As investors seek a safe haven in which to park their money during a recession punctuated by plenty of volatility in the stock market, commercial real estate provides an attractive solution.
NREI and Marcus & Millichap Real Estate Investment Brokerage Co.'s exclusive survey of hundreds of investors reveals that more than two-thirds of respondents who consider commercial real estate investing to be a full-time endeavor plan to increase their holdings in the industry in 2002.
The joint study, which was conducted in the fall of 2001, also reveals that respondents with large commercial real estate holdings are likely to diversify their investments across property types, with apartments being the most prevalent (Figure 1).
“If you have $1 million to invest and you have the choice of putting it into the equity marketplace or putting it into the capital markets, I'd rather be in real estate than stock,” says Harvey Green, president and CEO of Marcus & Millichap, headquartered in Encino, Calif.
“Even though the returns may not be what they were in the stock market during the last seven or eight years, they are still stable,” Green continues. “We're seeing a tremendous demand for real estate in all of the product types.”
For example, apartments graded Class C or higher typically sell in less than 45 days when they come to market, Green says. Grocery/drug-anchored shopping centers and single-tenant retail deals also sell quickly.
A stratification among product is occurring throughout the industry. Older and/or poorly located properties are experiencing vacancy and cash-flow problems while newer product in the right location typically is thriving. But even high-end product is not immune to the effects of overbuilding as evidenced by relatively high vacancy rates in the office and apartment sectors in key markets such as Atlanta and San Jose, Calif. While a robust economy can mask problems of overbuilding, conversely a recession can expose a market's weaknesses.
The importance of maintaining high-quality real estate in portfolios explains why 54% of respondents plan to redevelop, renovate or expand properties they are currently invested in. “You want your property operating competitively and looking good,” says Green. “That's the translation of managing the margins, that's the translation of the longer-term hold period, and that's the translation of the importance of internal management of the product.”
What is not in dispute among industry experts interviewed for this survey is that the pipeline for new development has slowed dramatically. Corporate America finds itself in a malaise. Consequently, real estate projects are being put on hold temporarily.
Sensing last summer that retailers were becoming hesitant about their expansion plans, Atlanta-based Cousins Properties opted to drop plans to build a lifestyle center project in North Fulton County, Ga., north of Atlanta. The diversified REIT made the move despite the fact it had experienced great financial success with a similar product, The Avenue East Cobb, in suburban Atlanta.
“I think the thing that kills any real estate development investment is uncertainty,” notes Joel Murphy, president of the retail division of Cousins Properties. “Bad news is better than uncertainty because you can factor into your corporate business plan the fact that rents are down or sales are off,” Murphy adds. But the worst is to hear, ‘I don't know. I'm uncertain. I've got to wait and see.’”
Figure 2 shows the value of commercial real estate holdings among survey respondents. The largest group (42%) has holdings between $1 million and $9.9 million. Another 20% have real estate holdings between $10 million and $49.9 million.
While investors in the survey appear poised and ready for opportunities, Green acknowledges that the spread between the bid and the asking price in many product types hasn't narrowed as much as some investors had hoped. That's partly a function of low interest rates, which causes owners to sit tight and refinance. “I think market values have held up relatively strongly,” Green says. “In reality, I don't think those [buying] opportunities have presented themselves.”
What follows is an overview of the study's findings within each property sector.
Apartments: The investors' pet continues its run
Conventional wisdom in real estate circles has long espoused the notion that apartment properties are attractive and popular investments, and this study strongly reinforces that assertion. In fact, 64% of respondents indicate that they are invested in apartments, by far the most popular property type. The next most popular was the office sector, with 40% of those surveyed invested in that property type.
The multifamily sector is especially alluring to investors for two reasons: they have a relatively high degree of familiarity with the apartment industry, and they look favorably on the stable cash flows it provides, Green says. If, for example, one tenant vacates a 10-unit complex, the property is still 90% occupied. On the other hand, an office or retail building could have the majority of its space tied up in a single tenant, and the loss of such a tenant obviously would have a devastating effect on that property's income stream, he adds.
Approximately 36% of those surveyed predict the apartment investment market will be stronger in the next year, 44% say it will be the same, and 20% predict it will be weaker. Also, 57% of the respondents indicate that now is the time to hold apartment investments, 27% say to buy, and 17% say now is the time to sell. (Figure 4)
The availability of low interest rates has enabled owners to hold and refinance their properties and explains why more don't feel the investment market has weakened, says John Bartling, president and CEO of Dallas-based Walden, which owns 140 apartment properties. “Whatever you've lost in rents, you've been able to make up in refinancing,” he says. The years 2003 and 2004 could see owners anxious to sell as the double whammy of a recovering economy and the arrival of the Echo Boomers into their prime rental years could spike apartment demand, he adds.
Respondents also were optimistic about apartment rents, as 70% say that effective rents are higher now than a year ago, and 53% predict that effective rents will increase in the upcoming year. (Figure 5) The findings may surprise some given the news about rent concessions that have popped up in certain markets.
Despite a recent dropoff in rent growth and lower occupancies, many owners of Class B and C apartments believe that the rents they charge are below market rents, says Hessam Nadji, managing director, Marcus & Millichap. Although fundamentals may support higher rents, most owners are reluctant to raise rates in a soft economy, he says. Marcus & Millichap's research indicates that weakness in the apartment sector intensified late in 2001 and was higher than expected, especially in markets closely tied to the tourism and technology industries.
Another reason for optimism may be that many apartment markets remain quite healthy, including Boston, Philadelphia, Sacramento, Calif., and South Florida.
Among the weaker markets for apartments are Atlanta, Northern California, Phoenix, Austin, Texas, and Charlotte, N.C., places that have felt the effects of overbuilding and/or job losses.
Roughly speaking, there is about a six-month lag between the performance of the national economy and the apartment industry. So even if a turnaround begins in the middle of the year, the sector as a whole won't start to rebound until the end of 2002 or the beginning of 2003, according to Gary Kachadurian, a principal at Chicago-based RREEF, a full-service, real estate investment advisory firm. “Generally, we're looking at a weak market for all of 2002.”
Retail never stands still
Even in the best of economic times, retail winners and losers abound. A myriad of factors such as location, quality of real estate, merchandise mix, competition and consumer trends combine to assure that this property niche is ever changing.
A recession can magnify a retailer's weaknesses. Consider the plight of Kmart, which filed for Chapter 11 bankruptcy protection in January and plans to close hundreds of unprofitable stores. Landlords will now be scrambling to fill those big-box spaces vacated by the troubled retailer, which pioneered the discount store concept. But while Kmart struggles to boost its credit rating and find the right product mix to keep customers coming back, rivals Wal-Mart and Target continue to thrive.
The survey reveals that among retail investors, 63% are invested in neighborhood/community centers, 62% in strip centers, 25% in malls and 19% in power centers. On the whole, investors believe now is a good time to hold their retail investments. However, 25% consider the current market conditions good for buying neighborhood/community centers (Figure 6).
“Historically, the safest plays are relatively new properties occupied by retailers that, day in and day out, fill the necessities of the market surrounding them. That includes the drugstores and the supermarkets,” says Michael LaRue, president of Chicago-based LaRue Associates, a retail consulting firm. “Everybody needs to eat, everybody needs to have their prescriptions filled. And if they are relatively newer stores, they won't be obsolete in three, five or 10 years.”
Despite concerns raised perennially about the nation being “over-stored,” retail remains a popular product type with investors, particularly net-lease deals.
“I think investors see good opportunities,” says LaRue. “When you start talking about neighborhood centers, strip centers, or in many cases net-lease properties, what many of these folks are looking at are multi-use kinds of properties that, if well-located, can easily be adapted for another user.”
It's a much more selective marketplace today in which the less desirable properties are even more vulnerable. For example, single-tenant space that's not located on a high-profile, main-on-main site is a tough sell, particularly if it's in a neighborhood that is not attractive to retailers.
“Nationally, we have nearly 20 sq. ft. of shopping center space per person, with over 21.25 sq. ft. per person in Illinois,” LaRue says. “As that number continues to increase, any space considered less than attractive will be continually harder to sell or lease.”
LaRue recommends that investors avoid any property that isn't easily reconfigured to accommodate another user, even if it appears as though the current tenant is healthy. He cites drug store chain Phar-Mor Inc. as an example. Phar-Mor closed more than 200 stores after entering Chapter 11 in 1992. It emerged from bankruptcy protection in 1995 before entering Chapter 11 again in 2001.
“Phar-Mor had what looked like a great financial statement several years ago. The drug chain was growing. It was the kind of tenant for whom most any developer would be delighted to build,” LaRue recalls. “But then it turned out that the financial statement did not accurately reflect its condition, and there was a bankruptcy. It took a long time to refill those Phar-Mors.”
Retail investors are most likely to predict that effective rents will remain the same over the next 12 months. However, for each retail property type, a larger percentage predicts a decrease in effective rents than an increase, as shown in Figure 7.
“Effective rents are sagging compared with six months ago,” says LaRue, referring to retail trends in Chicago. “I think they will sag more six months from now. It takes a while before enough pain sets in from vacancy for someone to say, ‘Maybe it's time to accept a lower rent.’”
To be more specific, LaRue says inline space in most centers as well as big-box space is facing the greatest downward rent pressure. Conversely, end-cap spaces and high-profile spaces are under the least rent pressure.
Indeed, not every landlord is suffering in this recession. For example, Cousins Properties, whose 3.1 million sq. ft. retail portfolio includes lifestyle and power centers in primary markets, boasts a healthy occupancy rate of approximately 96%. “I'm not seeing a deterioration of rents,” emphasizes Murphy in reference to the REIT's retail portfolio. “I don't think you're going to see rent growth as big as you did before, but I'm certainly not seeing rents plummet.”
Murphy glows when he talks about the lifestyle center concept. Tenant occupancy costs — which include rent, common area maintenance expenses and taxes — are substantially less than these same tenants would pay in a regional mall, according to Murphy. “How much lower do we really need rents to be to make this deal make sense for the retailers based on their sales per square foot?”
Although he would not release retail sales figures at any of the company's Avenue lifestyle centers, Murphy says that collectively their performance has met or exceeded expectations.
“Even in September and October when things were bleak, we were holding our own at the Avenue projects across the board. I don't know if it's because of the convenience factor, the comfortable open-air environment, or because shoppers feel safe close to home,” he says.
The investors themselves are the silver lining to the economic clouds currently hovering over the industry, Murphy believes. “Owners are not highly leveraged like they were [during the last recession]. And even if they are leveraged, they're leveraged with better coverage ratios because of lower interest rates,” he adds. “The risk of an owner losing the deal to the lender is not as great because even if their cash flow drops, they're still probably OK.”
Industrial is a stable force
Though it isn't glamorous, the industrial sector is a sound investment for two reasons, according to Marcus & Millichap's Green. First, it is perhaps the most difficult property type for which to win zoning approval, which leads to a scarcity of product. Secondly, the sector offers stability, as industrial tenants typically sign long-term leases.
The stability of the sector is reflected in the survey's results. Like the other commercial real estate property types, the industrial sector has felt the sting of the recession, as some big markets such as Atlanta have softened a bit in the past year. However, industry members don't believe the sky is falling.
“In general, in terms of rents and occupancies, the industrial market is the weakest it has been since 1991,” says Luis A. Belmonte, executive vice president of development for San Francisco-based AMB Property Corp. “However, interest rates are low, and compared with the early 1990s, participants are better capitalized. You don't have a wave of people going broke and defaulting.”
Among those invested in manufacturing properties, 53% indicate that effective rents are the same compared with a year ago, 29% say they are higher, and 18% say they are lower. As for those respondents invested in warehouse properties, 50% say effective rents are the same as a year ago, 34% indicate they are higher, and 16% say they are lower.
Belmonte says he has witnessed a tougher rent market than the respondents indicate. “My sense, based on our own portfolio, is that rents are lower,” he says. “We have seen decreases of 7% to 15% in effective rents.”
Belmonte is fairly pessimistic about the immediate future as well. “I don't think we'll see any improvement for at least 12 months because real estate is a lagging indicator,” he says, adding that rents in the industrial sector generally don't begin to increase until six to nine months after the general economy picks up.
Looking ahead to the next 12 months, 59% of respondents who are invested in manufacturing properties predict that effective rents will remain the same, 25% say they will decrease, and 16% predict they will increase. Among respondents invested in warehouse properties, 61% say effective rents will remain stable in the next year, 21% predict they will decrease, and 18% say they will increase.
As for the industrial investment market, investors have experienced a fairly stable environment, according to the survey. Among those invested in manufacturing properties, 53% say the current investment market is the same compared with a year ago, 39% say it is weaker, and 9% say it is stronger. Meanwhile, 52% of those invested in warehouse properties say the current market is the same compared with a year ago, 41% say it is weaker, and 7% describe it as stronger.
When asked to peer into the future, 53% of those respondents invested in manufacturing properties predict the investment market will remain the same during 2002, 36% say it will be weaker, and 12% predict it will be stronger. The numbers are similar for those with money in warehouse facilities: 53% say the investment market will stay the same, 29% predict it will be weaker, and 18% say it will be stronger. (Figure 8)
As for market action, 75% of those surveyed who are invested in warehouse properties say now is the time to hold industrial investments, and 73% of those invested in manufacturing facilities say now is the time to hold as well. (Figure 9)
The “hold” sentiment makes sense considering construction starts are down amidst a slower economy, says Tim Thompson, executive vice president and managing director of industrial brokerage for Chicago-based HSA Commercial Real Estate. “With not as much new construction, it's not as easy for owners to recycle their cash after they sell an asset,” he says.
The current investment market is a two-tier one, explains Belmonte. Properties that are in good locations in big markets and are completely occupied by credit tenants with at least three years left on their lease are selling for cap rates of approximately 8%, he says. Properties that are in less desirable locations or contain empty space feature cap rates of 9% or higher.
Office market likely faces stretched ‘U-shaped’ recovery
The 12-month office forecast is exhibiting signs of recession, according to investors. Nearly half of survey respondents foresee the same or lower rents during 2002, and nearly 75% say the current market is a time to hold all office investments.
Robert Sass, executive managing director of real estate investment banking for New York-based GVA Williams, attributes the pressure on rents to the downturn in the economy. He says the Sept. 11 terrorist attacks merely accelerated the rent decline initiated by the collapse of the tech sector in late 2000. “I don't think we'll see a V-shaped recovery. We will see a U-shaped recovery with a fairly wide bottom,” Sass predicts.
But there is cause for hope among office investors. “Excluding lower Manhattan, where the recovery is predicated upon the implementation of an effective tenant-incentive plan to encourage tenants to return, we don't expect rents to go much lower,” Sass says. “We're near the bottom of the U right now, give or take 10%.”
Across all three office property types, investors don't anticipate significant changes in rent levels this year. In fact, as illustrated in Figure 10, 42% of respondents expect effective rents for downtown office space to decrease during 2002. Why? Large amounts of sublease space coming onto the market continue to dampen rental rates, explains Brian Ross, president of office leasing and management for Chicago-based Jones Lang LaSalle.
And new construction weakens rates even further. “The construction pipeline that grew out of the economic health of the late 1990s has not fully hit the market yet,” Ross says. “The delivery of these new projects will weaken the market for the short term by increasing vacancy rates and creating a drag on rental rates.”
Ross expects office rents to reach a low point by mid-2002, and begin recovering about six months after firm indications of market recovery.
The office investment market looks just as mediocre as the rental rates. Forty-seven percent predict that the office/R&D investment market will continue to weaken over the same time period, while 37% and 38%, respectively, predict a weakening suburban or downtown market.
As Figure 11 illustrates, survey respondents are in a holding pattern when it comes to market investments. The majority considers the current market as a time to hold their investments in all types of office properties. Specifically, 62% of survey respondents say the sector is weaker than it was 12 months ago. Ross recommends that investors hold onto their properties because he believes the downturn will be short-lived. “Our recommendation will be to hold office investments and to refinance if necessary,” he says.
Ross says that much of the sublease space that is on the market will disappear by the end of 2002, sparking an increase in rental rates. “Direct vacancy rates in most markets are low now but are obfuscated by the amount of sublease inventory. The decrease in sublease inventory and the growth in rental rates will stimulate the office investment market back into action.”
Sass agrees, but adds that interest rates were one key to sustained prices. “There is an ongoing disconnect between bid and ask,” he says. “Sellers aren't willing to dump and buyers see pressure on rents.”
But, Sass adds, the low interest rates on floating-rate mortgages, particularly on floating-rate debt, help bridge this gap. “Generally, the office market seems at or close to the bottom after a tough year in 2001, and the sector will remain the same or a little weaker over the next 12 months unless we see an unexpected spike in interest rates,” Sass predicts.
Hotel sector back from the brink
The hotel industry would probably like to forget 2001. After the Sept. 11 terrorist attacks, the industry went into an unprecedented free fall as both business and leisure travelers cancelled trips.
Revenue per available room (RevPAR) plummeted 40% in the Northeast U.S. in September 2001 compared with September 2000. Prior to Sept. 11, the industry had already been experiencing declines in RevPAR and average daily room rates (ADR) due to the recession.
However, there is a glimmer of hope in the predictions of survey participants. Figure 12 shows that 46% of respondents predict RevPAR will stay the same and 24% expect an increase in revenues over the next 12 months, reflecting that the worst may be over for this beleaguered property type.
On the investment side, respondents expect the market to improve slightly in 2002 compared with the dismal results of 2001. While 64% reported a weaker investment market and only 9% characterized the market as stronger than 12 months ago, 29% expect a stronger investment environment in 2002 and 44% say it will be weaker. (Figure 13)
R. Mark Woodworth, executive managing director at the Hospitality Research Group, a division of San Francisco-based PKF Consulting, agrees with the respondents who predict RevPAR will drop in 2002. Woodworth notes that RevPAR nationwide decreased 9.5% in 2001 compared with 2000. Hospitality Research Group, in conjunction with Boston-based Torto Wheaton Research, tracks hotel industry trends in the top 50 U.S. markets.
“That [9.5% decrease] was the worst revenue drop we've seen in any one year going all the way back to the 1930s and the Great Depression,” he says. “We are forecasting in 2002 that it will be even worse, that RevPAR will decline 13.5%”
Woodworth's forecast for the sector improves toward the end of the year. “We think a recovering economy is going to be very evident as we head into next year, so demand will bounce up very significantly in 2003,” he predicts.
Arthur Buser, managing director and head of West Coast operations for Sydney, Australia-based Jones Lang LaSalle Hotels, has a more optimistic income outlook. He expects RevPAR in a majority of markets to remain flat or increase slightly. But he says revenues in some markets will increase only because 2001 was such an awful year.
“These markets [such as New York and San Francisco] and others that were significantly below 2000 all year long have a better chance for 2002 results to be ahead of 2001,” Buser says.
Survey respondents expect a sluggish investment market in the hotel sector this year. According to 74% of participants, “hold” will be the primary sentiment of investors in 2002. Woodworth says most investors will sit on the sidelines until hotel revenues begin rebounding near the end of the year.
“Buyers are looking for very low prices,” Woodworth says. “If you're a seller, you don't want to sell into that kind of market.”
Buser agrees that many investors are likely to stay in a holding pattern for at least the first half of the year. “While there are many buyers, most are expecting to buy for 50 cents to 60 cents on the dollar,” he says. Because of the bargain-hunting investment environment, many companies that had planned to put their properties on the market will wait a year or two before selling, he adds.
However, Buser says the likelihood that RevPAR results will be either flat or increase should create a more favorable investment climate in the second half of 2002. “This will signal that the bottom has been hit,” he says. “Normally, all types of capital are attracted to investments where the bottom has been found and there is little risk of downside.”
Lenders will free up money for hotel projects when hotel revenues improve in the second half of the year, he predicts. “The first three to six months should reinforce for many banks that the risks were overstated at the end of 2001, and that the hotel industry remains a viable and profitable opportunity for banks.”
About the survey
The purpose of the 2001 Survey of Investors study was threefold:
to examine current real estate investments among Marcus & Millichap Real Estate Investment Brokerage Co. clients and National Real Estate Investor (NREI)subscribers;
to investigate future investment plans;
and to determine which property investment markets are strongest and will be most attractive to investors in the near term.
Questionnaires were mailed out to 4,000 industry professionals, including 3,000 randomly selected names from Marcus& Millichap's database in addition to 1,000 NREI finance subscribers. The survey was compiled in the fall of 2001. Results reflect respondents' assessment of the investment climate after the terrorist attacks on the World Trade Center and the Pentagon. The mail survey resulted in 462 usable surveys, for a response rate of 12%.
Respondents are primarily long-term private investors who have invested in commercial real estate for an average of 21 years. The majority of respondents (62%) consider investing in commercial real estate to be a full-time endeavor. Institutions surveyed include advisors, REITs and financial services firms.
The survey measured feedback on several issues, including renovation and expansion, the availability of debt financing and plans to invest in REITs and other asset classes.