NAIOP members detail trends to watch in commercial real estate
AZRE Magazine • September 2024
The commercial real estate market in Greater Phoenix has expanded in recent years, with some sectors outperforming others. With 2024 beginning to wane, AZRE magazine sat down with the following NAIOP Arizona members to learn more about their areas of expertise and what trends to watch in commercial real estate:
- Margaret A. Lloyd, senior vice president, Plaza Companies
- Eric Termansen, founding partner, Western Retail Advisors
- Kelly Royle, vice president, JLL
- CJ Osbrink, executive managing director, Newmark
- Cindy Cooke, vice chair, Colliers
Responses have been edited for length and clarity.
AZRE: Margaret, what is the state of the medical office space?
Margaret Lloyd: It’s really robust and active right now — Phoenix is ranked No. 1 in the country for growth in medical office. In 2023, we leased more than 517,000 square feet, which was well beyond any other major market in the country. We’re down to about a 10% vacancy rate because of all the absorption in the last couple years. All levels of medical office, meaning Class A, Class B and even some Class C is leasing at this point.
There are still some challenges, mostly that there hasn’t been much new construction because of the costs of labor, materials and financing. It hasn’t been zero, but it’s very limited, which has led us to higher rents.
The reason for all this absorption is population growth, so it makes sense that medical is expanding in areas such as Queen Creek, San Tan Valley and Buckeye. There’s also been interest in North Phoenix and in the Laveen area as well.
AZRE: What sort of medical products are being built in these growth areas?
ML: Interestingly, there’s a lot of activity in rehabilitation centers, behavioral health centers autism clinics, physical therapy and occupational therapy. Those users are taking anywhere from 8,000 to 12,000 square feet.
Our health systems are continuing to expand into the neighborhoods like they have for years now with primary care and multispecialty facilities, but also outpatient surgery center and micro hospitals.
AZRE: One trend that’s been talked about is converting traditional office space to medical office. Have you seen these happening in the market?
ML: It’s going to be very difficult, but not impossible. A few years ago, when retail centers had a lot of big space, everybody said, “Well, let’s put a medical facility in these retail centers.” That worked in a few instances. Retail is a bit easier to convert than office because it already comes with parking and typically has better-suited infrastructure.
A lot of office owners don’t understand how much it costs to put a medical tenant in a space, convert the infrastructure or do whatever they need to do to make the building work for medical. Do you need more power because there’s an imaging tenant? Parking ratios are usually a lot less for office than what medical requires, so can you add parking? Certain things need to be in place to make it work.
But CJ and I were just talking, and he’s got an office that’s potentially being converted, so that’s why I never say never. There will be opportunities, but will they be abundant? Probably not.
CJ Osbrink: It’s true that a lot of office buildings today aren’t going to be office forever. There will be adaptive reuse, but Margaret mentioned a great point — cost. It’s so easy for us to say, “Oh, this would be perfect medical because it’s right on campus and it’s by the freeway.” But then you look at the costs involved, and it becomes clear that it’s easier discussed than to execute on.
AZRE: Since we’re talking about office, could you tell us about what you’re seeing in the market? How are investors looking at the sector in 2024?
CO: Just looking at the first half of this year, there have been 10 notable deals that have traded for more than $20 million, for a total of about $387 million. If you look at the total transactional landscape, there have been about 39 deals — roughly the same number of deals as last year — totaling $640 million.
What’s interesting is that a lot of those trades aren’t going to be office anymore, just like we were talking about. There are, however, some deals that are pure office plays and will remain office. We sold two of the only $50-million-plus deals this year, which were the Beam on Farmer in Tempe, and then also 24th At Camelback. Those are trophy offices.
I’m not a leasing broker, but from a tenant and investor perspective, it’s all about a flight to quality. That’s something you’re going to continue to hear because it’s true. If you’re a tenant, you want your employees to be happy when they come back to the office. That’s something we’re battling every day — how do we get people back? If you have an unamenitized office building, it’s tough.
Employees want to come back because there’s a gym, a conference center, nice high-quality finishes and a good company culture. That’s what will bring people back.
AZRE: Are you seeing a lot of activity in specific submarkets?
CO: Tempe, Camelback corridor and Scottsdale are the preferred areas for companies wanting to plant their flag in Arizona. That’s driving all the activity from tenant and investors. That’s where people want to be.
If you have trophy office on one end of the barbell, on the other side are the trainwrecks. Those trainwrecks would be lender-driven sales, deals that are heavily vacant and that’s where we are seeing activity believe it or not. We’ve got a 20-plus acre site that is currently multiple mostly vacant and tired office buildings. But it’s a great land site. The group that is buying it plans to blade it and develop mid-bay industrial. Everything between the two ends of the barbell is really quiet right now.
AZRE: Will older offices getting torn down for other product types have a long-term effect on supply that could be an issue?
CO: Offices users are not going after those types of office properties — when you’re coming back to the office, you’re not looking at Class B or Class C office long term. So those buildings will sit vacant for a long time unless someone redevelops them or tears them down and turns them into something that’s a higher and better use, whether that’s something like industrial or multifamily.
It’s hard to predict what will happen in the future, but I think generally, we all feel good about the return to office. Some companies are mandating a return to the office for three days a week. They’re seeing more productivity and a boost to employee morale, because it’s a lot easier to spitball ideas in person than on the phone.
I consider this situation similar to what we’ve seen in retail. You have omnichannel retail, which is a combination of bricks and mortar and e-commerce. That’s what you’ll see with office, so you’ll be able to have some employees who work from home a couple days of the week, and still have access to the culture of the company at the office. There’s a way to do both.
Going back to the original question on supply, it’s going to adjust. Some office will be scraped, so we will reduce our footprint, but at the same time, as tenants come back and they expand, or they decide they want to be in Phoenix, you’ll see that excess inventory start to get gobbled up and vacancy rates will drop with it.
AZRE: Can you bring us up to speed on the multifamily market?
Cindy Cooke: Multifamily was a hot commodity in 2020 through 2022, but it has been the quietest of all segments in 2023 and 2024. Part of that is new construction. Interest rates moved and that changed cap rates. Everybody was pretty healthy before that happened, so they’ve been on a pause. We’ve got about 30,000 units being delivered this year, and another 25,000 in 2025. There’s hardly anything coming in 2025, only about 5,000 units.
Our absorption is great — we’re at about 20,000 units absorbed this year. The future look bright, it’s just getting through that pipeline of construction, and we’re making headway.
To me, what’s missing is the condo market. That got hit with latent defect laws, so nobody has been really converting apartments to condos, whereas last cycle that was the case. That’s a piece of what’s missing regarding affordability.
AZRE: Any other multifamily trends we should be watching?
CC: We’ve seen a lot more build-to-rent communities, which are attractive for single parents. But those projects require a lot of land so they tend to be on the outskirts of town.
Overall, cap rates have leveled off, but our fundamentals are still soft. Our expenses have gone up, but that might change now that unemployment is going up, so we may be able to lower some of the payroll. But insurance is double what it was five years ago. We’re seeing bad debt, concessions and rents have gone down about 6% since the peak.
To me, this is when great wealth is made — when buyers come in and say, “I like the overall growth of Phoenix, and now I’m able to buy at a price that doesn’t seem frothy.”
AZRE: How are things looking in the retail market now that we’re a few years out from the pandemic?
Eric Termansen: The pandemic ended up taking a whole bunch of things that were going to happen to the sector over the next decade or so and did it in about 18 months. What became clear was that people want the socialization and the environment. Retailers also did a nice job of adapting and giving people lots of choices.
I think we’re going to see a continual change, and retailers will become much more educated about their consumers with all the data they have available, whether it’s through geofencing in the stores, loyalty programs and even communicating with their landlords on the traffic in shopping centers. All of those tools are going to make the retail experience better, even if it does a feel a bit like Big Brother.
AZRE: How else has retail evolved?
ET: Retail is much more about food and much less about the department store now. When I grew up in the retail industry, regional malls and department stores dominated. The next big thing was the move to Walmart Supercenters and Targets.
Today, as department stores are failing, you’re only going to have a few strong players in the long term. In 20 years, Phoenix may only have one enclosed mall — my bet is Scottsdale Fashion Square. The others are fantastic pieces of real estate that will have to continue to evolve and add different uses.
If you look at the old Sears building at Arrowhead Mall, that’s going to be an Asian-focused grocer with an entertainment use on the second floor, so it’s going to be completely different than what it was and hopefully attract a different customer there.
I’d also add that we should not underestimate the change that’s happened with drive-thru food. Nine out of 10 food users want a drive-thru because of what it does to supercharge their sales. Starbucks often doubles their sales when they have a drive-thru option. That’s going to be an interesting trend to watch.
AZRE: Experiential retail is a buzz word that gets thrown around a lot. Is that something you’re seeing?
ET: That’s a small portion of retail, but I think retail overall is a social experience. If you go to a mall on the weekend, you see young people hanging out and shopping, which is not terribly different than what happened in my childhood. It’s less about what the retailers are doing to make it experiential, but the human connection that people are having by being together.
AZRE: Could you share what’s been happening in industrial?
Kelly Royle: It’s no secret that the vacancy rate has gone up a little bit Valley wide — we’re sitting at about 11% right now. The pandemic changed our business, but we’re starting to see that level out as companies start to right size, whether they’re downsizing or expanding.
To put everything in perspective, there’s a little over 400 million square feet of industrial, with another 32 million square feet under construction. That’s actually down from where we were in 2022 going into 2024 when we had a lot of product under construction and that was ultimately delivered.
We’re still pre-leasing buildings, maybe not at 50% like we were during the pandemic when people were scrambling for space, so that has settled down. We’re preleasing at about 35%.
AZRE: What some of the trends in industrial?
KR: There’s been a big push towards delivering products rent ready. We’re seeing a big push for 100% HVAC now in the building, and that’s for employee retention. During the pandemic, buildings were leased in shell condition and the tenant came in and made improvements, but that has changed.
Some tenants will come to tour when their timing to sign a lease isn’t even until Q1 or Q2 of next year, but they won’t even look at a building that’s just broke ground or is halfway done that could still hit their timeline. For them it’s the risk.
AZRE: Can you talk more about how tenants are thinking about risk?
KR: COVID-19 disrupted the construction industry like long lead on items. Companies can’t take on that risk that the space won’t be ready when it supposed to be. The broker wants to touch it and see it.
AZRE: Tell us more about tenants’ size requirements.
KR: I specialize specifically in the West Valley and we have a lot of mid-bay and big box buildings, but not a lot smaller industrial space that’s available today or even in the future. Tenants who need 5,000 to 15,000 square feet unfortunately don’t have a lot of options, and that’s the vacancy. When you peel back the onion with 11% vacancy rate, the smaller products are closer to 5%.
Generally, we’re seeing a lot more manufacturing requirements. I’m hearing now that “power is the new parking.” A lot of developers are including more power and assuming that tenants will need it, not only for 100% HVAC, but also their forklifts and material handling equipment they’re using. A true manufacturer may need upwards of a megawatt of power.
We’re still getting looks from all sorts of companies who want to come into our market, which has been nice. It’s no secret that Amazon took down 3 million square feet in the West Valley during Q1, so that pushed up our numbers, and similar brands are looking at Phoenix.
AZRE: Is there still a lot of interest from California companies?
KR: We see a lot of businesses from California looking to either expand here or completely relocate out of California. At one point, about 50% of all new leases were from California, but that number is down to 20% to 30% but there’s a lot of landlords in the Inland Empire with vacancy in the under 300,000 square feet category. The delta between Phoenix and some places in California isn’t as big as it was.
