67th Annual Review & Forecast: Groundhog Day
The following is an HTML version of a feature that ran in the February/March 2013 issue of Real Estate Forum. Click here to view this story in its original format.
The European debt crisis. Social unrest in the Middle East. Legislative gridlock in the US. Questions about the impact and timing of GSE reform. The availability of credit, or lack thereof. The continued housing foreclosures. Slow job growth.
2013 looks a lot like 2012. Some are calling it Groundhog Day.
“We have the same global challenges as last year, but with a few more industry specifics,” says Dennis Bernard, a partner at Strategic Alliance Mortgage and founder and president of the Bernard Financial Group in Southfield, MI. “In the hunt for yield and return, we have a plethora of lenders seeking to place mortgages while still having a limited amount of financeable commercial real estate. Will this cause a quickening of overheated lending practices that have haunted us in the past? How strange is it to actually wonder about that after what we have just been through?”
Groundhog Day may not be the worst fate, though. Driven by a better-than-expected surge in year-end transactions, sales of significant commercial properties totaled $283.2 billion in 2012, representing a 24% increase over 2011, according to Real Capital Analytics. Apartments were once again the darling, with trade volume rising 47%. The office and retail sectors posted 20% transaction growth while industrial and hotel remained largely flat against 2011. Meanwhile, prices are within 20% of peak levels, according to RCA, and are nearing, or already have surpassed, peak levels, particularly in the apartment sector. And cap rates are generally compressing.
Compared to the Great Recession, a Groundhog Day may be acceptable. There are X factors, but there is also a greater consensus about the pace and depth of the commercial recovery in 2013. There’s more certainty. Development opportunities are increasing even as distressed asset investments are decreasing. And global capital markets, although rife with unknowns, have thawed and are feeding the river of debt once again.
Setting the Pace
Economists generally expect the slow current pace of economic growth to improve moderately starting in 2014, but persistent deleveraging and macro risks—including the European debt crisis and the US fiscal cliff(s)—will likely continue to constrain growth from matching the pace of past economic expansions.
“A key real estate implication of the macro environment has been risk aversion, manifested by investors who’ve tilted strongly toward the safety of gateway markets and best-of-core assets,” says Timothy Bellman, head of global research for New York City-based Invesco. “These market segments were the first to experience meaningful value recovery and cap rate compression.”
No matter what angle you take, commercial real estate has witnessed a recovery from the Great Recession days of not so long ago. The economy is growing, albeit slowly. Rents are generally rising—more quickly in some markets than others. And leasing spreads are starting to hit double digits for top operators.
“For retailers, the issue is becoming ‘How do we grow from this point?’” says Glenn Cohen, CFO of Kimco Realty in New Hyde Park, NY. “The increase in tax rates and the expiration of the payroll tax holiday may throw a bit of a wrench into the progress that’s been made, and I think that’s why the Fed is being somewhat cautious in its bond buying program to help keep rates low and to ensure that the recovery, which seems to have gained traction, continues for the long haul.”
Developers, investors and lenders have similar perspectives, but what about architects and engineers? Joe Derhake, president of Partner Engineering and Science in Los Angeles, is optimistic. He says the construction industry seems to be making a comeback, architectural billings are up, homebuilders are active and there’s more demand for construction monitoring services.
“We are engineers, not economists, but our engineering and environmental due diligence industry is a unique barometer of the commercial real estate industry because our services are needed on most CRE transactions or financing,” Derhake says. “The due diligence industry as a whole has seen substantial growth throughout 2012. We plan to hire 100 technical staff this year, clearly betting on growth in 2013.”
Although paralysis by analysis is not completely out of the 2013 picture, the sentiment of certainty is more common. As Ray Cirz, CEO and chairman at Miami-based Integra Realty Resources, sees it, commercial real estate players may not like all the factors but the dust is more settled than last year. “We know the political environment, at least for the next couple years. We know taxes are going up and we see slow but gradual improvement in employment and low interest rates,” Cirz says. “Return expectations have also moderated. This has created an environment where investors are willing to commit to real estate overall.”
Cohen is looking for bumps in the road, but says Kimco is cautiously optimistic about what 2013 brings. He points to improving capital markets, recovering (and even increasing) housing prices, declining foreclosure rates, and improved bank balance sheets. “There is a significant build up in deposits at the major banks and a thirst for yield,” he says. “The real estate sector provides pretty good yield, especially when you look at it relative to where a 10-year Treasury is at 2%. If you’re buying high-quality assets at 6%, that spread is pretty favorable.”
Mark Rose, CEO of Avison Young, is also bullish on 2013. North American and world economies will face challenges in 2013, he says, but if the pundits are correct, we will address these issues and move past stagnation and government paralysis and exit 2013 with more clarity and the momentum to invest and grow.
“What we are recommending to clients is clear and consistent: focus on building capital positions in 2013, perhaps selling non-strategic assets to fund a war chest, and arrange for access to additional debt and equity, as 2014 appears bright,” he advises. “Continue to execute on current plans in 2013 as the environment is likely to remain stable. Re-balance investment portfolios according to a five-year strategy horizon and adjust your corporate real estate occupancy.”
The nature of opportunities in commercial real estate has gradually shifted from gobbling up distressed assets, to competing for trophies in core markets, to the new wave of development. Currently, opportunities prevail across the board, though multifamily remains the strongest sector on all fronts.
From Alan Dibartolomeo’s perspective, the biggest opportunity in commercial real estate this year is providing well-located, attainably priced housing at or near the job-creating centers in large metro areas.
“The high-tech, high-education level, and highly exportable products from areas like New York’s financial district, California’s Silicon Valley, Raleigh, NC’s Research Triangle or Hollywood’s media center are fueling the recovery. But new housing in most of these areas stalled for several years,” says Dibartolomeo, chief development officer at AMF Development, the Huntington Beach, CA development arm of American Multifamily. “Job creation is increasing demand for housing—mostly for-rent housing—where barriers to entry for housing developers ultimately yields product that is expensive or located a reasonable commuting distance from the job source.”
Overall, Randy Banchik, EVP of Los Angeles-based Westwood Financial Corp., says buying quality product in secondary and tertiary markets seems to create more value, and buying property at realistic cap rates where rents have been reset will provide good opportunities for long-term value creation. “Opportunities for short-term profit in stabilizing distressed assets through lease-up seem to be waning,” he says. “This is also a great seller’s market for the right properties, and an incredible time to acquire long-term financing.”
The Best and Worst Markets
Experts agree: The markets that will perform the best will continue to be those with high barriers to entry. Those include Metro New York, the Mid-Atlantic area and the Texas markets of Dallas, Houston and Austin. Others include coastal cities in Northern and Southern California and the southern part of Florida. Major metro 24-hour cities that have increased population growth and an improving job market will do best.
“There is keen demand for industrial properties, especially in markets with high barriers to entry,” Cirz says. “One of our clients is planning to build a state-of-the-art facility in the Meadowlands, just outside New York City. The development budget is $150 per square foot, which previously was unheard of. In order to make the project feasible, rents must achieve record levels.”
Meanwhile, experts also agree that the markets that have been challenged in the past—such as Las Vegas, Reno and New Mexico—will remain challenged. The Arizona markets are starting to see some progress, but they’re still troubled. Unemployment is elevated, as is underemployment, so the jobs situation will need to improve to drive further recovery.
Banchik is concerned investors are not accounting for the natural drag in actual value recovery that continues as market conditions reset when owners with new bases bring distressed property back into the competitive mix. “As prices have continued to improve, it’s increasingly compelling to be a seller,” he says. “Much of the product offerings we’ve seen over the past few years has been driven by lenders, and those sellers seem to have shifted to a more entrepreneurial mindset, utilizing the marketing tools and sales platforms that have been developed to greater advantage. Exchange sellers, however, might feel caught ‘out of the frying pan, into the fire’ due to limited exchange opportunities on the buy side.”
Dan Fasulo, managing director for RCA, says buyers have become more aggressive and interest rates allowed them to increasingly hit sellers’ expectations. The result: more sales activity. “Discretionary sellers came out en masse in the fourth quarter to beat the increase in capital gains. Going forward, more sellers will choose to unlock gains and recycle the capital into other assets via a 1031 exchange,” he says. “Bidding wars for top assets have the possibility to drive values even higher in the short term.”
A Capital View
After falling only twice in 2012, the CMBS delinquency rate started the new year with its first monthly decline, according to Standard & Poor’s. Should investors be worried about a stalled CMBS revival in 2013? Not necessarily. By property type, the delinquency rate fell for multifamily, office and lodging, though it rose for industrial and retail. In fact, S&P reports, retail continues to be the only property type with a delinquency rate in the single digits, ending January at 8.09% compared with 7.97% in December. In 2012, the retail delinquency rate averaged 7.89%.
Getting granular with the numbers, $42.3 billion worth of commercial mortgages was delinquent at the end January. That’s the highest amount since the first quarter of 2010. But the number of performing and nonperforming loans that are past their maturity date is improving. In total, S&P reports there were $5.42 billion of loans in this category in January, compared with $5.81 billion in December. S&P expects this trend to continue as special servicers resolve matured balloons.
“CMBS volume continues to increase. In 2012 issuance exceeded expectations with $39 billion and I expect 2013 to break $60 billion. With the Central Bank remaining an active buyer of mortgage-backed securities, interest rates will stay low. This is positive for the CMBS market,” says Constantine Scurtis, CEO of SL Capital, a correspondent of Cantor Commercial Real Estate. “It’s a win for borrowers that need loans, and it’s a win for investors to buy CMBS bonds because of their attractive yields.”
Steve Duffy, managing director at Moss Adams Capital in Seattle, sees tension in the real estate capital markets as equity becomes more plentiful and quality investment opportunities become harder to find. He calls it a barbell marketplace for investors, where core property at the high end is scarce and fully priced, and opportunities at the low end are plentiful yet with higher risks.
“The desirable middle segment—value-add opportunities—is dwindling. It’s getting very hard to find those fundamentally sound properties, like an office building in a good location that’s 60% leased and just needs the right value-add program to lease up and net superior returns,” he says. “We are now in a recovery and it is progressing into a market-expansion phase—and prices for commercial real estate will remain high. In the next year as confidence grows, lending will open up more and borrowing criteria will ease.”
Another Bubble Forming?
For all the talk of recovery, there’s already talk of another bubble. James Wacht, president of Lee & Associates, NYC and Sierra Real Estate, is concerned a bubble is forming in New York, where investors are paying prices that outshine rental growth. He attributes the “buying binge to historically low interest rates and the huge demand from foreign investors seeking to invest their money in a safe haven.”
At the end of the day, as the economy goes, so does commercial real estate. The industry has driven enormous activity in gateway cities including New York, Chicago, San Francisco, Boston and Washington, DC over the past 12 months, and all indications are that the trend will continue.
“As the economy continues in a slow-growth mode, barring some unforeseen calamity around the world, I would expect to see real estate continue regaining its footing,” says Mark Edelstein, chair of Morrison & Foerster LLP’s Real Estate Finance group. “One trend we might see in 2013 will be an uptick in activity for secondary and tertiary markets. Equity investors are finding it more difficult to find ‘deals’ in cities like New York, which will lead them to new venues.”
For his part, Young believes the real estate community will—and should—position and reposition to take advantage of what will likely be a healthier and clearer picture by 2014. “This is not to say that we should write off 2013, or sit on the sidelines,” he says. “Quite the opposite. There is much to be transacted in 2013 while strengthening positions for the future, as economic and political issues in the US and Europe see some form of resolution.”