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.
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