Investors search for steady footing as they climb commercial real estate's wall of worry.
As 2007 drew to a close, the investment environment transitioned from cautious optimism to a heightened level of realization that there was a global credit crisis brewing in the financial markets. Hidden behind the financially engineered products that drove much of the aggressive view that the economy could do no wrong during the last decade, Wall Street and Main Street have been oversold, especially with respect to securitized single-family residential debt products, or subprime loans. In fact, the housing market was overleveraged more than anyone realized or suspected relative to the fundamental values of the underlying residential assets.
Early last year as the residential market’s weakness continued, the commercial real estate market reached its pinnacle, with mega portfolio deals underway such as the Equity Office Properties Trust transaction. When the cracks in the foundation of the credit markets appeared as a result of the subprime mortgage market meltdown, the commercial real estate market took notice and quickly inventoried its own aggressive dealings and pricing during the past five years. Risk aversion reverberated throughout the world’s credit markets, resulting in the Federal Reserve pumping liquidity into the financial markets and dropping the federal funds rate. The world and domestic commercial real estate investors prepared for new terrain.
This year begins with a 180-degree turnaround due to the complex structural arrangements in the financial markets. What began as a few murmurs about subprime residential mortgages has escalated into a lack of transparency about the true financial risks held within commercial debt markets. It’s hard to predict what is under the next rock and few have the deep-down desire or courage to go excavating for what might be trouble that will not be easy to manage. There are too many potential unknowns.
For this reason, the commercial real estate market is climbing a wall of worry, and not everyone will reach the top. The question is: How do investors keep their footing in this environment? While the market is more informed and highly sophisticated, can it overcome the human tendency toward decisions that prove irrational and dangerous in the short run?
The Investment Environment
Despite a slowdown in 2007’s growth rate, the U.S. economy remains resilient beyond most expectations — but that is what keeps market nerves on edge while providing a much-needed stable market influence. While slow, the expansion should continue in 2008, fueled primarily by exports, business spending, and government spending, plus resilient but somber consumers. It appears that the U.S. economy will end 2007 with a growth rate of approximately 2.5 percent, which will stay about the same in 2008. Fortunately the global economy is on solid footing and is expected to grow at a faster pace, helping the U.S. weather this slow domestic economic picture.
Although inflation pressures probably will continue in 2008, the Federal Reserve has shown its willingness to accommodate the markets by lowering interest rates and injecting liquidity into the economy to help avoid a recession. Unemployment remains low, but with the continuing housing slump and high energy prices, consumer spending and job growth may slow. Strong employment will favor commercial real estate, keeping vacancies low and providing the necessary support for investment earnings. However, geographic differences in commercial investment markets will play a pivotal role, as some U.S. regions have seen variations in their local economies.
The view of the financial markets has shifted with the above economic analysis, and in particular, the links to the residential housing markets are not good. Six months ago stock and bond alternatives became more attractive investment choices and offered up the possibility of tactical capital moving out of the commercial real estate market. Clearly capital for commercial real estate would not dry up completely, but was there enough fickle capital to make a dent in the priced-for-perfection characteristics of the commercial real estate market?
This aspect appeared in the public commercial real estate market as unsustainable realized returns turned negative early in 2007, with returns reaching -8 percent by 3Q07. However, the concern that commercial real estate was alone did not last long, as the confluence of risk factors began to affect the equity markets with sizable and palpable downside volatility.
As indicated in Table 1, U.S. homebuilders were the whipping post of 2007, having seen 50-some percent of their market value evaporate in just nine months. The general equity market saw positive returns as of 3Q07, but recently there has been strong evidence of downside price pressure, which is expected to continue and will result in the market moving sideways this year. Ten-year Treasuries are reflecting two-year lows, dropping below 4.4 percent in October 2007.
However, these unstable financial market realities favor commercial real estate. As the financial markets become riskier and less attractive, commercial real estate — as long as it holds its own — becomes more attractive on a relative basis. It does not mean that prices continue to climb, but commercial real estate does maintain a more attractive position relative to stocks and bonds.
Assuming fundamentals remain strong and earnings continue at a stable pace, average yield expectations for commercial real estate during the last few months of 2007 were higher than those for bonds and Treasuries. Total return expectations have remained fairly steady since the end of 2005, after seeing a large decrease from 2004. With average yield rates on commercial real estate investments still higher than those for many other investment alternatives, commercial real estate likely will continue to be a preferred investment vehicle from a risk-adjusted basis. However, longer forecasts for yields on commercial properties and alternative investments indicate that the spreads between them may narrow. As the risk involved with commercial real estate investments increases, other investment alternatives may re-gain favor from a risk-adjusted perspective.
With continuing strength in overall commercial real estate fundamentals, it is no surprise that capital still is flowing into the market. However, the amount of funds has slowed, especially highly leveraged debt, and likely will continue to decrease this year. This trend will continue to affect asset pricing, working to move prices below the record-setting levels of the past year. This slow but steady downward movement should help to calm fears of overpricing in some markets. However, not all commercial real estate is in a good position or even in positive territory, despite the above financial analysis. Given this backdrop, the question is which properties maintain a relatively good status and which fall out of favor?
Table 1. Selected Markets Indices
1 Day %
|U.S. REIT Equity
|MSCI REIT (RMZ)
Sources: SNL Securities and RERC, Oct. 25, 2007
Nationally, office market fundamentals are in relatively good shape after realizing some strong gains in 2006. However, demand has fallen somewhat as the economy has slowed. Growth in rental rates is expected to slow but should remain positive over the coming quarters, helping to keep prices relatively stable in most markets. Although absorption will slow this year, it is expected to remain steady. A decline in construction should help further balance supply and demand.
Office properties reached an inflection point in 3Q07. Although average prices fell slightly on a quarter-to-quarter basis, prices still were above the previous year’s levels. This trend likely will continue as office pricing stabilizes.
Among high-quality properties, the East and Midwest regions are mirroring national trends, seeing slight price increases and slight decreases in capitalization rates. The West is experiencing slightly higher price growth and somewhat larger decreases in cap rates. Although the West continues to grow, some slowing toward national trends should occur this year. The South’s slightly lower prices for office properties, with slightly higher average transaction-based cap rates, are expected, since several office properties in some southern markets were considered slightly overpriced. A correction was inevitable and likely will stabilize prices and cap rates, bringing them more in line with national levels this year.
The year-end 2007 average investment conditions rating for the office sector is down compared to earlier in the year, according to Real Estate Research Corp.’s institutional investment survey. However, it was the highest rating for the major property sectors RERC tracks. This indicates that while office properties currently are losing some favor among investors, they still are viewed as the strongest performer when compared to the other sectors. RERC’s investment survey also indicated that while the office sector’s required pre-tax yield rate remained relatively unchanged, required going-in and terminal cap rates had declined somewhat.
With the sustained strength in fundamentals, prices nationally can be expected to continue to increase somewhat, but a correction is needed in some markets to accommodate the fear of overpricing.
With consumer demand and industrial production down, the need for industrial properties also has fallen. Supply has outpaced demand, further hurting absorption, which was very strong during previous quarters. However, occupancy remained strong during the second half of 2007, especially in the manufacturing subsector, as exports increased due to a weakening dollar. Net absorption is expected to slow, while rents should remain steady.
On a national level, end-of-year prices for industrial properties continued to increase slowly, while transaction-based cap rates remained steady, demonstrating an end to cap rate compression as prices adjust to lower rates. This trend likely will give rise to steadying prices, as demand for space is likely to level off.
Prices and transaction-based cap rates in each of the four regions were mixed as 2007 came to an end. The East saw lower average prices for industrial properties, with cap rate increases barely noticeable. Both the Midwest and the West saw strong increases in average prices for industrial assets, while cap rates fell only slightly. And in the South, prices remained steady, while cap rates increased slightly.
With some fear of an economic slowdown in the U.S. economy, demand for retail properties already is declining. Retail fundamentals were down during the last part of 2007, with availability rates up due to increased supply. Weak employment growth is starting to hurt consumer spending, but fundamentals for the sector should strengthen as 2008 progresses.
With fundamentals down, the national retail sector saw falling prices during the last part of 2007, while transaction-based cap rates remained steady. As fundamentals regain some strength this year, prices likely will switch gears, possibly even turning to positive growth.
The East saw decreasing prices and steady cap rates during the latter part of 2007. Average prices in the Midwest were up only slightly and cap rates were down slightly. However, the West and South saw slightly higher prices during the last part of 2007, with cap rates remaining constant, adding to fears of overpricing in some markets.
National apartment fundamentals were strong during 2007, thanks to a great deal of help from the subprime lending fallout in the residential market. However, supply may begin to outpace demand, as unsold houses are rented and units slated for condominium conversion re-enter the market as rental units.
On average, the national apartment sector saw slightly higher prices and slightly lower transaction-based cap rates during the last part of 2007. This trend is likely to continue, as demand should stay fairly steady during the coming year, but growth likely will slow as supply and demand reach equilibrium.
The Midwest apartment sector is following national averages, with prices increasing and cap rates falling slightly during late 2007. The East is seeing slightly lower average prices, but transaction-based cap rates are steady and may be serving to correct previous compression as prices struggle to come in line with very low cap rates. In the South, prices were down slightly for apartments, while cap rates were up slightly. Apartment prices also were down slightly in the West, while average transaction-based cap rates were fairly steady.
Investment Risks and Opportunities
This year, commercial real estate faces an investment environment that is riskier than we have seen in more than five years. Growing uncertainty over the economy and employment growth is forcing investors to re-evaluate their forecasts for investment income from commercial real estate and cap rate assumptions. This calls into question prices and values accorded to all commercial properties, especially those in average or marginal locations and those property types most at risk in a decelerating economy and a more risk-averse capital market. This also includes higher-quality properties that were purchased using significant amounts of leverage.
As these properties are sold or refinanced, they face a materially different pricing strategy from both equity and debt underwriting perspectives. This
re-pricing will be a more gradual and measured market response and will not create the meltdown experienced in the residential market. There clearly will be disappointed investors, but this same market is creating a more favorable environment for buyers. Perhaps this market-clearing reality is coming at the right time, as commercial real estate generally had investment expectations that were very difficult, if not impossible, to live up to. These downward shifting market dynamics are coming at the right time, before commercial real estate gets deeper into an overpricing situation.
Cap rates also have begun to change. Cap rate compression still is a fear in certain sectors where rates continue to fall. However, cap rates are decreasing at a much slower rate and likely will stabilize as prices also change. As shown in Table 2, the retail sector already saw some stabilization as early as 2Q07, with the industrial sector seeing slight increases in rates during the same time period.
Although we view debt capital as tightening the hatch and clearly as more discriminating and volatile, there is still an ample amount of debt capital to support the right level of financial leverage for commercial real estate. Further, there is plenty of equity capital from both domestic and foreign sources that is inclined to invest in commercial real estate.
All the turmoil that has commercial real estate investors climbing the wall of worry is probably not what most investors want to hear, but it is what the market needs at this point in the commercial real estate cycle. As indicated in Table 3, commercial real estate is in an over-performance investment phase that is unsustainable. Although the office sector performance continues to trend upward, the industrial, retail, and apartment sectors are down from the high-performance phase experienced during the past two years.
The underpinnings of commercial real estate are relatively stable, allowing for the market to carefully climb that wall of worry. There will be casualties and some disappointed investors. However, given the view of what other investors are faced with in the other financial arenas, commercial real estate should hold on and prepare for the challenges ahead.
2008: Markets to Watch
The following list of top 10 markets by property type is based on RERC’s price/value analysis, which utilizes RERC’s valuation expertise, market knowledge, and financial modeling capabilities to identify these markets.
|Salt Lake City
||Kansas City, KS