Divisions Still Separate Property Investors from Opportunities
As in every economic recovery period, there are both positive and negative indicators in the stabilization process. For each encouraging sign we see, there is another signal that reminds us that it will be a long time before the U.S. economy is self-sustaining. We are seeing signs of recovery in the commercial real estate market, but the market is bifurcated and the recovery will be very uneven. Demand for some institutional-level properties where capital is in ready supply and investors are eager to buy is increasing. But as reported by many CCIM members in response to Real Estate Research Corporation (RERC) surveys, there is also a lack of demand for second- and third-tier properties in most locations, and rents and pricing may remain flat or even erode further before recovery takes hold in some areas.
Since the health of the commercial real estate market depends on the health of the economy, and the economy—despite all its improvements—remains fragile (although strengthening), commercial real estate is also fragile. Not only are the fundamentals for each of the major property types weak, and will remain so as long as unemployment remains high, the investment side of this asset class continues to struggle, except in real estate investment trusts, which tend to adopt the characteristics of the stock market.
CCIM members’ investment conditions projections improved only slightly for the apartment and industrial property sectors, increasing to 5.5 and 4.2 respectively, on a scale of 1 to 10, with 10 being high, during first quarter 2010. The investment conditions ratings remained flat at 3.8 for the office and hotel sectors, and declined slightly to 3.7 for the retail sector. As has been the case throughout the recession, the apartment sector remains the only property type with a rating that was mid-range or higher.
CCIM respondents to RERC’s investment survey rated the overall return versus risk for commercial real estate at 5.1. This is a slight increase from fourth quarter 2009, and indicates that respondents believe that the return on commercial real estate is starting to outweigh the risk, with confidence in this asset class continuing to grow. CCIM members continued to rate the apartment sector as the highest return versus risk performer, with a score of 6.1. The industrial sector earned the next highest rating, at 4.7. The lowest-rated sector remained the hotel sector, with a score of 3.9. Survey respondents believe that the risk is still greater than the returns for the industrial, office, retail, and hotel property sectors.
The overall value versus price of commercial real estate was rated at 5.5 on a scale of 1 to 10, during first quarter 2010. This is up from the fourth quarter 2009 rating, and is a positive sign for commercial real estate in that CCIMs believe the value of commercial real estate overall is finally greater than its price. In addition, private equity demand is increasing for high-quality commercial real estate, and prices are starting to inch upward. But, unlike the value returns in the previous cycle that were based on cap rate compression, private equity will be looking for increases in net operating income in the form of rental growth and leverage. This seems to reflect the demand versus supply dynamic in the marketplace, where investors are competing for top-tier properties and driving the cap rates lower, combined with the fact that investors are willing to accept lower returns for a more conservative cash flow.
Although volume has increased slightly for all property sectors on a 12-month trailing basis, CCIM members have noted that there is still very little transaction activity occurring. However, for the properties that are changing hands, private funds, large institutions, REITs, foreign investors, and cash-rich or high liquidity/net worth investors are among the most active buyers. Based upon CCIM members’ comments, office and retail properties are the most available due to foreclosures and distressed sales.
Banks, over-leveraged or distressed institutional/private investors, and other firms that own real estate (REO) needing to raise capital are the most active sellers. Although some banks continue to “pretend and extend” the terms of their commercial real estate loans, several CCIM members noted that more banks are starting to “amend and extend” their loans for commercial real estate. This is effective for some of the better properties and loans, but many regional banks have no alternative other than to declare the loan delinquent. With less deal activity taking place, some of the best opportunity is in real estate consulting, working with lenders and special servicers, and servicing receivers who are taking properties back.
— Richard E. Juge, CCIM, SIOR, is the 2010 president of the CCIM Institute, and president of RE/MAX Commercial Brokers in Metairie, Louisiana.