The Soft Bottom in 2010
Posted: Jan 25, 2010
The current state of the commercial real estate market does not come as a surprise. Easy, stupid money and greed caused the economic bubble we had. The big clues at the time were:
Let’s rewind the old tapes of the last real estate cycles and view the differences from the early 1980s and early 1990s versions. The late 1970s were characterized by high inflation (10 – 13%). The Federal Reserve raised interest rates aggressively to combat it. In December 1980, the prime rate reached 21.5%. Permanent mortgage loan rates were in the 13 -14% range. Inflation dropped and the so did the interest rates. Prosperity returned.
In the late 1980s, the development community was overbuilding. Savings and Loan deregulation led to easy credit availability (sound familiar). In December, 1989 Opus sold the second of the Fifth Street Towers it developed, made a lot of money, and that was the end of the ‘80s run in the Twin Cities. The prime rate in January 1990 was lowered to 10% and the permanent mortgage loan rates were also at about 10%. The Fed lowered the prime rate to 6% by mid 1992 and stimulated the economy. Also, information technology was taking off and was a big economic engine for the economy. The market recovered nicely. The oversupply of space was absorbed in a few years.
Our situation today, from the recovery aspect is not like that of other cycles. Inflation is not an issue like it was 20 years ago. Our economy is weak, but we have no room to lower interest rates to stimulate, as was accomplished in the early 1990s. We are feeble in demand for space. Negative demand is worse than over supply in this writer’s view. An owner does not know where the next tenant is going to come from. A jobless recovery is a slow recovery for our industry. The potential growth industries of the next five years are in health care, technology and education, but these are not big users of existing space.
The economy does not get back to a prosperous level until 2015 and 2016. Even then, the economy may not reach the low levels of unemployment experienced during the last peak. Making a five year lease today is smart. The lease will mature when the economy ought to be robust and this will be the time to re-gain lost value.
When Do We Hit Bottom?
The bottom of the cycle for commercial real estate occurs in 2010 with the recovery starting in 2011. The entire shake-out period will take years. Owners who do not need to sell, will not. Those that have to sell will be faced with few buyers and the new world of tightened underwriting standards. Buyers in the 2005 – 2007 period, who used high leverage have seen their equity eliminated. They still may be able to pay their debt service, but the day of reckoning will come with either tenant losses or the inability to refinance. This is one of the reasons the shake-out will take many years. Other reasons include bankers who modify loans to avoid losses until they can earn their way out and CMBS lenders paralyzed by the complexity of the structures they created.
One of events that establishes the bottom is the re-entry of institutional capital into the markets looking to buy. Once there are enough arms length, multitenant transactions that other investors can understand, then, in effect, permission is granted to others to start buying as well. The other big determinate of the bottom of this cycle will be the return of permanent financing (see accompanying Finance segment).
Changing Values
The predictions from our last reports at mid-year and a year ago are coming true. Values have declined 30% – 40% so far and are still falling for most property types. The bottom of the fall for this cycle will be determined by:
Core property values will firm up first. While their cap rates are subject to additional upward movement, it will not be as much as Class B, C and value-add properties. The return of risk/reward pricing is back. The separation is already occurring with the differences being 75 -150 bps between the core properties and the rest. Once sellers are willing to sell at the new risk-adjusted pricing, equity will find its way back into the market and deals will get done.
Changing Perceptions
The trading approach to real estate investing is going to diminish greatly. Investors are going to have to revert their thinking to longer term holding periods of five to ten years and where the majority of the return came from cash flow and the minority came from appreciation. Sure, there are going to be buy, lease-up and sell situations occurring. The majority of investing is going to be focused on current returns. The ability to make money solely by doing a financial transaction is over. It is back to basics of buying right, proper management, capital improvements, diligent leasing efforts, and tenant service.
There is not going to be a Resolution Trust Corporation like in the early 1990s. The FDIC cannot afford it, nor can the market handle the negative perceptions. Most failed banks are being sold to other banks with loss share agreements with the FDIC. The problem assets get worked out by the acquiring banks. This approach limits the number of big portfolios the FDIC has to put on the market from the banks they cannot sell. It also limits the negative publicity of the big losses, which helps shelter the market from further declines.
For those wanting to take advantage of the downturn, this has been a waiting game since early 2008. You know what’s coming; the junk tips over first and so does land. For the most part, this has been true of 2009 as well. The good stuff is starting to come to market. However, much of it is in the form of large portfolios, only available to the biggest of investment funds. Individual property opportunities are working their way to market. Try to buy the best quality and location you can. If you cannot, be patient as this cycle has a lot of play in it.
Some early investors in the distressed game are already in distress. They did not see the macro devaluations coming, did not do their homework on the condition of the existing tenants, and were too optimistic about their leasing abilities and achievable rents. It is important to distinguish the bruised from the bleeding and to accurately assess exit pricing; the latter being the hardest to determine.
What to Buy
Investor consensus is that apartments are the best bet to achieve consistent cash returns. Low levels of new construction and favorable demographic trends are key reasons for this view. Being at the top does not necessarily imply to go for it. It is more like, if you are going to buy something, make it an apartment project. Financing is available from Freddie Mac, Fannie Mae and life companies.
Industrial properties today are suffering from high vacancies and declining rents. However, they have better recovery potential than office and retail. Focus on location, functionality, and special features.
Office: Be careful. There is a tremendous amount of shadow space. Downtown Minneapolis over everything else. Class A over Class B. The volatility of returns is high. New construction is 5 – 10 years away in the Minneapolis market.
Retail Centers: Do not buy until we see the economy definitely firming up. Focus on location, grocery anchored, and strong demographics.
Net Leased Properties: Given the turbulence the commercial real estate market is going to encounter, this may be the best place to be. Sale lease-backs by strong corporations and single tenant retail also with quality credit tenants provide consistent cash returns that typically increase over the lease term. It is the author’s opinion that there is not enough return spread, if any, today for the risk investors take in similar quality multitenant properties. Cap rates increased 50 – 100 bps over the past year for single tenant net leased properties and probably will rise another 25 bps on average over 2010. Financing is still a challenge, but for the all cash buyer, now is a good time to buy.
Hotels: Lowest on the fun chain, but capable of the big pop. Focus on full service, business oriented hotels. Prices for hotels may drop farther than they should. An economic rebound could lead to immediate revenue gains from new business travel.
Residential Land: Opportunities exist. One caution, lots that were priced and sized for 2003 – 2007 average sized new homes, need to be underwritten for smaller houses with thinner profit margins. Best bets are the remaining lots in established subdivisions.
Development is going to be limited to build-to-suits, medical, senior living, and some apartments. With existing prices below replacement costs, it generally does not make sense to build. Construction loans are being made with 50 – 75% minimum pre-leasing requirements to existing bank clients with strong financial capabilities and clean portfolios.
Other Factors to Consider
By: Mark W. Reiling, CRE, SIOR
Slow Progress in 2010
Posted: Jan 25, 2010
Obtaining debt for a new acquisition or a refinance requires a very good story and persistence. Here is what is going on today with the various types of lenders.
Banks
Every bank seems to have its own way of looking at real estate loan requests. These range from:
What is consistent are the requirements for personal guarantees, reliance on outside appraisals, and being conservative.
Life Insurance Companies
Life companies enjoyed being the only game in town in 2009 and are increasing their allocations for 2010. They were able to pick the loans they wanted to make, on their terms and at good spreads. That’s not to say all is rosy. They do have problem loans, but at far lower levels than CMBS. Mortgage loans are a better bet for life companies than bonds with interest rates as low as they are. Bonds are going to lose value as interest rates increase, while mortgage loans do not have that inherent loss of principal. Life companies are getting personal guarantees on some of their loans.
Interest rates for apartments range from 5.00% to 5.50%. For office, industrial and retail rates range from 6.00% to 8.00%. Most life companies are using debt coverage ratios of 1.30 -1.35x.
CMBS (Commercial Mortgage Backed Securities)
The first signs of life are emerging with the issuance by three single borrower transactions. The first was by Developers Diversified Realty with a $400 million TALF supported offering. Also, to market were Inland Western Retail for $500 million and Flagler Development for $460 million. Low leverage characterized each of these offerings close to the 50% level.
There are about five major investment banks gearing up conduit lending departments for 2010. Expect to see conservative underwriting, with an emphasis on five year loans with 25 – 30 year amortizations, versus the ten year terms and 30 year amortizations or interest only loans made in the last cycle. 7 and 10 year money will be back, but probably later in the year. A key component to the return of CMBS is the return of the “B piece buyer”. These are the investors willing to take the first loss positions. A second key component of a CMBS comeback is providing 70 -75% loan to value loans. A third key component are the banks’ willingness to warehouse loans until they can be brought back to market. Otherwise, there will be few borrowers showing up because they do not have or cannot afford the equity required on the current 50% LTV transactions mentioned above.
Interest Rates
The Federal Reserve has kept short term rates low throughout 2009. For those who are Libor based borrowers without a floor rate or have low floater bonds, life has been great. If you are not planning on selling, then consider locking in at a fixed rate through a swap. While seemingly painful in terms of short term margin give up, consider what interest rate you cannot afford your floating rate to get to and monitor the swap market closely.
A year ago, the ten year treasury was 2.08% and closed at 3.84% on 12/31/09, up as predicted in last year’s report. This author also said that bond investors will react instantaneously if they sense inflation on the horizon. Sure enough there were a couple of times the specter of inflation appeared and there were immediate, upward 10 -20 bps yield moves in a single day. The 10 year yield will break through the 4.0% level in the first quarter and will slowly creep up a bit throughout the year. Short term interest rates will also rise by an estimated 50 bps in 2010.
Interest rates are still at attractive levels from a historical standpoint. Be careful of five year financing when buying for a longer term hold. While underwriting is tight today and better terms may be available in five years, interest rates may increase by more than the underwriting liberalization, resulting in fewer loan dollars. By some economists, the economy may be peaking in the 2015/16 timeframe. It could also be a time of higher inflation and higher interest rates to hold inflation in check.
Problem Loans
Loans in default are a significant and growing problem for the commercial real estate industry. They are occurring because owners are facing maturity defaults and cannot get extensions, refinance or sell, and cannot hold on any longer. The aggregate impact extends beyond the affected lenders and borrowers, it permeates the entire market. There is less money to be lent, slowing investment sales activity to a crawl and restricting development. Real Capital Analytics provides the pie chart below showing the breakdown of distressed properties by type of lender.
Banks deal with their problem loans in a wide range of ways. At one end of the spectrum, there are those who mark down foreclosed real estate and move it out. Others, bury the problem, only to wanting to deal with it when values recover and their earnings improve. A new approach, approved by the regulators, allows banks to only recognize the problem portion of the loan and call the balance good. This approach is to help defer problems, so banks can stay alive. Ultimately, the problems have to be dealt with. The reality is that we will see the number of banks in the United States shrink by over 1000 through this cycle. Some may not fail, but they will not be able to grow, resulting in a sale so the shareholders can recoup equity.
In the Minneapolis metro area, as of November 1, 2009, there were 30 CMBS loans 30+ days or more past due or in receivership and/or foreclosure. The table below breaks this down by property type. Included in Retail is the $65.0 million Woodbury Lakes project in receivership.
The IRS issued a Revenue Procedure in September 2009, easing the rules to allow CMBS loan servicers to make deals with borrowers prior to default. Heretofore, any change to the loans prior to their going into default would change the tax status of the conduit pool. This will provide some relief to the log jam that exists because of the complicated structure of CMBS.
Summary
More money will flow into commercial real estate in 2010, than 2009. The best deals in terms of favorite property types, location, quantity and quality of tenancy, borrower strength, and debt coverage will be the money winners. Interest rates will be moving up, nothing dramatic, but combined with shorter amortizations and elevated debt coverage ratios, every basis point may matter.
By: Mark W. Reiling, CRE, SIOR
Investment Real Estate: The Slide Gets Slipperier
Posted: Jul 10, 2009
For Sale Housing:
The housing market will bottom when unemployment peaks. This is most likely to occur in early 2010. On average, there is 10-15% of additional price reductions yet to occur. At the low price end of the range, $200,000 and less, the decline may be only 5%. The largest adjustments are for those homes requiring jumbo mortgages and particularly for homes in the $1,000,000+ range. Here we are talking 20-25% price declines. The lack of liquidity is limiting the number of buyers.
There was an artificial slowing of foreclosures due to moratoriums. There are going to be more foreclosures because the lenders are taking action on those that were delayed, the number of default notices is rising, and the number of adjustable mortgages coming up for adjustment off the initial teaser rates is big.
The investment play is to analyze neighborhoods in a city and ascertain where values will fall the least and have the potential to rise the most. One of the measures to consider is the price/rent ratio. This measure got way out of line during the price run-up and now is getting back to normal. Other metrics to consider are the number of homes for sale and in foreclosure in a neighborhood.
Housing prices correlate closely with employment. When employment recovers and matches the peak of this past cycle (which was year end 2007), housing prices will match its peak about a year later. According to Moody’s Economy.com, employment gets back to the 2007 peak in the second half of 2013 and housing in the fourth quarter of 2014. Just like sledding in a Minnesota winter, it takes longer to walk up the hill than to slide down.
Multi-Family Housing:
Sales of apartment buildings nationally have dropped 75-80% from last year. Apartment cap rates have increased about 100 basis points since the first quarter of 2006, which was the high price point for apartments according to Real Capital Analytics. For garden style Class A projects, cap rates have risen from 6 to 7%. Fannie Mae, Freddie Mac and HUD are still the primary sources for multi-family financing. Without them and their below commercial property interest rates (by 1.5% +/-), apartment caps would be much higher.
Impacting this market but difficult to calculate is the increase in the vacancy rate of for-sale housing that has been rented and that is available for rent. Also, impacting is this market are the concessions to get new tenants and rising delinquencies by economically stressed tenants. The result is an economic vacancy surpassing 10% versus an occupancy vacancy around 5%.
The biggest sale this year was the 344 unit Riverview at Upper Landing in St. Paul on the Mississippi. This 2005 vintage property sold for $126,453 per unit.
Distressed Properties:
The greatest distress is in residential land and lots. Following that are malls, commercial land and development sites, and hotels. Apartments, office and industrial follow further behind. However, we are early in the process and there are considerably more problems coming. Mortgage delinquency rates are rapidly rising providing us the evidence. The causes of the problems are decreasing occupancies, lower rents, and lower values precluding sales and refinancings at high enough dollar amounts.
This year US Bank estimates there is $271 billion of commercial real estate loans maturing. This figure grows every year to about $600 billion in 2017. Today, there is not a source for refinancing a good portion of this debt, short of loan maturity extensions, and loan pay-downs through equity infusions.
Retail:
The number of retail centers for sale has risen dramatically, but sales are slow. There is a significant bid-ask gap between buyers and sellers. Grocery anchored center cap rates peaked in 2007 at about 6.5% according to Real Capital Analytics. Today, cap rates have moved well into the 8’s and we foresee them having to go into the 9’s for there to be a meaningful number of sales. During the past cycle there was cap rate compression relative to the creditworthiness of the tenants and type of market the center is located in (i.e. primary, secondary, tertiary). Buyers today are paying closer attention to the quality of the tenancy, tenant longevity in a center, and sales histories of the tenants.
Additionally, buyers who have equity capital want positive leveraged returns. They are also underwriting near term rollover tenants at market rents. In the Twin Cities, that means using gross rents versus net rents because of the high real estate taxes. During the second quarter, the sale of the 25,507sf Pinnacle Ridge Shopping Center in Apple Valley occurred. This is shadow anchored by Home Depot. It sold for a 10% cap.
Office:
There are relatively few office properties for sale in the Twin Cities and around the country and there have been hardly any sales. The absence of sales makes it difficult to say where cap rates are today. Part of the challenge is that there is little debt or equity capital in the market for large transactions, except for distressed or opportunistic buys.
In the Twin Cities there were a couple of sales, but neither straightforward investment sales. 12400 Wayzata Blvd. sold for $131/sf to its anchor tenant, US Internet, who has significant improvements in their space. Creekridge I & II reportedly sold for $143/sf. The property had one building that was leased and the other was vacant but a new tenant was sourced for it. The buyer was a 1031 exchange buyer and had to invest around $500,000 to get that new tenant in, effectively increasing the price.
Industrial:
Industrial investment sales have slowed across the country. Cap rates have climbed 150 basis points since the beginning of the year and continue to rise. Metro cap rates are mostly in the 9 – 10% range. Recent sales include Cobalt buying from AMB the 195,754sf Louisiana Ave. Distribution Center for $40/sf. AMB also sold the 96,636sf Circle Star office/warehouse for $46.34/sf in April.
Summary:
Generally speaking income property values are going to fall 30 – 40% during this down cycle from peak to trough. These declines are separate from the distressed property segment. Investors know or fear the market has not bottomed and do not want to get in too early. Rent growth and absorption lag GDP growth. We do not see commercial property fundamentals improving until the beginning of 2011. When is the time to get back in? Probably in 2010. However, one must be willing to endure some short term anxiety. Office and industrial have the potential to recover the best. A retail recovery is going to take longer. The United States is over-stored. While apartment vacancies are decent in the 5-6% range, the economic vacancies are considerably higher. Not until the economy regains solid footing will the economic vacancies in apartments dissipate.
Without knowing exactly where the bottom will be, both investors and lenders lack confidence in making significant bets. The sorting out process is going to take time, so do not expect to see much increase in investment activity through the rest of the year.
By: Mark W. Reiling CRE SIOR
Who Has The Money?
Posted: Jan 30, 2009
Last rites were given to the CMBS market in the first half of 2008. Do not expect to see a resurrection in 2009. What once was providing approximately 25% of commercial real estate debt is at zero. CMBS AAA paper is trading around 13% as of mid-December, and BBB at rates in the mid 30% range. This is happening despite the fact that CMBS delinquencies over 30 days are 0.63% as of 12/15/08, but moving up. Sales of newly issued CMBS bonds totaled $12.2 billion in 2008 compared to $237 billion in 2007, per JPMorgan Chase & Co.
Life insurance companies have money. They were active through most of 2008, selectively picking the loans they wanted to make. Without surprise, the best projects, in excellent locations, with strong sponsors and lower loan to values got the money. For 2009, the ratio of maturing loans (in dollar terms) to new money for mortgage loans ranges from 20% to 80%, per life insurance company. Since these borrowers are unlikely to be able to refinance that debt elsewhere or sell the property upon favorable terms, expect some of the life companies to be extending these loans while others will not. The ones that will consider it are for the strong performing projects/borrowers upon today’s pricing and terms. Why underwrite
new loans when your in-place performing loans have solid track records is their thinking. On the other end of the spectrum, pay up or else. These lenders want their money back. Bottom line: not much fresh life company money for 2009, so seek it out early in the year. There is an estimated $160 billion in commercial real estate loans maturing in 2009 according to Foresight Analytics. The competition for these limited dollars will be keen. Another consideration for life companies is their choice to buy CMBS AAA at 13% (today), or whatever the yields may be throughout 2009, versus originating new loans at 6.5% (today). Life company portfolios are clean, with only 0.06% delinquencies over 60 days, per the Mortgage Bankers Association.
Freddie Mac and Fannie Mae continue to provide mortgage capital to the apartment industry. Interest rates for apartments range from 5.8% to 6.5% according to Towle Financial Services. Delinquencies over 60 days for Fannie Mae are at 0.16% and for Freddie Mac at 0.01%.
The commercial banks have money, but are stingy when it comes to loaning it out. The money center banks are taking care of their existing clients through loan renewals and new loans. The underwriting is more thorough than it has ever been, both for the project and the guarantors. Pricing has increased to Libor + 275 to 300. Prime rate based loans are gone. Debt coverage ratios are up. Regional and community banks also have money. Those not too burdened with problem loans are still in the market. They are cautious as the regulators have been scrutinizing
their real estate loan portfolios with a fine-toothed comb. Most banks will lend for five year terms at floating or fixed rates, but not all at fixed rates. Most banks are also putting a floor rate on their floating rate loans.
Taxable floating rate bonds are very attractive with the super low floating rates in the market. The challenge is obtaining the letter of credit. Letter of credit fees have also materially increased. Best bet: obtain the floating rate bonds and swap into a fixed rate. Mezzanine debt has mostly dried up. Many mezz lenders are working out of the deals they did in the last five years and are not in the market. Others who have money are not seeing many opportunities they are willing to take on. The pricing of mezz money has climbed back up into the high teens.
The entire commercial real estate finance market has not only re-priced risk, it is also lowering risk through the most conservative underwriting this author has seen in his 29 years in the business. Permanent mortgage loan spreads over Treasuries have moved from 100 bps to 400+ bps. Some lenders are ignoring the spreads and just quoting a rate that works for them.
Short rates for 2009 are going to remain low as the Federal Reserve focuses on revitalizing the economy. Long rates will also be attractive, but they may creep up toward the end of the year. Bond investors keep a keen eye out for any signs of inflation. If they sense it on the horizon, they react instantaneously, bidding down bonds. Many economists see the GDP contracting through 2nd quarter 2009.
There is a perfect storm that could unleash harsh de-leveraging for borrowers with maturities in the next few years. Foresight Analytics says there are $530 billion in loans maturing through 2011. Let’s say a borrower obtained an 80% LTV interest-only loan with an interest rate in the 5-6% range, with 1.15x debt coverage. The new underwriting is going to be 1.25x – 1.35x debt coverage, 25 year amortization and an interest rate in the 6.5% to 8.0% range. Recourse or partial recourse may also come into play. If the borrower did not have reserves before, he will now for tenant improvements, commissions, capital improvements, and real estate taxes. The loan amount calculated in this approach will be compared to the lender’s maximum loan to value (probably 60-65%), with the lender using the lower of the two. The result will be a much smaller loan and the borrowers will need to invest
additional equity or sell. Borrowers are recommended to project into the future what loan amounts they could obtain under various scenarios and take appropriate proactive measures.
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2009 The Year Ahead
Posted: Jan 30, 2009
Investment sales in 2008 started off at an anxious pace as investors were figuring out where the market was going and trying to complete transactions at the same time. As the year progressed, the market’s direction became clear and activity diminished accordingly. According to Real Capital Analytics, U.S. investment sales over $5,000,000 during 2008 fell 56% from 2007 to $1,518,600,000.
Institutional investors are facing not only the denominator effect, but for the first time in a long while many are facing redemption requests from their clients. In times like these, where there is an absence of transactions, institutions tend to be very cautious. They do not want to make a wrong decision.
Capitalization rates initially decreased in the 1st quarter and then increased inconsistently throughout the year. The changes varied by property type and market. Office, industrial, and retail cap rates are up +/-50 bps in 2008 and apartments are up 25 bps. Cap rates and going-in IRR targets are increasing. According to PricewaterhouseCoopers, the going-in IRR spread between institutional and non-institutional grade properties is generally in the range of 200-225 bps across all property types. Today, there exists a bid-ask gap between buyers and sellers, which often is too big to close and properties are being pulled from the market. The lack of available debt and the deteriorating property fundamentals are the two biggest reasons for the upward cap rate movement. This condition is likely to persist throughout 2009.
Retail
The retail sector is the least favored by investors today. How quickly things change. Real Capital Analytics reports a 67% drop in dollar volume of retail investment sales during the past 12 months. There were 32 sales in the Minneapolis metropolitan area during this period at an average price per square foot of $126 and average cap rate of 7.4%. Minneapolis ownership is dominated by private investors. Malls and Power Centers tend to be on the bottom of buyers’ shopping lists. If any retail type is on the list, it is well-located grocery anchored centers.
Economic conditions are felt first by retailers and followed by their landlords. 2008 will set a record for the number of store closures and lease restructuring requests from national chains to the mom and pop stores. The bid-ask gap is largest in the retail sector. The active investors are underwriting on today’s rents and practically ignoring in-place rents, unless it is from a creditworthy
tenant with term left on the lease.
Office
As the fundamentals of the office markets weaken, so do expectations about future rents and ultimately prices adjust downward for investors to achieve the same yields. Cap rates are generally up 40-50 basis points from a year ago. According to Real Capital Analytics, the dollar volume of sales in the Twin Cities fell 66% from the end of 2007, while nationally the figure is down 68%. The average price per square foot in Minneapolis was $115 with an average cap rate of 7.59%, well above the 6.53% national average. Notable sales are featured in the office section. The larger sales are noticeably absent. Numerous office buildings (225 South 6th, Dain Rauscher Plaza, City Center, France Place, Edina Office Centre, and Midwest Plaza) were pulled off the market this year as sellers could not achieve their target prices.
Nationally, according to Korpacz Investor Real Estate Survey, suburban office cap rates average about 52 bps higher than their CBD counterparts. Investors think there is an advantage to attracting and retaining tenants, particularly large credit tenants, due to the advantages of mass transit, proximity to housing, and retail amenities in the CBDs.
Industrial
The industrial investment market adjusted to market changes faster than the other property types and is reflected in its sales activity. While declining on a year-over-year basis, it took less of a drop. Sales volume is down 19% in Minneapolis according to Real Capital Analytics, compared to 46% nationally. Reasons for the activity include a rise in cap rates from the low 7’s to the low to mid 8’s, and REIT sellers who were even willing to carry short term seller financing to get sales closed. The average price per square foot was $69. Private investors made 58% of the acquisitions. The bulk of the sales activity occurred in the first half of the year, with owner/user buildings in the highest demand.
Net Leased
The compression of cap rates for the risk taken is over. A return to the basics is occurring with investors again looking at what makes a good real estate investment: location, market trends, quality of the improvements, and does the concept/pricing/product of the tenant make sense for the long term. Cap rates are edging up. There is less new product being developed and hence less on the market. There are also fewer buyers, as a significant part of this market is driven by the back-end needs of 1031 exchange buyers, whose front-end property sales have declined. There are companies who are having trouble accessing the debt markets, and are now turning to the sale-leaseback market to raise capital.
Hotels
The dollar volume of hotel sales nationally dropped to a level last experienced in 2004. In 2007, there were approximately $77 billion of hotels sales in the U.S., according to Real Capital Analytics. For 2008, the volume will be about $11.5 billion. The economic downturn and lack of financing are the two main factors for the increase in sales. For the Twin Cities, the year-end sales volume is $55,200,000 and all are limited service hotels. All of the purchases were made by private investors. Cap rates for these sales averaged in the high 9%s. Cap rates for limited service hotels have risen nationally by 50-75 bps from a year ago according to RCA. See the adjoining table for metro area 2008 hotel sales.
2009 Outlook
A recent survey conducted by the Colliers Investment Services Group indicates that 22% of investors surveyed foresee being active buyers in the first half of the year. Seventy-eight percent said they would not venture back until the second half of 2009. Many want to know where the bottom is before buying. Leveraged buyers are mostly on the sidelines waiting for the debt markets to reopen. Sellers do not want to put properties on the market when there is a shortage of buyers to create a truly competitive market.
Investors with capital and access to debt will be able to make good buys on all property types and situations from opportunistic to value-add to core. The long term players are active, while the distressed asset buyers are doing more watching and waiting than buying. They know the number of foreclosed properties will grow throughout 2009 and into 2010, and therefore are being selective. There are distressed sellers emerging. Their properties may be good quality, but the loans on them are coming due and there are no refinancing options available. Compounding that problem is the fact that many of these properties were bought at the height of the market and are not worth what they were purchased for. (See the Real Estate Finance Section of this 2009 Report for capital market outlook.) Look for the private investors to be the most active buyers in 2009. Despite this group’s love affair with debt, they still find a way to make deals, especially when they are getting one.
Real Capital Analytics has identified $106 billion of distressed and potentially troubled assets. $4.5 billion of these have already gone back to the lender, and $21.2 billion are troubled in some manner: foreclosure, bankrupt borrower, past due on payments or loan maturity, major tenant bankruptcy, or slow sell out. Retail properties have the most potential for trouble ahead.
Distressed opportunities are coming from every investor type and every size. Look at General Growth, who is selling some of their trophy holdings to pay off maturing debts, or Lightstone Group, giving shopping malls back to its lenders, or the small partnerships that are being foreclosed for a variety of reasons. It seems no one is immune. Even Calpers will take over a billion dollars of losses on ill-timed land investments. The FDIC is auctioning off the assets they took over from failed banks.
There is a direct correlation between job losses and vacancy in office and industrial properties. Nationally, vacancy rates are expected to peak at 8.5%. This is going to lead to more vacancy and space for sub-lease. These weakened fundamentals will further erode property values and the ability of borrowers to re-finance existing debt. (See the Office and Industrial Sections of this 2009 Report for the graphs showing the correlations for the Minneapolis-Saint Paul market.)
According Brian Beaulieu of the Institute for Trend Research, the housing market will start coming back in 2010 and the commercial market in 2011. Commercial real estate this year hit the downhill side of the cycle and has a long way to go before hitting bottom. According to Mr. Beaulieu, 2010 will be the best time to buy. Vacancies will be up, values at their worst, and interest rates still attractive. Once the recovery starts, the anticipatory debt markets will smell inflation ahead and begin raising interest rates. In summary, buy low, load up on low interest debt, and let inflation (real estate’s friend) do its thing.
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National Forecast Predict Bleak 2009 for Commercial Real Estate
Posted: Nov 06, 2008
By: Burl Gilyard
Finance and Commerce
A new national study of the commercial real estate industry forecasts that the market will bottom out in 2009 – and pretty much stay there for some time to come.
Emerging Trends in Real Estate 2009, from the Washington D.C.-based Urban Land Institute and PricewaterhouseCoopers LLP, says that commercial real estate will “then flounder for much of 2010, with ongoing drops in property values, more foreclosures and delinquencies, and a limping economy that will continue to crimp property cash flows.”
Mark Reiling, president of Minneapolis-based Towle Properties and a principal with Colliers Turley Martin Tucker, thinks that those projections are right on the money.
Any recovery, Reiling said, is “going to take time. The wild card in that outlook is: where are interest rates?” Reiling doesn’t expect “meaningful recovery” for commercial real estate until 2011.
Bill Wardwell, executive vice president for Minnetonka-based Welsh Cos., generally agrees with the assessment and expects a tough market for the next 18 months.
In the current credit climate, property sales are particularly slow as owners as potential buyers often have vastly different ideas about value.
“Absolutely, the investor market is upside down. No one knows what the right price is anymore,” Wardwell said.
Wardwell said that the investment sales business at Welsh is down more that 60 percent this year.
The Emerging Trends report finds that “real estate value losses will average 15 to 20 percent off mid-2007 peaks, and could be more severe for lesser-quality commercial properties in secondary and tertiary locations.”
Wardwell said that for now, the property leasing business has held up fairly well for Welsh.
“The rest of our traditional brokerage lines actually operating fairly well,” Wardwell said. “Our concern would be retail.”
But Wardwell notes that on the current climate, it’s tough to make definitive predictions.
“None of us know really what ’09 is going to be yet,” Wardwell said. “It’s probably going to be a tough ’09 and it’s probably going to be into 2010 we see some meaningful recovery.”
Viewed from any angle, the commercial real estate market is in tough shape. Investment sales are down and property leasing is sluggish across the board in office, industrial and retail. Many brokers report that doing deals is taking longer as clients delay decisions or spend more time haggling over the finer points of and agreement. Credit markets have tightened, making it tougher to finance or refinance deals.
The Emerging Trends report predicts that “commercial real estate faces its worst year since the wrenching 1991-92 industry depression.”
But as tough as times may be today, there’s also some consensus that it’s not as bleak as the industry saw in the early 1990s.
“I would say it was a commercial real estate depression in those days,” said Whitney Peyton, senior managing director for the local office of CB Richard Ellis.
“We were in that slump from ’90 to ’92, basically. It took us until ’95 to get out,” Reiling said.
The Emerging Trends report offers a sobering assessment for the year ahead: “In 2009, expected total real estate private equity investment returns will likely register in negative territory for the first time in nearly two decades.”
Noting the cyclical nature of real estate, the report notes: “Indeed, the market always comes back, just now in 2009.”
Yet industry veterans also take the long view of the real estate market. Yes, the business is in rough patch, they’ll say, but it won’t last forever. Real Estate remains a cyclical business.
“My general position is I don’t think it’s quite as bad as people might tend to think. I don’t think it’s ever quite as bad as people make it out to be,” said Clint Miller, regional manager for New York-based Cushman & Wakefield. “I believe that the recovery will come quicker than you would think.”
Jeff Eaton, president of Bloomington-based NorthMarq Real Estate Services, said that while today’s market may look similar to the early ’90s on the surface, it’s different in many key respects.
“Some of the symptoms today are similar, but the underlying causes are very different. In the past, we generally caused our own problems. There didn’t use to be the discipline in the industry. Oftentimes, we oversupplied the market and created the problems with the fundamentals – the imbalance between supply and demand,” Eaton said.
“Our underlying fundamentals continue to be solid. We’ve had this credit crisis and this related economic slowdown that has kind of surprised everybody,” Eaton said. “The current vacancies are relatively low compared to that (early ’90s) period. Property owners are generally in better shape to weather a downturn. Rents should hold up relatively better than they did before.”
Even so, Eaton acknowledges that there won’t be any quick turnarounds.
“Our forecast is for soft demand through ’09 – ’09 will be a tough year,” Eaton said. “It’s just hard to imagine that we can pull out of this quickly enough to make ’09 a decent year.”
Lean & Green
Posted: Oct 03, 2008
By: Elizabeth Millard
In commercial real estate, design and construction that adhere to LEED standards for energy efficiency and green building continue to be popular, but that doesn’t mean older buildings are being left out of the green revolution.
As many property managers and tenants are finding, even small changes in building operations can have a major, lasting impact toward long-term efficiency gains.
“People believe that energy costs will continue to rise at a rate that’s higher than normal, so they’re thinking about how to get ahead of those increases in their operational strategies,” says Mark Reiling, principal, at real estate and property management firm Colliers Turley Martin Tucker (CTMT).
REDUCE, REUSE, RECYCLE
Sometimes, just changing key pieces of equipment can make a difference, Reiling notes. For example, at International Market Square in Minneapolis, which is managed by CTMT, intelligent motor controllers were installed to monitor controllers were installed to monitor and regulate the amount of power that goes to each piece of equipment in the building.
The controllers quickly saved 20 percent, Reiling says, and another 20 percent was saved with the use of surge protectors that prevent types of small energy surges that happen when equipment turns on and off.
“There’s definitely interest in the big stuff like underground water tanks, green roofs and solar panels, but the payback for components like those are still a long way out,” notes Reiling, “Putting in controllers or doing more recycling are things that can be done now, and can impact short-term energy costs.”
With experts predicting a teeth-gnashing winter for heating prices in both the commercial and residential realms, boosting efficiency before the snow falls is likely to keep getting more popular.
Creating more awareness among a building’s tenants is also crucial, as it can increase the type of smaller efforts that bring efficiency to homes, such as turning off lights and computers, or increasing recycling. Even encouraging more bicycle commuting can be beneficial, since it increases air quality in parking garages when fewer cars are coming in every day.
In its quarterly newsletter, Normandale Lake Office Park highlights efforts such as theses, and gives tips on recycling, says general manager Theresa Elveru. The office park has also implemented changes such as restroom remodeling, with low-flow toilets and urinals.
“Things cost money, so there’s a limited amount you can do,” she says. “But over time, the savings add up.”
In its tenant newsletters, CSM includes Xcel Energy marketing materials related to energy efficiency and also gives advice on recycling. In addition to creating greater involvement from tenants, CSM is gradually changing its lighting to more energy efficient versions—whenever a bulb burns out, a more efficient type of bulb, called a T8, is installed, says John Ferrier, the company’s director of architecture.
Tenants have also asked for tips on getting the most out of their HVAC systems, since many of the units are older, and CSM is also looking into ways to revamp warehouse space to bring in more natural lights.
“These types of changes might seem minor,” says Ferrier. “But in spaces that are older and less efficient, even changing the lighting can become a big deal.”
LONG-TERM THINGKING
These types of operational changes could be more widely routed in the next few years, Reiling believes, especially if the buzz over LEED certification begins to quiet down.
“Some companies are finding they can follow the LEED criteria but they don’t necessarily want to pay the major fees to get the certification,” he says. “So, I think in the future you’ll be seeing more claims of a building being ‘LEED compliant,’ which means that they’re using energy efficient strategies and green materials.”
Also likely to be a greater trend are recommissioning reports, in which engineering consultants come into a building and do a year-long study, recommending changes in operations and equipment. Normandale recently had a report done, and Elveru notes that it resulted in several significant upgrades.
For instance, an infrared scan done of the tope of the office park’s four buildings revealed that a good deal of energy was being lost through one of the roofs. The roof was sealed, and Elveru noted that they’re already seeing energy savings for the building.
In the next few years, another shift will be landscaping around commercial buildings, with growing emphasis on drought-resistant narive plants, Ferrier adds. Although exotic species might be pretty, they can take a good deal of water, and this past summer proved challenging for many companies that wanted their green space to stay green.
“There is a list of both major and minor things, from HVAC to landscaping, that can make a difference in terms of efficiency,” says Ferrier. “Tenants of commercial buildings are actually excited about how much they can do.”
Constrained Credit Slows Market
Posted: Jul 08, 2008
Last year at this time, the first signs of problems in the investment market were evident. An investor had placed a property under letter of intent and was getting an early start on his due diligence while the purchase agreement was being drafted. He figured he had 10-12 basis points of wiggle room if interest rates moved against him. During the following three weeks the 10 year Treasury moved 40+ bps and loan spreads increased by another 10 bps. The deal was doomed. He was not alone.
Despite the upheavals that began a year ago, there were $513 billion of institutional sales transacted in the U. S. last year, per Real Capital Analytics. Through May of this year, $56.5 billion of deals have been completed. The second half of the year ought to be better, but it is only a gut feel. So what is going on?
The biggest contributor is the near extinction of the commercial mortgage backed securities market (CMBS). This accounted for over half of the debt placement in 2007. Today, Moody’s is predicting $35 billion of CMBS issuance for 2008 versus the $230 billion done in 2007. Life insurance companies are filling in a small portion of the void, but they are cherry-picking the best deals. Banks are also lending more, but are being cautious as bank regulators are heavily scrutinizing commercial real estate loan portfolios. While the percentage of problem loans is very low (.35% for CMBS as of 3/08 and .01% for life companies as of YE 2007), it is likely to rise and that is also causing some anxiety about new lending.
The loans that are being made are conservatively underwritten on today’s cash flow. Debt service coverage trumps loan to value for many lenders, with no credit for the potential owner from vacant space. Debt coverage ratios have increased and loan-to-values have decreased. Also, very few interest only deals are getting done. The result, more equity is required.
Another contributor is the “denominator effect” occurring at life companies and pension funds. Say a pension fund allocates 8% of its funds to real estate investments and the rest goes into stocks and bonds. Then stock and bond values tumble, and real estate stays the same. All of a sudden, the percentage of the investment portfolio in real estate becomes, say, 10%. Now the pension fund is over allocated in real estate, resulting in no new or net new investing in real estate until the allocations get back into balance.
A key factor holding back sales is the bid-ask gap. Leveraged buyers that are still in the game want positive leverage, including loan amortization, a concept that got lost on many in the over-exuberance of easy debt. For investors to get the returns they need, cap rates need to rise. Investors who shoot for a targeted IRR are being conservative with their assumptions, resulting in lower priced offers. However, sellers are reluctant to lower their asking prices. History shows us that it usually takes 6-12 months for sellers to adjust their thinking to a new reality. The sales that are getting done are at higher capitalization rates. Core property cap rates are up 25 – 60 bps and value-add property cap rates are up 75 – 125 bps from a year ago. Apartments are the darling of the property types and cap rates are only up 25bps. Retail is at the high end of the range. Sellers will tend to hold their pricing if they are able to raise rents, which is occurring in apartments and the better office markets.
Historically, income property cap rates were 400+ bps over the 10 year Treasury. In 2003 that spread began to narrow all the way down to about 150 over by mid 2006, with apartments below 100 over. Today the spread is around 300 over, varying from 250 for apartments to 350 for retail.
Another hurdle is that deals are taking longer to get to closing. A year ago a typical transaction had a 30 day due diligence period and 30 days to close. Now a 45 day due diligence period is more typical with up to 60 days to close, or when the lender is ready.
2nd Half Outlook:
• The 10 year Treasury is going to increase due to inflation pressures, which will
increase capitalization rates. This is going to be bigger than most real estate
owners want to think about, particularly in 2009.
• The Federal Reserve will have to start fighting inflation late in the year by raising
short term interest rates. We will probably be in a stagflation period by 2009.
• Fannie Mae and Freddie Mac have been increasing their loan spreads and will
likely continue to, as they are the best apartment lender by far today.
• Rising unemployment historically has reduced apartment demand and it is rising .
• The for-sale housing market, while separate from commercial real estate, is
going to be in the bottom of the trough through 2009. Higher home mortgage
rates, combined with already tightened underwriting are going to further delay
that recovery.
• The CMBS market will crawl back into the game in a small way, making selective
deals. Look for loan spreads to shrink only a little.
• Value growth will lag rent growth
• Retail properties are going to see the largest value declines due to failing
retailers and slower new store expansion. Risk – return pricing will return to
retail real estate pricing. Cap rates for weak credit tenants are going to rise the
fastest. Sellers are going to have to prove viability by showing their tenant
sales histories to prove their centers’ worth.
Recommendations:
• If you are buying or are an owner who can refinance, do so as soon as you can
and lock in for the long term. Inflation is running very high when all factors are
added in. Long term interest rates are going to rise and perhaps dramatically so.
Currently the 10 year Treasury is well below historical averages (See chart).
• Reposition your portfolio by moving (selling) out of second and third tier cities
and weak assets. You may not get your price, but in one to two years you will
be happy you sold.
• Accumulate cash. Be patient for the type of investment you want. Have your
banker prepared to finance you ahead of time. Move assertively when your
deal surfaces.
Written by Mark Reiling CRE SIOR.
What is on Mark Reiling's Mind?
Posted: Mar 12, 2008
I am on my way home from India, assimilating my experiences of this trip and comparing them with trips to China and Japan. The economic power of the world is will shift to the East this century, from the United States. China has 1.3 billion people and India’s population of 1.1 billion is growing by 18 million a year. 50% of India’s population is under the age of 25 and desires the trappings of the West. For example, three million new cell phone accounts are opened each month and the number is growing. I saw a man on an elephant talking on his cell phone! India’s best and brightest are educated at top U.S. universities and return to India to utilize their new talents in this vast untapped market. Other than gas stations, Dominos, Pizza Hut, McDonalds and cell phone stores, there are very few retail chains in India. This is a huge untapped market.
An example of how a lot of goods are moved within Mumbai.
The world’s largest democracy is not without its issues. Its infrastructure of roads, water and sewer are grimly inadequate and plans to improve and pay for it are non-existent. In and around Agra, (home of the Taj Mahal), I regularly witnessed public defecation, as so many people do not have bathroom facilities. 72% of India’s children drop out of school by age 14, although the numbers are improving. The work ethic of these people is incredible. Even in the grisliest slums I visited, people were producing everything from brooms, leather goods, and clothes. About 1/3 of the people earn $2.50 – $3.00 per week.
There is no welfare check. Regardless of the caste an Indian is born into, they are accepting of their fate and are very friendly.
50% of India’s 1.1 billion people live in poverty.
The density of people in Mumbai (Bombay) was even greater than what I saw in China and Japan. The astounding part about it this is that these people are packed into 1-3 story buildings with families occupying 100 – 300 square feet. In one slum area visited, it is estimated that 400,000 people live in 538 acres (less than one square mile). They get water once or twice a day for 1-2 hours either in their dwelling or from a central tap and the bathroom is communal.
Infrastructure in India
India and China are both growing at 9%+/- a year, yet there are many contrasts as to how it happens.
Property Rights: India has strong property rights to a point of being detrimental and China owns its land and moves people for new developments and infrastructure growth.
Freedom of the Press: India is open and China censors.
Corruption: Both countries have it.
Entrepreneurial: India embraces entrepreneurship by its people, but not foreigners and China is exactly the opposite. China’s government seems to be more efficient than India’s and is evidenced by the success in getting things built.
Investment Market 2008
Posted: Dec 29, 2007
What a year for investment real estate. It started off smokin’ hot and ended up just above freezing. High leverage, low interest rates and loose underwriting fueled unbridled deal making. Debt continued to flow freely as it did in 2006. Then, out of the residential sector of all places, came the sub-prime storm. From mid-June on, the investment market mirrored this past Fall’s top 10 college football polls. Every week a few upsets and many close games. Deals were falling apart and/or being re-traded as lenders raised spreads or withdrew from the market. The 10 year Treasury rate was fluctuating dramatically. The Commercial Mortgage Backed Securities (CMBS) market shrunk as investors of these securities pulled away until the risk had been re-priced.
The beginning of 2008 will be a continuation of the market’s stabilization. Banks and life insurance companies are making more loans to buyers as the CMBS market recovers. Sellers are in a 6-9-12 month price expectation adjustment period that prices are 25-50 and even 100 basis points lower (i.e. higher cap rates). The other adjustment occurring is the change in rent growth assumptions. The attitude in 2006 and early 2007 was that rents were going to be climbing faster than the typical 2-3% per year underwriting assumption, especially for office buildings. Supporting this approach were declining vacancy rates and high rents needed to support new developments. Space absorption and rent growth expectations are now scaled down for 2008 and underwriting is dialed back to reality. Many sellers have pulled properties off the market after offers did not meet expectations.
One area in which the risk-return tradeoff got skinny in 2006 and early 2007 was in the valueadd segment of the market. In many cases, cap rates for under leased or under-performing properties rivaled those of core properties. Buyers felt greater returns (IRR’s) could be generated through this type of investment, and they were willing to pay for the opportunity. There were many lenders underwriting the speculative income and providing interest only loans. The jury is still out on some of these situations.
Investment property sales volume is down anywhere from 30–70% from a year ago, depending on the property type. Buyers with cash are in the driver’s seat now. In particular, institutional investors and foreign buyers taking advantage of the dollar’s declining value. Foreign investors mostly invest in core properties and in the major markets. After a slow start, 2008 will be a decent year. The Twin Cities had its share of big deals in all property types. The office market again generated many big deals as shown on the accompanying chart. Office cap rates were generally in the 6.7% to 7.5% range. There were approximately 60 office building sales over $5,000,000. Do not expect this level of activity during 2008. Investors are going to be looking carefully at the impact of the new development, both under construction and proposed in the southwest and west. Vacancies are going to rise and may level off as rapidly rising rent assumptions that have been liberally used in projections for the year prove unfounded.
Shopping center sales were steady throughout 2007 with cap rates mostly in the 6.5 -7.5% range and prices in the $175 – $250/sf range. The biggest sales were completed by institutional buyers, such as BlackRock Realty buying Calhoun Square, Centro Properties buying Oakdale Village and Teacher’s Insurance & Annuity buying Champlin Marketplace. Private investors accounted for the balance of the activity. Investors began shying away from retail in late 2007, believing the fundamentals are now flat for this sector. Cap rates are creeping up on strip centers and the underwriting of vacant side shop space has become conservative.
It was a strong year for industrial investment sales in both portfolios and individual assets. There were a few new entrants into the Twin Cities such as Cobalt Capital and High Street Equity Advisors, as well as buying by the familiar local names, First Industrial, Hines, IRET, Inland, and Hoyt Properties. Pricing per square foot varied in range from $45 – $90/sf and cap rates from 6.5% to 8%. Expect pricing to hold. Vacancies are declining and there is little new construction in the pipeline. Buyers and sellers will both benefit in 2008.
Opportunities for 2008:
Investing in residential land and lots is a good opportunity for patient capital. Focus on the growth markets of the future and carefully judge the supply against various absorption scenarios. The first money in this space closed deals in 2007 to allow sellers to carry-back tax losses against the last three boom years. Did these investors discount enough? Land buys are a play in 2008.
There are a lot of properties with 10 year loans maturing. Figure out which ones, who owns them, and what they want to do. This is an offmarket deal making opportunity. Buy vacant, general purpose industrial buildings with patient money. Declining industrial vacancies, especially inside the ring, and with the cost of new construction raising the rent bar, has created an exploitable gap.
The tightening apartment market will provide buyers the ability to improve the properties and raise rents. Nothing dramatic, but a solid play.
