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Guarded Optimism
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Concerns about financing and a sluggish U.S. economy won’t deter commercial real estate investors.
- Despite a softening economy and turmoil in the capital markets,
investors continue to have confidence in the U.S. com mercial real
estate industry. A survey of more than 1,000 private and institutional
real estate investors shows only one in five respondents believe the
economy will be stronger in 2008, yet the majority want to invest more
funds in the sector.
- “To see that a majority of investors are still
planning to increase real estate holdings and that the percentage is
higher than last year is a strong validation that they are separating
capital markets issues from commercial real estate fundamentals,” says
Harvey Green, president and CEO of Marcus & Millichap Real Estate
Investment Services.
- The survey, dubbed the 2008 Real Estate Investor
Outlook, was conducted jointly by National Real Estate Investor, Marcus
& Millichap and Countrywide Commercial. This is the fifth year in a
row this exclusive survey has been administered to U.S. real estate
investors.
- The survey reveals that 62 percent of respondents plan to increase
allocations in real estate over the next 12 months compared to 60
percent in 2006, 69 percent in 2005 and 74 percent in 2004. Only 7
percent of real estate investors plan to decrease their investments in
real estate over the next 12 months (see figure 1, at right).
- “Investors are going to invest more in real estate because pricing is
more attractive and they’ll be able to get slightly higher yields,”
says Chris Tokarski, managing director of Countrywide Commercial’s real
estate finance group. Of the investors who plan to increase their real
estate holdings, the average estimated increase is 21 percent.
- “Availability and cost of debt may have changed, but healthy
occupancies, rent growth, lack of overbuilding and moderation in prices
are the drivers behind the optimism,” adds Green.
- Investment sales activity in 2007 is on pace to eclipse 2006’s $356
billion, according to Real Capital Analytics Inc. As of October 1, the
New York-based research firm, which tracks all deals $5 million and
above, had recorded $356 billion in sales of the five main property
types (office, apartment, retail, industrial and hotel).
- For the first two quarters of 2007, U.S. commercial property provided a
cumulative return of 8.21 percent and is on track to at least meet the
2006 annual return of 16.6 percent, according to the National Council
of Real Estate Investment Fiduciaries.
- “People who have invested in real estate over the past several years
have enjoyed really good returns,” says Rick Cavenaugh, president and
COO of Fifield Cos., a Chicago-based developer and owner that
specializes in multifamily and office properties. “We believe there
will still be ample capital flowing into the real estate sector because
returns will still be pretty strong, even as they come off the levels
where they were.”
- In order to gain an in-depth understanding of investor attitudes
and expectations about the commercial real estate industry, NREI,
Marcus & Millichap and Countrywide Commercial collected data from
August 16 to September 17, 2007. Similar to previous years, private
investors account for the largest group of survey participants (45
percent). This year’s survey also questioned a large number of
developers – roughly 13 percent of overall respondents. The survey also
includes the views of 92 institutional investors.
- Respondents have an average of 19 years’ experience in the industry
and an average of $36.6 million invested in real estate. On average, 62
percent of respondents’ portfolios are allocated to real estate.
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Among the key findings:
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• Only 16 percent of respondents predict the economy will be stronger
in 2008 than it was in 2007. Another 41 percent expect the economy will
stay the same, while 42 percent expect it will be weaker. When compared
to respondent responses from previous years, this survey indicates
concerns about the economy have grown significantly since 2004 when 63
percent expected the economy to be stronger over the next 12 months and
only eight percent expected it to be weaker (see figure 2, at
right).
• Availability and cost of financing moved up to the top concern for
2008. Unforeseen shocks to the economy rank as the second-highest
concern among all groups except developers; 43 percent of developers
express concern over rising interest rates (see figure 3, page 4).
• Investors are optimistic about rental increases, although not as
much as they’ve been in the past. Seventy-eight percent of respondents
expect to see an increase in effective rents for one or more property
types compared to 84 percent in 2006. Investors feel most positive
about rental increases in the apartment sector.
• Replacement cost continues to be a key criterion for investors when
they make acquisitions. Almost 90 percent of investors agree that
replacement value is important. Nearly two-thirds of respondents
indicate their most recent acquisition was at or below replacement
cost, while 12 percent of respondents say their acquisitions were above replacement costs.
- • Sixty-one percent of respondents say that returns are
artificially low, with 38 percent predicting that returns will rise
back to long-term averages as conditions change and 23 percent
forecasting returns will rise as conditions change but will not reach
long-term average levels.
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HOUSING HURTS
John Donne’s famous
quote “No man is an island” definitely applies to the commercial real
estate industry. Despite the industry’s insistence that the troubles in
the residential real estate market had absolutely nothing to do with
it, the commercial real estate sector has suffered.
“The commercial real estate industry has caught a cold from all the
coughing and sneezing of the housing market, which is deathly ill,”
notes Dennis Yeskey, national director of Deloitte & Touche LLP’s
Real Estate Capital Markets Group.
Although everyone had high hopes the U.S. housing market would have
a soft landing, increased foreclosures and the meltdown in the
residential mortgage market caused the housing sector to crash-land.
Even worse, the residential mortgage crisis spread to the rest of the
credit markets, infecting everything from corporate bonds to commercial
mortgagebacked securities (CMBS).
Most survey respondents believe the housing market will be unstable
for at least 12 more months. In fact, only 14 percent of investors say
the housing market will stabilize within the next few months.
Housing starts fell 2.6 percent in August to 1.3 million as the
downswing in the housing market continued, according to the U.S.
Commerce Department. Starts were down 19.1 percent from a year earlier,
falling to the lowest level in 12 years. In August, existing inventory
reached the highest level since February 1988 with an inventory-sales
ratio of 9.8 months, according to the Mortgage Bankers Association
(MBA).
Dennis Lockhart, president of the Federal Reserve Bank of Atlanta,
believes that the bottom of the housing downturn could arrive during
the second half of 2008 or even later.
That’s not good news for the U.S. economy, especially when you
consider that prior to the recent downturn in housing, there were 10
prior housing declines during the postwar period and all but two of
them were followed by a recession. (The exceptions were the housing
declines in 1950 and 1966 when major increases in defense spending
helped keep the economy afloat.)
In fact, the outlook for U.S. growth has deteriorated due to the
weak housing market and increasing concerns of defaults on subprime
mortgages. RREEF Research is forecasting economic growth of just 1.8
percent in 2007, and 2.2 percent in 2008 compared to 2.9 percent in
2006 and 3.1 percent in 2005. Consumer spending is expected to drop
from 2.8 percent this year to 2.3 percent in 2008, and unemployment is
expected to rise from 4.6 percent to 5.1 percent.
“There is no doubt that the economy is more vulnerable to any
additional disruptions after the credit-tightening that has occurred,”
says Hessam Nadji, senior vice president and managing director of
Marcus & Millichap Research Services.
“We don’t believe the housing downturn has bottomed, and that will
be a drag on the economy well into 2008. However, strength elsewhere,
particularly corporate balance sheets, profits, business investments
and exports should result in a slowdown rather than a recession.”
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FINANCING WORRIES
Still, there are ongoing concerns about
the credit markets for both residential and commercial real estate. In
fact, availability of financing is the top concern for respondents in
this year’s survey. Last year, only 16 percent of respondents were
worried about it – more were concerned about the economy and cost of
building materials. - Six out of 10 respondents say debt financing will
be harder to get over the next 12 months, which compares to just 35
percent in 2006 (see figure 4, at right). And they have every right to
be spooked by what’s happened in the capital markets.
There’s a global liquidity crisis in all asset classes that is going to
make financing much more difficult,” Tokarski says. - In mid-summer, the
CMBS market all but shut down as bond buyers exited the market, leaving
billions of dollars’ worth of CMBS paper in “warehouses” and forcing
many borrowers to pursue debt financing from portfolio lenders
including life insurance companies. At their worst, CMBS spreads had
widened to swaps plus 70 basis points for 10-year triple-A bonds, while
triple-B- spreads widened to swaps plus 425 basis points.
I would describe the capital markets’ adjustment to commercial real
estate as an overreaction to the residential subprime issue,” Green
says, adding that he expects the capital markets to settle down and
spreads to decline eventually. "But they will not go back to their preJuly 2007 conditions.” - Before the
subprime meltdown and subsequent credit crisis, $136.7 billion of CMBS
loans were originated during the first half of 2007, an increase of 55
percent from the same period in 2006, according to MBA.
- As of early
October, CMBS lenders were still working through much of the warehoused
paper. But only $10 billion worth of CMBS bonds were priced in
September, less than half of the $26 billion that was initially
projected, according to RBS Greenwich Capital, one of the world’s
largest CMBS issuers.
- Many of the deals that were slated for September
were expected to come to market in October, pushing projected issuance
to $34.2 billion. If no other deals come to market in 2007, domestic
issuance will total $245.4 billion, or 21 percent above 2006’s total,
according to RBS Greenwich Capital. The firm initially projected 2007
issuance at $290 billion.
- Fortunately, there are signs that the CMBS
market is calming down. Fixed-rate CMBS spreads tightened in early
October, with triple-A spreads reaching swaps plus 55 basis points. The
tightened spreads, along with lower interest rates, mean investors’
cost of debt has decreased.
By the beginning of the second quarter 2008, I think the upheaval in
the credit markets will work its way out, but the stricter underwriting
will be here to stay,” says R. Craig Butchenhart, president of
NorthMarq Capital Inc., one of the largest mortgage banking firms in
the nation. - In fact, underwriting standards today are much more
conservative than they were in 2006 and early 2007. Ratings agencies
Fitch Ratings and Moody’s Investors Service both issued reports earlier
this year indicating that conduit lenders had become too aggressive in
their underwriting and loan terms, putting CMBS investors at risk.
"Over the last five years, anyone who could breathe could get a loan and
could buy real estate,” Tokarski says, adding that investors are going
to have a much harder time raising debt and equity in today’s market.
- Previously, many loans were based on projected income streams rather
than current income streams. Borrowers routinely closed highly
leveraged loans, with loan-to-value ratios exceeding 80 percent.
Moreover, interest-only loans (IO) were easy to come by, with many
borrowers obtaining 10-year IOs.
- Today, loan-to-values have returned to
more traditional levels in the 70 percent range, while IO provisions
have all but disappeared. "This was a muchneeded adjustment that will make our industry much
stronger,” says Scott Derrick, chief acquisitions officer of SCI Real
Estate Investments, a Los Angeles-based tenant-in-common (TIC) sponsor
that is scheduled to make roughly $550 million in acquisitions this
year.
- The stricter underwriting standards and lower leverage limits are
good news for SCI Investments and other investors with long track
records that aren’t overly debt-dependent. If you can find the right deals and can align your-self with financing,
it can be a good opportunity to invest,” says William Hughes, senior
vice president of Marcus & Millichap Capital Corp.
It’s a better environment for sophisticated investors because lenders
are going to back borrowers with more experience and a longer track
record.
- FROTHINESS FADES
- The challenging debt markets and tighter
underwriting standards are expected to impact asset pricing and cap
rates.
We’ve seen the highly leveraged buyers leave the market because they haven’t been able to close loans,” Derrick says.
That means there’s less competition and less pressure on pricing.” In
fact, SCI hopes to invest $700 million in real estate in 2008. - San
Diego-based office and industrial investor Equastone also has high
hopes for 2008 and is targeting a total investment of $1 billion, says
chief investment officer Jeff Schindler. The firm had similar goals for
2007 but is “proceeding with caution” to make sure its acquisitions are
priced appropriately.
Since the highly leveraged buyers have been sidelined, the market has lost some of its frothiness,” he explains.
There’s still some NOI growth that supports strong pricing, but there
aren’t as many buyers showing up.” - While respondents are split on
whether pricing for commercial property has reached a peak – 44 percent
of respondents say yes and another 36 percent say no – most do
anticipate a decrease in pricing for most property types (see figure 5,
above).
- That response is a big change from last year’s survey when the
majority of respondents expected pricing to increase for all property
types except for grocery-anchored retail and regional malls (see figure
6, page 7).
I think we are entering a pe-riod of realignment between the rate of
price appreciation and rent growth, but to say we have peaked implies
prices across the board will stagnate or fall, and I do not believe
that will be the case because of healthy fundamentals,” Green says. - In
fact, Green expects rents to continue to grow across most property
types, although the pace will be slower than it has been for the past
several years. "The recovery period is behind us for office, apartments, industrial and
hospitality, creating a more normalized market rather than a recovering
market in which vacancies have a long way to drop and rents have a long
way to climb. Retail, which never had a downturn, is now more likely to
experience slower rent growth because of weakness in housing,” he
explains.
- Additionally, the slowing economy will reduce the pace of
absorption, and in some markets – such as those that are vulnerable to
financial services or mortgage industry cutbacks – vacancies will rise
and rent growth will stall, at least temporarily.
- “It all depends on the economy, and if the economy slows, we won’t see any rent growth,” Yeskey says.
But we won’t see any decreases either.” The majority of respondents
agree – four out of five do not expect a decrease in the effective
rents for any property type. In fact, 78 percent of respondents expect
to see an increase in effective rents for one or more property types
with apartments leading the way (see figure 7, page 8). - In addition to
healthy fundamentals, commercial property valuations are well-supported
by replacement costs.
It still costs far more to build a building than it does to buy an
existing one, not to mention the difficult approval process in most
markets,” Nadji points out. "Replacement cost is still well above acquisition pricing in most markets and property types.”
And although construction costs may not be increasing at the rapid pace
they were six to eight months ago, they’re still high enough to make
development more difficult than acquisition.
"I expect there is going to be less development in 2008 because
construction financing is much more difficult to get,” Tokarski says. "If a project is not already under way, I doubt it will break ground
without preleasing.” - Last year, construction costs were one of the top
three concerns for survey participants. This year, worries about
construction costs were less acute. However, seven out of 10
respondents experienced an increase in construction costs over the past
12 months, and more than half expect an increase in the next 12 months.
The survey suggests that construction costs increased an average of 16
percent. Going forward, respondents forecast construction costs to
increase six percent.
- Many experts say the slowdown in single-family housing construction has
decreased demand for commonly used building materials, therefore
mitigating extreme price increases. However, construction costs
continue to be a big concern for Chicago-based Fifield Cos., which
develops high-rise apartments and office buildings.
Demand for concrete and steel hasn’t dropped off because there are
still a lot of projects under development that use these materials –
particularly public projects,” Cavenaugh says, adding that global
demand for these building products continues to be high as well. - All of
these market dynamics make a substantial price correction unlikely. In
fact, only eight percent of respondents expect a major pricing
correction, while 90 percent expect there to be a minor or modest
pricing correction for commercial real estate assets.
- Tokarski
forecasts a five percent to 10 percent decrease in pricing for top-tier
real estate and a 10 percent to 15 percent decrease for assets in
secondary and tertiary markets. If the market does experience a 10
percent pricing correction, that 10 percent corresponds directly to the
appreciation commercial property experienced from fourth quarter 2006
through first quarter 2007 when underwriting was at its most aggressive.
"Many buyers have become more cautious – as have lenders – and there is
much more focus on real income as opposed to aggressive pro forma
expectations,” Green explains. He, too, expects buyer demand and
pricing for higher-quality assets in primary markets will remain
strong, while lower-quality assets will see more of an adjustment,
especially in secondary and tertiary markets. - Respondents expect cap
rates to increase for all property types over the next 12 months, but
the increase is expected to be slight – only 29 basis points. As of
early October, the average cap rate for commercial property was 6.94
percent, according to Real Capital Analytics. In 2006, the average cap
rate was 7.12 percent.
- The upward pressure on cap rates comes from the
credit crunch and the looming threat of recession, Nadji says, adding
that cap rates for top-tier properties are not expected to rise more
than 25 basis points while cap rates for lower-tiered properties and
markets will increase 50 basis points to 75 basis points.
- Bob
Dougherty, chief acquisitions officer with Buchanan Street Partners,
has already seen a 25basis-point increase in cap rates. "Many cap rates have been predicated on the availability of cheap debt,
and that’s driven pricing to artificially high levels,” he notes. "We’ve been underwriting a 100basis-point increase in cap rates for
almost two years because we’ve been expecting a correction. Now we
think cap rates will return to historical norms of 200 [basis points]
to 300 basis points over Treasuries.”
- But NorthMarq’s Butchenhart is
less confident that returns will ever return to historic levels. "Real estate is recognized as a strong asset class by most investors
today, so returns are not going to go back to where they were when
investors didn’t recognize the asset class,” he says.
APARTMENT APPEAL
Apartments and mixed-use assets are the most attractive to respondents.
In fact, 33 percent of them say they’ll enter the apartment sector in
the next 12 months, and 19 percent indicate they’ll enter or expand
into the mixed-use sector. Office properties and retail assets rank far
lower with investors, according to the survey. - Investors are
increasingly interested in the apartment sector. In 2004, for example,
roughly $51 billion worth of apartment assets changed hands in the U.S.
– about $1 billion less than the volume of transactions during the
first three quarters of 2007, according to Real Capital Analytics.
- Today, much of the investor interest in apartments is driven by the
weakness in the housing sector and continued upheaval in the mortgage
markets. "With both the condo market and the single-family home market falling
apart, people have to live somewhere, so they’re going to rent
apartments,” Yeskey points out.
- Buchanan Street Partners is bullish on
the apartment sector, Dougherty says, and plans to grow its portfolio
by investing in the multifamily sector. "We like the demographic and demand trends in the sector because
affordability of single-family housing is out of reach of many people,”
he explains. This year, the company is on track to close $325 million
to $350 million in new equity investments. Next year, it is shooting
for $400 million to $450 million.
- Dougherty, along with many other
investors, expects apartments to benefit from increased pricing and
rental rates. In fact, three out of four respondents who are currently
invested in apartment properties predict an increase in effective
rents, and nearly one-third expect to see an increase in the market
pricing of apartment properties. More than half of those who invest in
apartments expect a slight or major increase in cap rates.
- As of
October, the average cap rate for apartment properties was six percent
and the average price per unit was $104,857, according to Real Capital
Analytics. To compare, the average cap rate in 2004 was 8.66 percent
and the average price per unit was $67,776.
- Alan George, chief
investment officer for Equity Residential, says cap rates for Class B
and C apartment properties have increased 25 basis points and 75 basis
points, respectively, since mid-summer. "I think cap rates for those types of assets has plateaued, and I
wouldn’t expect more of an increase in 2008,” he notes, adding that
Class A cap rates have moved very little.
- Some industry experts are
less enamored of apartments. Yeskey, for example, feels apartment cap
rates are too low for most investors to make a good return. "I really worry about the cap rates on apartments – investors better be
sophisticated operators because there’s not a lot of juice there,” he
says.
- Beyond apartments, Nadji says there are investment opportunities
in office and retail. "The office market still has a lot of room to run, and the concerns
about the retail sector are overstated,” he contends. Nadji points out
that the office leases that were signed from 2002 to 2004 were at the
bottom of the market. "When tenants renew in the future, there is a mark to market that should
result in higher rental rates and revenue increases,” he explains.
Three in five downtown office investors expect effective rents to
increase, and nearly half of suburban office investors expect rents to
increase. These numbers are consistent with the 2006 findings.
- As for
the retail sector, Nadji admits that that there are some valid concerns
about consumer spending, which has dropped off significantly this year.
But he contends that retail sales are still growing and retail
fundamentals are still strong. Most projects that are under development
are preleased, preventing serious overbuilding in most markets and
keeping the expected rise in retail vacancies moderate.
- Property types
aside, Nadji expects continued investor interest in properties that
they can renovate, redevelop or expand. Nearly half of respondents (45
percent) plan to acquire properties specifically for redevelopment,
renovation or expansion. More than two-thirds of developer respondents
(70 percent) plan to acquire properties for this purpose. SCI, for
example, is raising a $50 million fund specifically to invest in
value-added properties in infill locations.
"In a low-yield environment, it is not surprising to see the appetite
for value-add investments, but these types of assets will be harder to
finance because of the risk level,” Nadji says. "For investors with cash and a higher tolerance of risk, value-added properties will present a great opportunity.” - "George agrees:I think the value-added sector is a more difficult business today than
it has been in the past, but rehabs of quality assets in quality
locations always make sense.”
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