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Recovering from 'the slings and arrows of outrageous fortune'.

With the first quarter behind us, uncertainty and speculation abound on the future state of the real estate capital markets. The first question on everyone's mind is where is the economy heading? We think we can confidently say the recession is over and the recovery has begun, but the process will take time.

Every recession revalues financial assets downward, whether real estate, common stocks or hybrid debt. This is simply how financial markets correct the euphoria that preceded the downturn, when a "bubble" resulted in an overstatement of the economy's net worth -- at least on paper. Since everyone's asset is directly or indirectly somebody else's liability, the correction requires holders of financial claims to realize that their claims may not be fully collectible.

There is, however, good news for the real estate industry, specifically that real estate is not at the center of our economy's troubles. The industry may be a victim, but for the most part it is not a culprit (as it was in the late 80s and early 90s due to excess financing and overbuilding). Real estate undoubtedly will suffer the slings and arrows of outrageous fortune due to reduced occupancy rates and weakening rental rates, but it cannot be blamed for creating a vast oversupply. Furthermore, lenders as well as private and public equity investors deserve much credit for exercising discipline and market surveillance. Most of today's malaise can comfortably be attributed to Internet and Telecom companies, their venture capitalists, and their underwriters (whose investment research showed the real estate world how the "Chinese Wall" between sell-side and buy-side is less than paper-thin).

Possibly the favorite subject today, especially among institutional investors with plentiful capital to invest (or substantial property to sell) is the infamous "bid-ask" spread. Despite opinions to the contrary, the spread is not such a bad thing. Yes, it is a sincere complaint from buyers that they can't justify putting out money at the prices being sought by sellers.

And yes, it is a pain-ridden clamor by sellers that they can't rationalize letting go of properties at the yields being sought by value-oriented buyers. But remember that the existence of the "bid-ask" spread means that there is ample willingness to transact on both sides, even if they're having difficulty finding a middle point. This too will change. It is only a matter of time. It's better to have a spread between "bid" and "ask" than to have only an "ask" and no "bid" (remember 1992?).

In regard to leasing, the vacancy problem has reared its ugly head in most markets for obvious reasons. Companies leased vast amounts of space based on financing availability, revenue projections and employment trends that fell short of projections. This has created higher vacancy rates not only in prime space, but has also in sublease space. Ample availability of sublease space may not be good for owners, but it would still further landlords' cause to assist larger tenants who have significant sublease inventory. Rather than force their tenants to compete with their own space, landlords should endeavor where possible to cooperate with sub-lessors to work off the excess inventory while still maintaining lease rate support. Whenever possible, landlords should take a proactive approach with sub-lessors and seek "win-win" solutions.

The question arises: Why be a seller in today's market? This is a thorny issue if one considers the "bid-ask spread" - especially if you believe you can outperform pricing expectations by holding out another year or two.

An obvious alternative is to finance or refinance, but then you have to evaluate floating-rate bridge financing vs. fixed-rate long-term financing. If you are an eventual seller, you probably should either sell into the market or finance on a floating-rate basis. If, on the other hand, you are a long-term hold investor, you must first decide whether the property is worth holding in the context of the current cycle and the return parameters you've promised investors.

Rents are not likely to go up for the next 12-24 months while the leasing market works off inventory. Since hopes of "cap rate compression" will eventually be countered by rising interest rates, it would appear that properties have generally reached stabilization and that financing rates will not get better.

So why not sell? Doesn't the classic DCF model envision a profit-maximizing sale when a property's leasing has stabilized and financing is optimally available...?

Finally, remember that a systematic marketing effort realistically takes some 60 days to orchestrate. This means that from the time you select a marketing agent (say, sometime in the next 30-60 days), it is not likely that you will be in the market until after June 30. It is likely that the game will be different during the second half of the year. And since re is ample debt and equity capital poised for investment, we expect that the game will be different during the second half of the year and that transactional velocity will pick up significantly.

So, where is the real estate market headed in 2002? There are no guarantees, but the prospects are likely far better than they were six months ago.
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Copyright 2002, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Kohn, Steven
Publication:Real Estate Weekly
Article Type:Brief Article
Geographic Code:1USA
Date:Apr 24, 2002
Words:852
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