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Realistic perspectives on real estate: it's likely to be 2011 or 2012 before U.S. commercial real estate sees significant recovery in property values or a corresponding uptick in the overall industry.

Sir Winston Churchill once remarked, "A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty." While the U.S. commercial real estate industry will continue to grapple with adverse conditions in 2010, optimistic investors are seeing opportunity in a difficult market via the purchase of distressed assets.



Many of the issues that challenged real estate owners and operators in 2009 are expected to extend well into 2010 and 2011.

Declining real estate values

U.S. commercial real estate values have decreased significantly--according to some reports, up to 40 percent across all property types--since their peak in 2007. Job losses and declining consumer spending in 2009 have had a negative impact on all classes of real estate investments, particularly office and retail properties. Vacancies are up, which drives down rental rates and decreases value.

For example, in its April 2010 MarketView: Midtown Manhattan report, CB Richard Ellis Group Inc., Los Angeles, cites a Midtown Manhattan office vacancy rate of 10.2 percent at the end of first-quarter 2010, versus 4.5 percent at first-quarter end 2008. Building owners subsequently have dropped their asking rental rates by 34 percent during the same period.

Have real estate values bottomed out yet? If the fledgling real estate transaction volume that began to appear in late 2009 and early 2010 continues through the remainder of 2010, it should provide some clarity.

Transaction volume continues to be negatively impacted by the lack of credit, uncertainty about valuation and existing owners with little to no equity in properties with little incentive to sell. Ultimately, it will take sustained improvements in employment figures and consumer spending to drive demand for office, retail, industrial, multifamily and hospitality space as well as produce a corresponding uptick in occupancy and effective rents.

With the index of leading economic indicators rising in March 2010 and pointing toward economic growth in the second half of the year, this potential recovery could create the next leg of the real estate cycle, with values bottoming out and slowly beginning to climb.

Debt maturity and credit access

Declining real estate values are exacerbating another major issue for property owners and investors: debt maturity and credit access. According to New York-based Morgan Stanley, almost $1.8 trillion in commercial mortgages will come due by 2014, and as much as 65 percent of these will have difficulty getting refinanced (see Figure 1).


Organizations that took out large loans to purchase property during the market's heyday did so assuming that rents and occupancy rates would continue to rise; instead, both have fallen dramatically. When a mortgage loan comes due in this negative environment, the property owner faces difficulty replacing the original loan with one of similar size.

Although capital markets for credit and debt have opened to some extent, the situation is different than before--lenders are allowing less leverage on new loans. Also, debt is more expensive--in part, because lenders are only willing to lend at a lower loan-to-value (LTV) rate.

Finally, the commercial mortgage-backed securities (CMBS) market, a huge source for real estate debt capital in the past decade, virtually disappeared in late 2008 and for much of 2009, severely impacting the supply of debt capital, as shown in Figure 2. Although the CMBS market has shown some signs of life in late 2009 and into early 2010, it remains a small fraction of what it was.


Because of these constraints, and the fact that any uptick in value drivers for commercial real estate will probably lag the general economic recovery by three to six months, many commercial real estate owners and their mortgage holders will continue to struggle with debt maturity in 2010 and beyond.

Interestingly, there appears to be a "pretend and extend" pact between undercapitalized real estate companies and their existing lenders to help retain ownership of a property until the economy improves. In this scenario, the lender says to the mortgage holder, "Given that rates are so low, you can probably still pay interest on your loan. Let's extend that loan out three or four years, give the economy and capital markets time to come back, and the property the opportunity to return closer to its original value, and we will deal with the debt refinancing then."

The government has signaled its support of real estate debt extensions and loan restructurings in a couple of ways: It allowed a change in the tax law for 2009 and 2010 so that a company that has to modify or cancel a debt can defer the gain for five years (until 2014) and then amortize that gain. And the Federal Deposit Insurance Corporation (FDIC) has given guidance to banks about how to work with borrowers rather than foreclosing on assets--although recent regulatory actions by the Federal Reserve have sharply limited some banks' ability to change loan terms for troubled borrowers without first getting approval from the banks' boards of directors.

The alternatives to "pretend and extend" are for the lender to take back the property from the borrower, sell the loan or make a permanent adjustment in the loan. Generally, banks are reluctant to take back real estate and put it on their balance sheet, especially if the property isn't making any money or requires significant management attention to restore value.

The lender's decision to foreclose or acquire via a deed-in-lieu requires a thorough risk and operating assessment of the property, and consideration of various alternatives to taking the property back. If the borrower is managing a property well, is honest with lenders about its financial constraints, and convinces the lender that it is the best company to manage a property and bring its value forward, lenders will likely work with the borrower to modify or extend the loan, with the hope of maximizing returns.

That certainly was the case at the end of 2009, when quite a few loans were extended, and it will likely continue in 2010.

Still, debt-maturity issues and poor financial returns are prompting more and more real estate companies to hand back properties to their lending institutions. This is especially true with properties under construction and properties requiring additional capital due to unprofitable operations, such as hotels.

Some financial institutions, in turn, are using take-backs as a strategic opportunity to expand their real estate portfolio, manage the assets and (hopefully) profit by selling them in an improved market. Significant capital has been raised to invest in these distressed assets, and opportunistic investors are developing strategies to work with banks, mezzanine debt holders, special servicers on CMBS securities and the FDIC to capitalize on these investment opportunities. Figure 3 shows the increasing amounts of outstanding distressed assets and the various approaches taken by lenders.


Stalled construction

Expect virtually no new construction activity in any asset class in 2010. Developers may wrap up existing projects, but the industry likely will see historically low levels of new construction, as there is excess capacity in almost every asset class. (This is evidenced by the glut of office space in Midtown Manhattan and other major markets, as well as an oversupply of full- and limited-service hotel stock, most notably in Manhattan and select Texas markets, according to Boston-based CBRE Econometric Advisors' Hotel Overview & Outlook, Winter 2010 report, and multifamily residential properties in areas such as Florida, Nevada, Arizona and parts of California).

On the industrial front, high availability rates and sharply reduced construction have been the norm in the large distribution markets of Chicago and Atlanta, according to CBRE Econometric Advisors' report.

Retail construction activity has fared no better, with 10 major markets showing no projects in the pipeline for 2010 and regional Mountain and Northeast markets with near-empty pipelines, according to CBRE Econometric Advisors' Retail Overview & Outlook, Winter 2010 report.

There may be select locations where it could make sense to build something new, but there is no broad-based impetus to build.

Bottom out, then recover

Most real estate asset classes are expected to bottom out and start to recover in 2010. Rent levels will begin to recover with sustained job growth and increases in consumer spending and gross domestic product (GDP) that had begun to appear in the first quarter of 2010.

Hospitality and multifamily residential properties are already showing some indicators of stabilization, and may be the first to show recovery due to the relatively short-term nature of their leases. The recovery for retail, office and industrial properties will be slower, a result of the longer-term leases for those properties.

Some industry observers believe that the hospitality market has already bottomed out. Occupancy rates in 2009 were extremely low due to significant declines in leisure and business travel, which drove down the average revenue per available room (RevPAR). Many hotel operators have subsequently lowered rates, appealing to leisure travelers; combined with an uptick in business travel, occupancy rates have recently shown some improvement.

How quickly hospitality will come back remains a big question. The outlook for 2010 is mixed, with forecasters expecting declines in supply and occupancy, but increases (relative to prior quarters) in demand, RevPAR and average daily rate (ADR).

Although a handful of markets, including San Francisco and Atlanta, are expected to post positive room-rate growth in 2010, the majority will need to wait until 2011 for a return to profitability, according to CBRE Econometric Advisors' report and Atlanta-based PKF Hospitality Research's December 2009 Hotel Horizons [R] report.

Recovery in the office market is heavily dependent on job growth. If this happens in 2010, it will benefit office space; however, many expect to see continued, significant weakness.

A surplus of available office space--in part, the result of sublease space made available by companies that had to downsize--has driven down rental rates and created a very competitive market for owners. In the first quarter of 2010, average effective rents in Manhattan, for example, declined 16 percent year-over-year, to $43.72 per square foot.

Average effective rents year-over-year in Washington, D.C., decreased nearly 5 percent, to $41.43 per square foot, while nationwide, effective rents fell close to 8 percent compared with first-quarter 2009, to $22.22 per square foot, according to New York-based Reis Inc.'s Office Sector, 2010 Q1 report.

Retail is expected to fare a little better in 2010 than it did in 2009. Consumer spending has improved, as evidenced by better-than-expected holiday sales and four consecutive months of increases in consumer spending through March 2010.

Single-family home prices seem to have solidified (although it could take years for home values to truly recover), which has a big impact on retail spending. There are some indications that retail real estate may be in a position to recover before the office market. In fact, healthy retailers view 2010 as an opportunity to enhance their current space, move stores to higher-traffic locations or selectively expand--both great pricing and strategic locations are available to retailers with ready capital.

Projections for the industrial real estate market are less clear. Rising U.S. exports are helping to stimulate growth; however, recent strength of the U.S. dollar due to concerns about debt issues in Greece and elsewhere in Europe may negatively affect exports. In addition, global trade levels are still down from a couple of years ago, reducing demand for distribution centers.

Furthermore, industrial has been hurt by the recession and resultant corporate cost reductions, with many companies closing facilities and reducing warehouse space. Tight financing and weak demand for space have also slowed any recovery, with several quarters needed to absorb existing supply.

Despite these obstacles, a few bright spots in the market are emerging, with a number of large intermodal projects in the near-term pipeline and more than half of the rail-serviced markets showing positive demand, according to CBRE Econometric Advisors' Industrial Overview & Outlook, Winter 2010 report.

Finally, a turnaround in the multifamily residential market could take hold in the second half of 2010, but it will depend primarily on job growth. Apartment vacancies hit a 30-year high in fourth-quarter 2009 and rents fell 3 percent last year, according to The Wall Street Journal, as many young, laid-off workers moved back home or doubled-up to ride out the recession.

Cities seeing the sharpest increases in vacancies were Tucson, Arizona; Charlotte, North Carolina; and Lexington, Kentucky. San Jose, California; Seattle; and San Francisco led the decline in rental rates, according to The Wall Street Journal. To reverse this trend, apartment owners are enticing tenants to renew leases with an array of perks and amenities.

One positive for multifamily property owners is continued weakness in the single-family home market. The decline in home values, combined with stricter lending by banks, means fewer people are able to buy homes. Concurrently, falling rents make apartment rentals an attractive alternative. Many analysts believe that the level of homeownership, which rose to record highs in the past decade due to relatively easy and affordable mortgage financing, will return to more historical levels, which should help multifamily demand.

Where are the investors?

Capital is available and waiting to deploy, and the financing environment has improved somewhat (although it still has a long way to go), yet most commercial real estate investors have waited on the sidelines for a sense that values have reached bottom. Many of these investors may remain sidelined until employment figures and consumer-spending numbers improve consistently and spur a subsequent resurgence in real estate. However, some deal-making that was evident during 2009 bodes well for 2010.

* Public capital markets have shown increasing interest in commercial real estate, a trend that should continue. Throughout 2009, existing real estate investment trusts (REITs) accessed the public equity and debt markets for additional capital to strengthen balance sheets, reduce leverage and prepare for future acquisition opportunities. In total, REITs raised almost $32 billion in public market capital offerings in 2009, with initial public offerings (IPOs) accounting for $2.6 billion, according to the Washington, D.C.--based National Association of Real Estate Investment Trust's (NAREIT's) December 2009 REITWatch [R] report.

Among noteworthy offerings in 2009, Indianapolis-based Simon Property Group Inc. raised more than $3.2 billion in the public capital markets with five equity and debt issues, and New York--based Vornado Realty Trust raised $645 million in a common equity offering, according to the New York--based Thomson Securities Data Corporation database. Greenwich, Connecticut--based Starwood Property Trust Inc. and New York--based Apollo Commercial Real Estate Finance Inc. also issued equity offerings in 2009, and Bethesda, Maryland--based Pebblebrook Hotel Trust completed an IPO, according to the Thomson Securities Data Corporation database.

* Foreign investors continue to view the United States as a relatively stable economic environment and commercial real estate as an appealing investment, with the potential for good returns on a risk-adjusted basis. In 2010, the United States should see significant foreign capital coming from Asia (especially China and Korea), German investment funds and the Middle East.

To enhance the attractiveness of U.S. real estate, industry organizations have been working to ensure that U.S. tax policy does not discourage foreign investment. In January 2010, a bill (H.R. 4539) was introduced in the House of Representatives to modify the Foreign Investment in Real Property Tax Act (FIRPTA), which places restrictions on foreign investment in U.S. real estate, in an effort to facilitate more foreign capital investments into the United States.

Concurrent with the influx of foreign capital, U.S. investors in 2010 are expected to spend more of their real estate dollars in their own back yard. Looking at the past three to four years, substantial U.S. capital was invested in foreign real estate, particularly in emerging markets, to take advantage of superior returns. Now, however, more of that capital will be staying in-country, at least for the near term.

For well-capitalized players--whether existing REITs or funds that have been raised to take advantage of the depressed conditions that exist today--there has been an expectation of significant, broad-based opportunities (both geographically and across property types) to make distressed-asset acquisitions, whether from banks that took back properties or property owners themselves. Thus far, however, surprisingly few properties have come to market; for those that have, competition among prospective buyers has been fierce. Fortunes were lost in the past couple of years; many industry watchers think there could be fortunes made in the next couple and are acting accordingly.

Opportunistic buyers, realistic sellers

Will 2010 be a positive year for U.S. commercial real estate? The outlook is, at best, uncertain. The sector likely will see continuing pressure on operating results across every asset class.

While the hospitality and residential markets may have bottomed out, demand recovery will be slow. However, with virtually no new supply of hotels and multifamily residential coming online in the next few years, demand growth should set the table for an overall recovery.

As the economic recovery begins to gain traction, much of real estate's revival will depend on the pace and strength of job growth. Some opportunistic buyers and realistic sellers will complete deals in 2010 that could prove to be very positive for investors. Realistically, however, it will be 2011 or 2012 before the United States sees significant increases in real estate value and a corresponding uptick in the industry as a whole.

Robert T. O'Brien is U.S. real estate leader with Deloitte & Touche LLP in Chicago. He can be reached at (This article was condensed from a Deloitte report.)
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Comment:Realistic perspectives on real estate: it's likely to be 2011 or 2012 before U.S. commercial real estate sees significant recovery in property values or a corresponding uptick in the overall industry.
Author:O'brien, Robert T.
Publication:Mortgage Banking
Geographic Code:1USA
Date:Jul 1, 2010
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