Making Sense of the Market
Investors who know where to look can find opportunities.
While commercial real estate is more than ever intrinsically linked to the capital markets, the fundamental outlook for its stability and long-term success remains healthy for the balance of 2008. Escalating construction costs, specifically for materials such as wood, steel, and oil, have hampered overbuilding in most domestic markets. These input costs are not expected to decline, which constrains the market’s tendency to overbuild. Escalating land prices and expectations of future land and development demand clearly have cooled, and commercial land values will be re-benchmarked well into 2010 in all markets where vacant land is plentiful. For most asset classes, continued strength in occupancies, rent levels, and demand appear to be in balance in most markets.
So why does everyone feel so badly about this year’s commercial real estate prospects?
A survey of industry experts and analysts point to four current trends that are affecting lenders, investors, brokers, and owners in the commercial sector:
- general economic malaise;
- investors’ wait-and-see attitude;
- lack of available capital; and
- buyer-seller price disconnect.
However, these four trends affect the trading of real estate, not the underlying supply/demand fundamentals of the commercial sector. But how each of these factors develops through the balance of 2008 frames the midyear forecast.
Economic Malaise. New commercial real estate demand essentially is a function of job growth (office and industrial) and discretionary consumer spending (retail and hotels). Multifamily investment has been the hot-button focus for 2008 because it is the sector most decoupled from job growth and consumer spending, and multifamily demand is directly linked to declines in housing purchases.
But for the other investment classes, expectations of slower economic growth and decreased consumer spending create uncertainty. Radically escalating oil prices, continued housing-value declines, waning consumer confidence, decreased tourism and vacation spending, and contraction of overall general domestic product in a presidential election year all conspire to alter occupancy and rent growth projections. But these changes are cyclical, and investors should remember that such uncertainty breeds opportunity.
Investor Attitude. By mid-2007, investors already were asking, “Where are the good deals?” This problem plagued large institutional investors to a greater degree because packaged institutional-class real estate premiums (capitalization rates, yields, and price ratios) had reached a level that moved seasoned investors to the sidelines. As interest rates continued to climb in late 2007, investors were rewarded for hoarding cash. In addition, significant industry discussion that capital gains rates must be increased post-election accelerated local and regional investors’ desire to convert to cash. But by 2Q08, these interest rate increases were reversed, as the Federal Reserve radically cut interest rates to stave off recession and recapitalize the banking system.
Recession or not, these interest rate cuts will remain throughout 2008, which will require that investors get back in the game or suffer pitifully low returns in the cash market. The continued weakness of the U.S. dollar also will punish the wait-and-see investors hoarding cash into 2009 as well.
Lack of Capital. The commercial mortgage-backed securities market has been paralyzed since the residential subprime meltdown. The demise of Bear Stearns and the quantity of unsold B+ pieces and lack of B-piece buyers has halted this increasingly significant commercial financing component. Given strong supply/demand fundamentals, the B-piece investors are poised for phenomenal returns in 2008 because diversified B-piece packages are being severely discounted in the market for liquidity, and 2Q08 interest rate cuts will unlock huge returns based on 2008 B-piece spreads.
At the same time, traditional insurance and bank lending sources are moving slower and being more conservative in their underwriting, which has slowed the transaction pipeline significantly. This pace probably will continue to trickle through 2008 and well into 2009 as insurance and bank lending plays an increasingly larger role in the short term.
Price Disconnect. The decreasing transaction pipeline is due to a clear disconnect in sellers’ price expectations. This response confirms strong real estate fundamentals because sellers are the current owners of the real estate. They are experiencing reasonably good performance and are not willing to reduce their asking prices purely based on speculation that performance will worsen.
At the same time, sellers are looking at late 2006 and 2007 deals that closed in early 2007 and must eventually face the reality that if they want to exit, something must give. Buyers with cash will not buy in 2008 on short-term negative equity returns just to get the deal. It is time for sellers to get serious and let go of 2006 appraised value premises with a 5 percent cap rate and 25 percent property appreciation assumptions over the next seven years. And unlike 2006, sellers don’t have the opportunity to refinance to generate cash this year. This should bring asking prices more in line with bids into 2009.
Asset Classes to Watch
Everyone in the industry — mortgage brokers, bankers, appraisers, and commercial transaction brokers — is experiencing the current pain of declining transaction-based fees. And frustrated investors keep asking, “If everything is getting worse, why can’t I find a deal that makes sense?” Sellers are just as frustrated since they can’t exit at their projected prices, and refinancing doesn’t make economic sense.
But this friction is healthy, if only out of respect for the old maxim “the higher you go the harder you fall.” All markets reported a decline in activity, reflective of aforementioned factors. But national and dominant regional markets are stalling almost universally. These markets are poised for a re-benchmark of seller expectations and price corrections that favor buyers.
But the current climate does not point to long-term fundamental value declines because the analysis of supply and demand indicates balance in most markets and sectors. So the situation represents good investment opportunities in 2008 and 2009 for those investors who aren’t waiting for the pack to tell them where to look.
Multifamily. The collective zeitgeist over the past 12 months has been to buy multifamily in a declining housing market and eschew office and retail in light of declining job growth and consumer spending. This perspective has resulted in massive equity shifts into multifamily investment in almost all markets, which compresses cap rates and drives prices upward.
Multifamily ownership is only a safe haven in a recession if investors don’t buy at the top of the market. Prices on class B apartments are skyrocketing past depreciated replacement costs on extremely aggressive rent growth assumptions. This probably will continue into 2009, but absent a severely land-constrained market like northern New Jersey or suburban Chicago, investors are cautioned to look long and hard at multifamily assumptions before following the herd into aging properties.
That being said, smart land acquisitions in under-supplied class A apartment markets should appreciate nicely into 2010 as rent pressure makes new construction feasible. Markets to investigate: Chicago suburbs, New York suburbs (New Jersey and Connecticut), Pittsburgh, Cincinnati, and Charlotte, N.C.
Industrial. Warehouse acquisitions are the emerging darling of 2008 and 2009. Industrial exports will expand with the weak dollar, and port capacity will be at almost terminal levels nationwide in the next five years. The closure of Port New Orleans has shifted intermodal demand to Houston and Dallas-Fort Worth, and East Coast cities are poised for continued growth. Major retailers have upgraded their supply-chain management, and major industrial shifts into the central U.S. are expected to continue. Markets to investigate: Kansas City, Mo., Dallas-Fort Worth, Boston, Tulsa, Okla., Baltimore, New Hampshire-Maine, Memphis-Nashville, Tenn., Charlotte, and San Antonio.
Retail. It has been a tough ride for retail since 2006. New construction has been fairly well absorbed in most markets, but almost every U.S. market reported substantial construction into 2007. Discretionary spending will decline through the end of this year, and continued weakness for major retailers will make headlines into 2009. Investors should stay in markets that have good core housing fundamentals. Vacancies will increase, but properties that are in strong markets will rebound quickly. Retail most likely has the biggest potential in 2009 to be the value-add real estate class for repositioning and long-term hold. Markets to investigate: All markets reported are saturated with investors, so deals are hard to find. Investors should find a market they like to visit and stay on the ground looking.
Office. Concerns regarding job and rent growth means that aggressive investors are looking at office building buys. However, the 2004-06 run up in prices when job growth prospects looked strong, culminating in Blackstone’s buyout of Equity Office and subsequent flips, essentially deflated everyone’s perspective of opportunity. There are still markets with strong job growth and/or good prospects for immediate job growth rebounds after a recession. There also are immediate opportunities in demographically aging markets for segmented medical office growth, particularly in second-tier retirement markets with high population influx of retirees. Markets to investigate: Boston, Miami, Detroit, Milwaukee, Portland, Ore., San Diego, Kansas City, Mo., Dallas, Houston, San Antonio, Richmond, Va., and coastal North and South Carolina.
Hospitality. In recent years, lodging has elevated itself into a commercial property asset class. But it is difficult to make price or investment generalizations about lodging because market segmentation is so important. As a general comment, the entire U.S. has been flooded with extended-stay and limited-service formats. Some of this new construction was driven by real demand and undersupply, but the lodging market is in for a tough ride through 2009. In addition to general discretionary spending, business and leisure travel are not expected to rebound through 2009 and have been artificially buoyed over the past two years. Markets to investigate: Any market with high predominance of international travelers such as Orlando, Fla., Miami, New York, Seattle, and Los Angeles, since the weak dollar will favor international tourists. Otherwise, investors should conduct local due diligence on supply and be sensible regarding average daily revenue projections.
Values Will Decline
It is impossible to say that transaction activity is down for two quarters and a recession is looming, but values will not decline. Current sellers that reduce their asking prices to meet current bids may be underselling themselves if economic conditions reverse drastically by 2009, but those sales are the comparable transactions appraisers will use to value real estate at the end of 2008. Capital availability and equity return requirements will continue to place upward pressure on cap rates, and future rent growth forecasts will continue to be flat or moderate at best until the economic clouds blow over.
Investors with an understanding of real estate cycles should care less about paper losses in 2009 based on downward appraised value trends. With fewer buyers in the market and hungry real estate and mortgage brokers working hard to catch deals, today’s commercial investors are in a great position to find true value-add deals over the balance of 2008 and into 2009.
Expect values to generally decline 10 percent to 15 percent into late 2008 as cap rates rise to meet minimum investor return requirements. The conundrum in 2009 will be reflected in the battle between recession fighting, which will require a low-interest rate environment, and investor confidence in upside, which will dictate a higher risk premium. Although investors won’t be rewarded for holding cash in 2009, it will be harder to find good investment deals at sensible equity returns if interest rates remain low and capital availability increases once again. The best prediction for 2009 is probably level to slightly declining values, pockets of opportunity, and a return to investment fundamentals.
A general recession never helps commercial real estate, but a short-term recession will not result in a fire-sale environment circa 1990-92. In the event we look back on 2008 and see recession in the data, 2009 will carry forward the wait-and-see attitude for another two to three quarters. But at that point, investors will have missed their buying opportunities when everyone was paralyzed and confused.
Investment Market Prospects
with positive demand
Boston: Strong convention and office market
Dallas-Fort Worth: Barnett Shale gas field generating strong economy
Denver: Past employment declines have reset expectations
Houston: Energy and Port Houston drive activity
Indianapolis: Buys against replacement cost very favorable
Miami: Condo bust masking international in-migration that drives demand
Richmond, Va./Charlotte, NC: Banking gets profitable again
Strong regional markets
Austin, TX: Nonstop job growth
Cleveland: Negative population growth masking good opportunities
Milwaukee: Healthcare activity
Minneapolis-St. Paul: Fortune 500 haven, highly educated workforce
Savannah, GA: Port city and tourism drive activity
Seattle: Strong job growth in technology and airline industries
Detroit: Opportunities exist at 50 percent of replacement cost
Boise, ID: Poised for rebound
Portland, OR: Land constrained and underpriced
Columbus, OH: Ignored by institutional investors
Memphis, TN: Historically slow growth, under recognized
Tulsa, Okla.: Energy suburb of Texas
Wait until 2009–10
Northern New Jersey