"Certain asset types have definitely hit bottom, but in others, like office, I see a lot of headwinds. And I would argue that office values have not hit bottom.

"Multifamily was the first to re-price. Once artificially low cap rates driven by the condo converters ended and the housing bubble popped, multifamily underwriting had to revert back to a cash-flow analysis. Since multifamily adjusted first to the changing market conditions, this was followed up by what we're seeing in terms of rental rate pressures and increased concessions in many markets. There are also unsold condo units and sales of condo projects putting pressure on rental rates. But I think the sector has hit bottom, and as employment recovers, rental housing should be the first to benefit.

"The primary word of caution on multifamily values, that could have an impact in the future, is that right now they benefit from government financing, courtesy of Fannie and Freddie. If that changes then cap rates will rise and you will see more conventional financing, which has a higher cost associated with it.

"The other product type that has likely hit bottom is industrial. We saw rapid rental rate declines, especially in markets where there was overbuilding. For the past few years, especially in New Jersey, we have seen smaller tenant requirements, which hit the big boxes particularly hard. What you see in the industrial market is more transparency because it is commodity space. Whereas, in an office deal, you hear what the rental rate is, but you don't know what the entire concession package is in terms of TI and other moving costs benefits. But in industrial, you know what the rental rate is, you know there are not a lot of concessions and you can see pretty quickly where market rental rates are heading.

"In addition, a lot of industrial investors were cognizant about marking shorter-term rents to market. So, if you bought a building that had a $4.50 net rent, but you felt the market was $3.25, then owners were trying to immediately price that based on the $3.25 mark to market rent versus the in-place rent.

"I don't see much more downward pressure on industrial. In fact, as the economy recovers and industrial production picks up warehousing will benefit. You will also see, especially on the East Coast, a benefit in the port areas. The dollar is weaker than it has been in quite some time, so we will see some international trade pick up. And since small business typically leads us out of a downturn or economic recession, this will be good for flex and service space.

"Retail is really a tale of two product types. In general, retail suffers when the consumer suffers. Vacancy rates doubled in the past 12 to 24 months, especially in New Jersey. Early on, you saw the Linens 'n Things, Circuit City and Levitz Furniture bankruptcies. This hit some owners particularly hard because, in many cases, they were in the same shopping center. And it also hurt pricing on power centers and large community centers. Lifestyle centers, where the tenants tend to pay higher rents, have also suffered pretty dramatically from a capital markets point of view.

"There are two things you need to be careful of with retail. First, many tenants will have kick-out clauses--basically, rights to terminate their lease or pay a lower rent if their sales don't hit a certain number. Then there's the co-tenancy clause, which means if a shopping center loses its anchor tenant or if occupancy falls below a certain percentage, the tenant has the ability to drop its rent in half. It's possible to have a cascading effect of co-tenancy clauses that can wipe out the economics at a center.

"The flip side is grocery- and drug-anchored centers, which still remain in high demand and the pricing is relatively strong. At the best grocery-anchored centers--meaning you have the number one and two grocer in the marketplace--you're still probably in the mid-to-high-sevens on a cap rate basis.

"What I'm still concerned about on the retail front is that there are a lot of players that investors are concerned over, whether it be Michael's or Pier One. There are still more chains that may have some pretty significant issues. I think we'll see more bankruptcies as well.

"The key asset class is office and that's where I'm most pessimistic because we have seen values already drop by 30% to 40%. Anything that was financed in the past two years at relatively high LTVs has seen the equity whipped out. It's a very capital-intense business and the largest piece of distress is in the office sector. We have seen trades that are at a fraction of replacement cost--almost close to land value for a vacant office building. The term we're using is a 'basis reset' similar to what we saw in the early 1990s, where the new buyers of value-added office buildings are in at such a low cost basis that they can dramatically undercut the rent to bring tenants into their building. And that impacts the market and drops rental rates, which hurts the economic viability of all landlords.

"We're not seeing any net absorption in the office sector and we are certainly not going to see anything until we have positive employment growth and some kind of economic recovery. It probably gets worse for office before it gets better. And a majority of the lenders and special servicers are in this pretend and extend mode. With $1.4 trillion of loans coming due in the next five years--which the system doesn't have the capacity to refinance--we're going to see a lot more in the way of distressed office sales. And if they all come at once, it will further push down the values."

Instant Insights /

Cushman & Wakefield's David Bernhaut

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