In Phoenix, the only place to go is up. Commercial real estate transaction velocity came to a virtual standstill last year with total dollar volume equating to less than 10% of the properties traded in 2005. In Q4 of 2010, investment sales velocity began to increase, a trend that will continue through 2012. However, only two types of transactions are expected to dominate the investment arena this year: trophy and trauma sales. Trophy assets, including class A office, retail and multifamily properties in primary locations with strong occupancies and operational performance, will trade at near-market rates. Meanwhile, trauma assets, B and C apartment complexes, multi-tenanted retail assets and office buildings under duress, will trade at a significant discount. In most cases, trauma properties that were either foreclosed upon or were the subject of potential short-sales that owners and lenders sat on last year, will now have to be moved to the market. Apartments

Although it posted dramatic improvements in fundamentals last year, the Phoenix apartment sector continues to account for the greatest share of known distress in the marketplace. Nonetheless, property fundamentals were bolstered by above-average job creation, which is expected to continue through year's end. In addition, multifamily construction will drop to its lowest level in more than 15 years and single-family foreclosures will push many former homeowners into rentals. An estimated two-thirds of homeowners with mortgages in the metro area owe more than their homes are worth, which will continue to encourage strategic defaults and expand the renter pool. Class A units accounted for most of the absorption last year, due in part to renewed job growth in the typically higher-paying professional and business-services sector.

Following a 260 basis-point reduction in 2010, apartment vacancy will slip another 120 basis points in 2011 to 8.5%, approaching levels last reported in late 2007. Yet many owners who entered the market during the boom period used high levels of leverage and have since encountered difficulties meeting debt-service obligations or refinancing maturing debt based on reduced valuations. Nearly one-quarter of the CMBS loans outstanding in the metro area are now at debt-service coverage ratios of less than 1.0, while the market wide median price per unit has slipped 35% since 2007. Over the past year, many investors have re-entered the Phoenix apartment market, targeting REO listings and well-located, high quality assets offered at attractive prices compared to just a few years ago. While more lenders have started to clear their books of reclaimed assets, many will stabilize high-vacancy properties and address deferred maintenance ahead of taking them to market. This trend may become more pronounced in 2011 in light of expectations for above-average job growth and declines in vacancy rates, limiting price discounting.

Retail Distress remains a primary concern in the Phoenix retail sector, and the projected lengthy recovery in property performance will only prolong difficulties for many owners. Through 2011, the vacancy rate will remain around 12%, in line with the market's performance in the early 1990s. Construction has dropped off dramatically in the metro. In 2011, just 290,000 square feet of new retail is forecast to come on line, down from an average of six million feet per year from 2005 to 2009. Also, positive net absorption will occur for the first time in two years due to a projected increase in consumer spending and modest improvement in tenant demand. In addition, depressed home building will limit shopping-center development for the next several years, providing a foundation for future rises in demand.

But high vacancy in many areas continues to serve as a reminder of the magnitude of challenges ahead. Areas with high vacancy include those where the housing downturn was most severe. In Surprise and El Mirage, the vacancy rate in properties opened since 2007 exceeds 25%. Several spaces in these areas will remain dark this year and not become viable retail locations until the housing market strengthens. High vacancy and recent rent declines will sustain average cap rates of around 10% for multi-tenant assets. Intense interest in top-rated single-tenant properties, though, will keep cap rates for these properties near 7% in the months ahead.

At the end of 2010, nearly $1.5 billion of retail properties in the market were considered distressed, one of the largest amounts in the country. While distressed property listings will provide attractively priced opportunities for investors, they will continue to come to the market very slowly as lenders elect to stabilize or restore property performance before listing.

On a positive note, trophy retail asset sales will be primarily single-tenant net-leased sales in prime locations. There has been incredible demand among private and institutional investors for credit-quality, class A net leased assets. As more perceived risk enters the Phoenix retail sector, there will continue to be a flight to these properties in prime locations.

Office

The Phoenix office market has bottomed and will experience leasing and investment sales gains in 2011. As the pace of construction falls to the lowest level since the mid-1990s and job growth accelerates leasing activity, the vacancy rate will drop for the first time in five years. More than 800,000 square feet of office space will be absorbed during 2011, particularly in premier submarkets. Fortune 500 companies AECOM and Cole Capital recently inked deals totaling nearly 160,000 feet in the new 24th at Camelback II building, which will help push down vacancy in the area by 210 basis points. Outlying suburbs such as the West submarket, however, will continue to struggle. Vacancy peaked at over 40% in the area during the recession, and several more quarters of household growth and small-business formation are needed to return pricing power to owners.

Office transactions will accelerate this year as property fundamentals begin to move off the bottom and more troubled assets, particularly multi-tenanted properties in less-than-desirable locations, come to market. Private buyers are expected to purchase mid-tier properties in suburban areas for value-add opportunities and a wave of distressed assets and short sales hits the market. As banks unload nonperforming properties from their balance sheets, local and regional syndicates that have been waiting for indications of a turnaround will come off the sidelines to compete for discounted assets. Many of these listings will be vacant properties located in submarkets where construction was robust over the past several years, such as North Scottsdale. Owners unable to refinance loans will return properties to the bank or attempt a short sale, attracting cash-heavy buyers looking for per-square-foot pricing. Maturing debt poses a significant risk to the local office sector since high leverage loans originated at the market's peak will start to come due this year. Refinancing these loans will be nearly impossible for many owners without significant equity contributions, which could result in more REO activity and short sales. At the start of this year, the CMBS delinquency rate in the Phoenix office sector was already above 20%, and it stands to rise further as vacancy in the metro remains in excess of 25% over the next 12 months. Commercial real estate activity in Phoenix will occur on opposite ends of the investment spectrum this year. As a result, well-capitalized private investors, as well as institutional investors, will continue to compete for trophy product. The polarity of the market will attract some new investors as well. Over the past 18 months, there has been an influx of Canadian investors seeking single-family housing throughout Arizona, and those investors are now seeking to acquire assets at a discount. As the year progresses, expect Canadians and other foreign investors to target distressed multifamily and multi-tenanted retail properties.


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