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Commercial real estate's comeback: increased occupancy and rising rates are reviving Alaska's commercial real estate, despite a dearth of office building construction.

Commercial Real Estate's Comeback

Increased occupancy and rising rates are reviving Alaska's commercial real estate, despite a dearth of office building construction.

If a small group of people who have been consulting in their spare time combined forces and went searching for office space in which to establish a firm, what are they likely to encounter?

Whether in Anchorage, Fairbanks or Juneau, they will find pretty slim pickings for the better, Class A office space. They will find more choices for less-select quality office space. They may even discover that converting retail space to office use in a shopping mall is an affordable option. But they are unlikely to find dirtcheap rental rates wrapped up in landlord concessions, which was a common situation when Alaska's economy bottomed out in the late '80s.

Alaska's commercial real estate market is healthy and getting healthier. Generally speaking, both office and retail space are tightening up, commercial buildings are being sold, rents are going up, and major Outside retailers are expanding their Alaska operations.

The big question is: When will new development -- especially of Class A office space -- occur? Industry experts don't have an answer yet. Market value of commercial buildings, while showing increases, is still well below replacement value. New construction currently would be unprofitable. And lenders are cautious.

Commercial construction will become viable when rental rates increase enough to provide income sufficient to justify owners' investments. For Class A office space in Anchorage, that figure is considered to be about $2.25 per square foot. As of April, the high end of Class A space rates was at $2.00 per square foot. Activity overall in Class A space appears to have slowed down this year compared to last year, when Anchorage saw tremendous increases, so no one is sure when the $2.25 figure might be reached.

Some real estate industry experts aren't convinced that higher rental rates, even in the presence of increased demand, would motivate lenders enough to take a chance on new commercial construction. "It's risky to finance new construction, regardless of where rents go," says Bruce Chambers, an associate with the Anchorage real estate firm of TRF/Brayton Inc.

He explains that, although increasing, sale prices on existing buildings are still running approximately 30 to 50 percent less than costs to replace the properties, given today's construction costs. With typical new construction financing, a lender would require a down payment of 25 percent cash to finance the other 75 percent. However, that 75 percent by itself could easily represent more than the current market value of the property -- and lenders balk at loaning more on a property than it's worth in the current sales market.

Also, if Alaska's present economic upswing were to last only a short time, such as three years, and then experience a similar-length decline, lenders who had financed new construction during the upturn could find themselves holding the bag -- again. In order to meet loan payments, the mortgagee of a newly constructed building likely would need to keep rental rates on the high side and therefore may not have the option of reducing rental rates to keep tenants if the economy plummeted again.

Chambers notes that the value dilemma could make bank financing for new construction virtually impossible. He explains that such a "chokehold" could cause demand to outstrip supply, with no way to increase the supply. The situation could lead to intense competition among potential lessees of a given property, resulting in quickly escalating rental rates.

"It could get interesting," says Chambers. He notes that Anchorage's warehouse-rental market appears to be reaching this condition.

The major exceptions to the "no new construction" situation are in the retail sector. Several national retailers, including Fred Meyer, Sears and J.C. Penney, plan to open spacious new stores from Fairbanks to Juneau within a year.

One reason for national retailers' interest in the 49th state is directly related to Alaska's recent recession and lower housing prices. Explains Chambers, "When the housing expense was reduced, it broke free a higher level of disposable income for retail spending and soft goods."

These examples of retail space construction fall under the heading of "owner-user," which is different from the commercial "investor-speculator." According to Chambers, lenders are more likely to finance a new project in which the owner is also the tenant, because they have the strength of the company to help back up the investment. He cites the planned Veterans Administration Hospital in Anchorage as another example of user-oriented new construction that lenders are willing to finance.

Greg Johnson, vice president of the Anchorage real estate firm of Livingston and Johnson, says, "There are a few situations where a company might build its own building, but that's not like a developer-speculator-investor going out and speccing a new building for renting to tenants." Traditionally, Class A office buildings fall into the developer-speculator-investor category.

Although new construction is mostly stymied for now, other commercial real estate activities are not, as the following report of the market's status in Alaska's three major urban areas shows.

ANCHORAGE. "The market overall is pretty good -- it's pretty active," says Johnson from Livingston and Johnson. Other real estate industry experts concur.

Fred Ferrara, owner of the Anchorage real estate appraisal firm Alaska Valuation Service, says that retail space rent is increasing. "In the recession, rents were down 40 to 50 percent all over town, but they're up now."

He says that for highly desirable locations, rents have increased about 15 to 20 percent, and for properties with less desirable locations -- for example, with low traffic and little or no street exposure -- rents are up at least as much. Ferrara notes absorption of retail space has been steady, although slow because "the number of new businesses and new occupancy/expansion of retail is not great."

But Anchorage in the near future may see new retail expansion. Not only has the national discount warehouse firm Costco announced plans to construct a second store, but also Chambers says that other "good-sized Outside retailers" are expected to break into the Anchorage market.

Office occupancy is in good health overall. Vacancy rates for all classes of office space -- A, B and C combined -- are estimated to be 11 to 15 percent. According to the latest Market Watch report by Ronald W. Bunn and Co., Anchorage's total office building inventory of 7.3 million square feet was 89 percent occupied as of January 1991.

Citywide, Class A space is roughly 93 percent occupied. Downtown, it's about 90 percent occupied and in midtown, about 95 percent. Says Ferrara, "For Class A, it's tough to find 6,000 to 10,000 square feet in one chunk in midtown."

According to Johnson, changing supply and demand has caused activity in Class A space to slow down compared to activity 12 to 18 months ago. Reduced rental rates in the last few years allowed many businesses to upgrade to Class A space, resulting in tightened supply. And as supply has decreased in relation to demand, rental rates have increased.

Whereas Class A rates at one time softened to $1.50 per square foot or lower, they now average $1.75 to $1.85 per square foot. Says Johnson, "There's not a lot of incentive (now) for people to move, unless they grow out of space."

One option for expanding businesses is to establish outlets in less expensive space, classified as B or C. Class-B and Class-C absorption rose during 1990 and exceeded Class-A absorption rates toward the end of the year, according to the Market Watch report. Alaska Valuation's Ferrara says, "Class B is firming. We're seeing $1.25 to $1.45 per square foot average rates. Class C is running around 75 cents to $1.00 per square foot."

Another effect of the rebounding rates is that several Class A buildings have been sold. According to TRF/Brayton's Chambers, these include Peterson Tower and the Signature Building downtown and the Alaska Energy Building in midtown. He also says that the former United Bank Alaska headquarters building in midtown has been sold and was expected to close in May.

Chambers notes, "New purchasers are buying because the market is strong and rents are going up to higher value. This reflects market confidence." He adds that Class B buildings are not available. Not only are they affordable for a larger number of purchasers, but also they tend to be owned by users that lease the excess space.

Buildings sales, increasing rental rates, and shrinking space availability indicate that demand is catching up with supply, especially for Class A space at less than 10 percent vacancy. Says Chambers, "We see plans for new development when 10 percent vacancy, or 90 percent occupancy, occurs. And we're seeing this in the Fortune Properties/Neil Bergt (Alaska Diversified Properties) proposal for a new building at 36th and C streets."

The March announcement of plans for the building may mark the end of a five-year drought in new Class A office space. Although Class A space typically is investor-speculator oriented, this project would be partially owner-occupied, with excess space leased to tenants. As of early May, financing for the building had not been secured.

Despite uncertainty about new office space construction, commercial real estate in Anchorage is doing well. Says Chambers, "We have numerous buyers in the market. There are good buys. You can still buy properties at 50 to 70 percent of replacement value. Rents are trending up because of continuing demand. ... It's a good market."

FAIRBANKS. "It feels very positive in Fairbanks right now," says Mike Harter, associate broker for Fairbanks' Cook Co. Realtors, which specializes in commercial real estate. The big news on the Fairbanks commercial real estate scene is new retail space. "Three hundred thousand square feet of retail in one shot, in one summer -- that's a lot," explains Harter.

Site work began last fall on a second Fred Meyer store in Fairbanks. The new 180,000-square-foot structure is expected to be completed this year. Sears expects renovation of the former Fairbanks Center for Entertainment building to be finished by November. The retail store and auto service center will occupy 114,000 square feet.

These large investments in the retail sector by Outside interests signal investor confidence in the area. In Fairbanks, retail space is tightening up overall, with space in the city's four major malls already very tight.

Space in strip malls is shrinking, too. Much of this space is being utilized as office space, with some strip malls having been converted almost entirely to office space. Averaging $1 to $1.50 per square foot, strip mall rents are lower than those of the major malls, which average $2.40 per square foot, but tenants must pay additional operating expenses such as heat, explains Harter.

Office space also is shrinking, and soon businesses needing office space may find themselves scrambling, especially for Class A leases. "There's lots of activity in office space," says Harter. "It's mostly people shuffling, moving around. But there is little supply left." He says economic expansion has created the increased demand.

Contributing to the tightening supply of office space is the Fairbanks-North Star Borough, which purchased the 70,000-square-foot First Interstate Building for school district use. The building's current tenants, who occupied about half that space as of April, must relocate. "That's 30,000 to 40,000 square feet that needs to be taken up elsewhere," says Harter.

Class A office space for more than a year has averaged $1.25 to $1.50 per square foot. Harter points out one reason rental rate figures aren't showing increases is that many leases still have two or three years to go and were drawn up during the economic downturn, thus locking in lower rates for a longer period of time. But he adds, "There's not that much vacancy. So we expect Class A to go up soon -- as the supply goes down more. ... We're busier now than we've been for a while."

JUNEAU. Commercial real estate in Juneau continues to improve as the economy strengthens from the crash of the late 1980s. "Our economy has recovered a good portion -- we're at 85 percent of our pre-crash values," says John Williams, broker and owner of Re/Max of Southeast Alaska, a real estate brokerage firm in Juneau.

During the last several months, only one major commercial building has gone through foreclosure, according to Williams. He explains that many of the notemakers for prerecession building purchases have allowed borrowers to remain in the buildings when possible, even during the troubled times.

But these borrowers could start receiving ultimatums from their lenders, due to the real estate market's comeback. "Lenders who took properties back are finding reasonable markets now," Williams says.

Although the number of commercial buildings sold recently is relatively small, office occupancy is high. With the state legislature in session, downtown Juneau's better office space is enjoying an occupancy rate of about 95 percent, according to Williams.

"The latest leases for Class A are $1.85 to $2.20 per square foot, which is a substantial improvement over the market bottom," he says. He estimates that, within a highly variable range, older, less-select office space downtown averages about $1.25 per square foot.

Approximately nine miles from downtown Juneau, better quality space in the Mendenhall Valley business district is bringing lease ranges of from $1.20 to $1.70 per square foot. Occupancy is 85 to 90 percent, according to Williams.

No new private-sector commercial office space is under construction. Juneau's one new office building is for state government use.

But new construction for retail space is on the books. J.C. Penney plans to open a retail store next spring in a 35,000-square-foot addition to the Mendenhall Mall.

Juneau's three major retail centers -- the Nugget, Mendenhall, and Airport shopping centers -- are entering the summer season with occupancy around 85 percent, which is significantly better than during the recession, says Williams. He notes that mall space rents, including utilities, marketing programs, and mall fees, range from $2.00 to $2.50 per square foot.

The future of Juneau's commercial real estate market will follow the area's economy. Williams cautions, "There's a finite number of engines that run the Juneau economy. If Hickel reduces the government, that can have a chilling effect on Juneau's economy."

On the other side of the coin, the area's potential for increased mining activity has many people excited. According to Williams, if the A-J and/or Kensington mines begin production, Juneau could see from 400 to 1,100 new jobs. This expanded employment base could lead to much new real estate development.

For now, Juneau -- and its commercial real estate market -- is enjoying solid support from continued production at the Greens Creek Mine; from a relatively stable tourism industry; and from the state government's presence.

THE BOTTOM LINE. The state's economic upturn is buoying Alaska's commercial real estate market. In particular, existing office and retail space has been showing healthy activity for more than a year now. Says TRF/Brayton's Chambers, "For all intents and purposes, the market has come back."

PHOTO : Peterson Tower is one of several Class A office buildings that have sold recently in Anchorage.
COPYRIGHT 1991 Alaska Business Publishing Company, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Collins, Gloria
Publication:Alaska Business Monthly
Date:Jun 1, 1991
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