Are We Better Off Than a Year Ago?
Since last year, investors have heard three themes repeated ad nauseam to explain this year’s market malaise: The banks are extending and pretending; asset owners are fretting about the coming due of $650 billion in securitized debt; and it’s going to get worse before it gets better.
Last year’s buyers were merely hamstrung by a bid-ask spread artificially based on prior-year expectations. Direct real estate investors with cash were waiting on the sidelines for a flood of distress coming from the banks and sellers squeezed by securitized debt coming due.
But at mid-2010, these events have yet to mature into any market-making reality. Instead, commercial real estate investors face a materially different problem. In contrast to the expected deluge, many market participants report that investment deal flow is at a trickle. The available product on the market is so thin that investors are having a hard time finding solid deals. It’s as if sellers have decided that no sensible seller would sell in this market, so buyers assume that what’s currently listed is not worth buying. More than 40 percent of the markets surveyed report that investors are plentiful, but they cannot find deals at prices that make investment sense. Thus, pricing on the existing thin crop of offerings must come down to spur investment demand. Until some sense of market stability is achieved, sellers of quality offerings will remain sidelined unless they are distressed.
Bearing Bad News
Much of the current climate is self-fulfilling. Buyers and sellers have all been listening to the same bad news since third quarter 2008, and even longer in some markets. But it’s hard to assume that real estate returns vis-à-vis net operating income have remained stable for the past 12 months. Tenants in all sectors have spent the entire year retrading their higher lease rates for longer terms and short-term rent concessions where possible. Even the multifamily market has not been immune to the rent retrade, with most markets reporting slightly higher vacancy rates and more frequent concessions. The nation’s commercial landlords are active participants in the effort to restart the economy, working with tenants to stabilize operating costs (particularly real estate taxes) and retain quality businesses where possible.
Unemployment fears persist, but general economic indicators appear to suggest that while major new growth is not imminent, continued systemic employment losses are not likely, at least in the private sector. The wild card is that 37 states face gubernatorial elections in 2010, so the hard work of paring government payrolls to match economic reality will not begin in earnest until 2011. The impending disruption of the healthcare industry will compound employment malaise into 2011, and will likely cause major value disruption in markets predominated by healthcare sector employers.
While it is difficult to make generalizations about all property classes, the market’s perception that bank-owned real estate will be coming to market in huge waves has had a profound impact. Investors continue to sideline cash waiting for a halcyon Resolution Trust Co.-like disposition process to begin.
But a correlation of investor activity and bank disposition trends reveals some underlying themes. (See sidebar, “Investor vs. Bank Disposition Activity.”) In fairness to lenders’ strategic — or accidental — decision to not aggressively dispose of everything at once, the real problem in markets that lack buyers despite aggressive bank dispositions is that investors don’t have enough confidence in the market fundamentals to understand the turnaround timing and its impact on current value. However, in markets that lack buyers but only have selective bank disposition, one can almost certainly expect continued price volatility as the market seeks the bottom. Asset stability only will be evident when transaction activity demonstrates market pricing. Markets that lack buyers will continue to see softer pricing into 2011.
On a positive note, more than 50 percent of the markets reported that investors actively are looking for deals, but market activity remains stalled. Expect these markets to start finding the equilibrium price points that will demonstrate the new stability. In markets noted as “deals happening,” seek a deeper understanding of the fundamentals. It is unlikely that appreciation will be rampant, but at least market fundamentals are supporting transaction activity.
The deepest acquisition price discounts will be found in markets that lack buyers and have aggressive bank disposition activity. Expect some of the selective disposition markets with no current buyers to go aggressive in the coming 12 months.
On balance, a massive wave of active dispositions is not expected from the current stock of commercial real estate held in bank portfolios. Land, particularly residential development land, remains the poison pill in the bank portfolios. Residential market conditions continue to improve, but new development cannot make a major correction until active job growth returns.
The major income-producing assets attractive to mid- and large-scale investors still are overshadowed by the commercial mortgage-backed securities balloon. This year begins the mounting pressure of CMBS maturation that will last into 2013. The increasing stress of debt maturation will place significant strain on the major private equity players — many of whom overpaid at the market’s height. Defeasance and prepayment penalties coupled with a dearth of market evidence supporting strong valuations have stymied the ability to clear the CMBS logjam, even as debt and mezzanine capital has trickled back into the market looking for the strongest lending opportunities.
As a result, investors are seeking joint venture opportunities where investor equity is being committed to predefined JV purchases to cushion the inevitable likelihood that refinancing will require additional cash. Unlike the banks’ REO, securitized instruments do not lend themselves to extend–and-pretend modifications. These JV transactions generally are invisible to the market and do nothing to assist in understanding where the market currently is trading. Similarly, sophisticated equity investors are buying debt companies or specific debt securities with the understanding that at maturity, the debt almost certainly will confer an equity stake or entire liquidation of the equity piece.
The REIT market may not be as well positioned as current price/earnings ratios demonstrate because CMBS fallout will affect REITs’ capital ratios and balancing, and may keep many REITs sidelined from new acquisitions that would otherwise be accretive. REITs’ current trading ratios already demonstrate a built-in premium for new acquisitions that could otherwise add value. If there is nothing accretive to acquire, REITs could be overpriced.
Essentially, we may be no better off in 2010 than we were in 2009, save for the fact that time cures all ills. Quality deals are few and far between. Bidding on these deals is aggressive and quick, and pricing is being bid up — keeping a lot of good deals from being great.
The major economic variables at the edge of this rebalancing equation are inflation and a likely punitive tax regime, both of which favor direct real estate investment. Continued low interest rates and compliant banks seeking to avert general economic disaster have helped salvage a lot of deals from immediate wreckage.
Some of the current delay in bringing assets to market almost certainly is abetted by groupthink that a return of inflation will shore up the asset values. This will almost certainly be true in the long run. The punishing reality is that while inflation may seem like an immunization for real estate stability, the economic effects of inflation will cripple business and job growth, which will be counterproductive to real estate stability in the short term.
Prior midyear updates identified trends by asset classes that were driving the general real estate demand nationally. The difference in 2010 is that asset classes are performing at different levels in different locales. As a general rule, lodging has been hit hard in all markets. However, certain key markets will fare better than others. The same can be said for office investment. Office demand is a function of job growth, and early 2010 indicators appear positive. But there is no nationwide trend that indicates that office property is a good investment. The answer is in the local and regional demand patterns that drive growth.
In last year’s survey, nearly 50 percent of the markets were three years out. This year’s responses indicate a more positive outlook: Markets are returning to more near-term prospects for positive investments, based on fundamentals, good pricing opportunities, or both. (See “Investment Picks” at www.ciremagazine.com.)
In the long view of history, perhaps we will count ourselves lucky that 2010 wasn’t as bad as it could have been and that 2009 was far better than it should have been. Unfortunately, there is not much consolation in the long view when you are forced to live in the moment. The reality is that allied professionals in the construction trades, engineering, and the architectural fields all are suffering under the stagnation that is approaching its fourth full year. The disruption and chaos facing our healthcare (and insurance) sectors will be transformative and painful, and the effects on real estate serving these sectors will be equally uncomfortable. Energy, biomedical, security, technology, and entertainment are poised for strong growth. Even our auto industry is making positive structural changes, giving rise to business confidence. If we can only see the banking and financial services sector solidly on the mend, the future might just require shades.
While not an entirely positive outlook, most analysts believe the structural issues contributing to general economic recovery are in place. A real estate recovery generally lags an economic recovery by 18 to 24 months. Logic follows then that we can’t start crawling out ahead of the economy. The real estate sector must resolve that the nearer we travel toward real long-term economic growth, the more realistic the upside real estate presents. Until appreciation expectations return, we just need to keep moving in a positive direction.