an environment of declining yields and rising prices to sell some of their holdings.

Tenant-in-Common Sale Component Raises Possibility
Of More Such Transactions In Twin Cities’ Future

Tenant-in-common investment (TIC) programs are also gaining momentum as a favored investment strategy among private investors. In October, Dallas-based program sponsor Behringer Harvard Funds used a TIC program to purchase the 276,000 sq. ft. Class A Minnesota Center office building in Edina. TIC investing is particularly attractive to 1031 exchange investors who have sold a commercial real estate property and wish to keep the funds invested in a tax-deferred, “like-kind” investment property. By pooling their capital with other investors and purchasing fractional interests in a TIC program, 1031 investors can often purchase an interest in higher quality, more expensive real estate. Since TIC programs are often triple-net lease transactions in which the tenants by definition pay all expenses, individual owners don’t have to be involved in day-to-day building operations.

Sponsors of TIC programs received a big boost from Internal Revenue Service guidelines issued in March 2002. The IRS’s 2002 ruling clarified the agency’s view that TIC programs allow investors to have an interest in real property and thereby qualify for 1031 tax-deferred status. Until then, there were concerns that the IRS would view TIC programs as a partnership enterprise and thus not eligible for 1031 status.

THE OUTLOOK  2003 ended with slightly fewer major transactions taking place than some observers had anticipated. However, many of those transactions will likely close in the first half of 2004, giving the new year what might appear to some to be a roaring start from an investment perspective.

Investor interest in grocery-anchored retail will continue to be strongest, with some increased carryover into other types of retail properties as well. Demand for multifamily properties will likely continue to exceed supply in all property types.

The market for stabilized office properties will remain strong among institutional and private investors alike. Investors with a desire to gamble on the strength of the economic recovery may be more active in putting money into the “second tier” of office buildings – those with more significant leasing and operating challenges. There are few of these properties available in the Twin Cities today. Adding to the demand is that no substantial increase in new office building construction is anticipated for several years.

Several major office warehouse and bulk warehouse transactions are likely to close in the industrial market in the first half of 2004. Investor demand for office-showroom industrial properties may regain some momentum, but the greatest increase in demand will likely be postponed until the office market more generally recovers – perhaps one to two years in the future.

If commercial mortgage interest rates rise modestly in 2004, as is widely expected, institutional investors will maintain their competitive advantage over private investors.