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A Time to Defend

A number of unfavorable market forces are closing in on commercial real estate investors, threatening to compromise asset values in 2008. After a tremendous run in which commercial real estate values in the U.S. rose 90% over a five-year period, prices fell 1.2% on average from August to September 2007, according to Moody's Investors Service. Transaction volume has taken a much bigger hit, plummeting 70% to $4.4 billion in October versus the same period a year ago, reports Real Capital Analytics.

Buyers and sellers are waiting for the other side to blink. The highly leveraged investors who helped to bid up prices before the credit crunch struck this summer have been relegated to the sidelines, while the equity players still in the game aren't willing to pay the lofty prices many sellers are hoping to obtain for their assets.

Flattening real estate vacancies also are putting downward pressure on prices and making it difficult for many owners to meet their goals for rental growth. Vacancy rates have ceased to improve across all property types, with the national office vacancy rate reaching a plateau of 14.7% in the third quarter, down from 15.3% a year ago, reports Property & Portfolio Research. That marks the end of 15 straight quarters of declining office vacancies.

Across the property types, vacancies are not expected to improve until at least 2009, according to the Boston-based market research firm. In fact, economists say the nation is closer to recession than it has been at any point since 2001, with the consensus calling for 2% to 2.5% GDP growth in 2008 — a snail's pace compared with the 3.9% growth posted in the third quarter of this year.

The U.S. created 166,000 jobs in October, a modest figure by historical standards, but continued housing contractions and write-downs by financial services firms have most forecasters projecting fewer than 100,000 new hires per month in 2008.

That hiring rate might sustain a healthy absorption rate in a more robust economy, but slowly growing companies will be reluctant to expand their leased space amid today's economic uncertainty.

Owners and managers who fail to adapt to the changing economic climate may have difficulty increasing rent to meet revenue projections as the market shifts to favor tenants. Sellers who attempt to cash out quickly by selling at a reduced price before conditions worsen risk even greater deterioration of their capital next year because real estate is unlikely to lose value as quickly as cash.

That's because the U.S. currency has been losing ground against the euro and accelerated its decline when the Federal Open Markets Committee lowered the overnight Fed funds rate to 4.5% on Oct. 31 (See sidebar p. 28).

“It's time to get defensive,” says Josh Scoville, director of strategic research at Property & Portfolio Research. “We are in a time when the capital markets are working against investors.”

Preparing for battle

Today's tepid market conditions will soon provide a hunting ground of buying opportunities, according to Warren Diamond, CEO of American Real Estate Management LLC in Tinton Falls, N.J. In October, his company refinanced five of its properties to extract approximately $30 million in cash. Diamond plans to use those proceeds to expand the firm's portfolio, which currently encompasses 4 million sq. ft. of self-storage and mixed-use projects in the Northeast and California.

“We saw an opportunity to place these mortgages on the properties and stockpile cash because we believe there are going to be buying opportunities throughout 2008,” Diamond says. “We believe people are going to be selling at distressed prices.”

Yet, there's little evidence of distress so far. Delinquencies in the commercial mortgage-backed securities market fell by one basis point to an all-time low of 0.28% in October, reports Fitch Ratings.

But the recent past belies cracks in the armor that will widen as the economy slows. Case in point: 20 newly delinquent apartment loans worth $78.7 million boosted the dollar volume of multifamily CMBS delinquencies by 10.4% in September. Experts offer four approaches to avoid investment losses in the current market:

1. Wait it out — Commercial real estate prices are in the midst of a correction, and many buyers and sellers aren't seeing eye-to-eye. Lenders insist that credit is available to qualified borrowers, but more conservative underwriting that now eschews interest-only periods and speculative income, and demands greater debt service, has reduced the amount leveraged borrowers are able to pay for commercial real estate.

Reduced liquidity had an immediate effect on September sales volume, which fell 26% from year-ago totals to less than $8.5 billion for office properties, according to Real Capital Analytics. More deals fell out of contract in September than were placed under contract, and volume across all property types dropped 25%. Rather than agree to sell at reduced prices, many owners simply took their properties off the market.

Forecasters say sales volume will begin picking up again in 2008, when sellers align their expectations with leveraged buyers' ability to pay. Many owners would be better off shelving their sales plans pending healthier market conditions, says Dr. Mark Dotzour, chief economist at the Real Estate Center at Texas A&M University. Why? Because rising oil prices and a shrinking dollar suggest the nation is heading into a period of accelerating inflation, so cashing out now is inviting losses in purchasing power.

“History shows that quality real estate tends to hold its purchasing power about as well as any asset you can buy,” Dotzour says. “We might see some price pressure on commercial real estate, but five to 10 years from now, I would expect commercial real estate to be a lot more valuable than it is now.”

2. Shore-up the portfolio — Avoiding losses in a market downturn begins at home, within the investor's portfolio. Does the existing cash flow cover debt service, or was the mortgage on the property calculated with significant rent increases in mind? Relatively slow economic growth in 2008 will make large rent hikes difficult in all but the most robust markets, so owners may need to re-evaluate their leasing strategies.

Owners with significant vacancy in their properties would be wise to fill those spaces soon, before weakening economic growth reduces demand for the space, says Robert Bach, chief economist at brokerage Grubb & Ellis. “Move the leasing needle from the ‘aggressive’ to the ‘competitive’ setting; lock in tenants, try to get that deal, so that if we do see a recession, you can ride through it,” Bach says. “It's better to be competitive now to secure rent for your empty space.”

Even if an owner plans to sell a property in the coming year, making the effort to land tenants will pay off by bringing a wider range of bidders to the table, according to Earl Webb, CEO of capital markets at real estate services firm Jones Lang LaSalle. That's because leveraged buyers can still obtain financing for properties with an existing cash flow, but not for one that will require future leasing to meet debt service.

If a property is 15% to 30% vacant in a market with solid fundamentals, Webb is advising his clients to lease the space before taking the property to market. “If the market is mediocre in fundamentals, say in a secondary market with low absorption, then you're probably just as well off rationalizing the increasing cap rate and selling.”

3. Hunt for bargains — Like Diamond of American Real Estate Management, some investors are protecting their portfolios by going on the offensive and seeking acquisitions. The investors prowling today's market for deals form a stark contrast to the highly leveraged buyers of 2006 and 2007, however, and are more likely to be pension funds, insurance companies or other equity players, says Dr. Sam Chandan, chief economist at research firm Reis.

“They're looking at commercial real estate as an income-producing asset versus one that will exhibit significant price appreciation over a short amount of time,” Chandan says. “It's an asset you hold, not one that you flip.”

Observers say few bargains have turned up so far, but will grow more numerous in 2008. A good place to search is in markets where cap rates and prices remain more closely in line with fundamentals. Average cap rates for offices in secondary markets climbed 63 basis points from the second to third quarters this year, rising from 6.38% to 7.01%, suggesting the pricing correction is occurring more quickly outside primary markets, according to Real Capital Analytics.

For investors planning to use borrowed capital in order to snatch up properties from distressed sellers, it's a good idea to visit with a lender early in the process, advises Charlie Williams, vice president at KeyBank Real Estate Capital in Cleveland. “At least have a discussion with the financing [provider] upfront before getting into the deal and assuming you are going to be able to get the financing,” Williams says. “Let's talk about the financing first and be a partner from Day 1.”

4. Break from the herd — Now that most commercial real estate investors are resigning themselves to be content with incremental returns based on property income rather than rapid price appreciation, a daring few speculators will take a riskier path. In an extreme version of bargain hunting, these investors will be buying assets in the markets and product types hit hardest by the slowing economy. The opportunity for contrarian plays will increase in 2008 as the economy slows and liquidity issues moderate, according to Scoville of Property & Portfolio Research.

“That's something we haven't seen in a number of years,” Scoville says. “That's buying on the bad news; that's investing right now in Florida or Southern California, where there's just not a lot of investor interest,” he says. “There's a lot of fear about investing in those areas, but at the end of the day Florida is a high-growth state. It's going through its woes right now, but it will come roaring back.”

Contrarian investments require investors to look beyond existing conditions and evaluate the long-term prospects of a property and its market. Miami is a good example of a market with a surplus of residential condominiums and a rising office vacancy rate, but promising long-term prospects as part of a primary market in one of the fastest growing states in the nation. “I do expect there to be some excellent opportunities in Miami,” says investor Diamond, who is a resident of Boca Raton, Fla.

A narrow escape?

Warnings of a looming recession seem to crop up in every economic forecast, but some economists say a recession in 2008 is decidedly unlikely. One reason is the makeup of the labor force, says Dr. Edward Leamer, director of the UCLA Anderson Forecast.

Manufacturing layoffs have contributed to every housing-induced recession in modern U.S. history. Most recently, the nation lost some 2.7 million manufacturing jobs between 1998 and 2003. Since then, manufacturers have rebounded with increased productivity, but without significant job growth. “Manufacturing is still very lean and not positioned to have enough layoffs to cause a real recession,” Leamer says.

Should the economy slow precipitously, the Federal Reserve will act quickly by lowering rates to stimulate lending and consumer and corporate spending, even at the expense of driving down an already depressed dollar and fueling inflation, according to John Burford, senior vice president and investment portfolio manager at the International Bank of Miami.

Fighting inflation has been the central bank's chief objective, but now that subprime losses have put some of the world's largest banks on thin ice, the Fed is poised to lower rates rather than risk the global consequences of a major bank failure. As Burford puts it, “lower rates are way cheaper than a government bailout.”

A lengthy siege

Commercial loan defaults are almost certain to accelerate in 2008, predicts Chandan of Reis. That's because many mortgages originated in early 2007 were underwritten to meet debt-service requirements with projected rental income that landlords are unlikely to achieve now that the economy has slowed. “The loans we make as we approach the peak of price appreciation ultimately default at the highest rates, and that is an empirical regularity across real estate cycles.”

Investors will need to maintain defensive postures until the economy moves beyond its current malaise, which may not occur until 2009 or later. It will take that long to work through a housing recession that promises to deliver a few more blows to the economy, says Dotzour of Texas A&M.

Specifically, hybrid residential mortgages, which charge fixed interest for two to three years before converting to floating market rates, will bring new rounds of defaults as those fixed periods end. Assuming unsound loans of that type were made up until April 2007, then residential mortgage defaults will continue to drag down the economy until April 2010 before tapering off, Dotzour reasons. “We're just seeing the early stages of a multi-year problem.”

-Matt Hudgins is an Austin-based writer.

NREI asked five forecasters to predict the direction of key indices. Here are their responses:

Robert Bach: Chief Economist, Grubb & Ellis
Prediction: “This is what long-term investors have been waiting for, and this is their time where they can get discounts on acquisitions.”

Dana Johnson: Chief Economist, Comerica Bank
Prediction: “The concerns about inflation are badly misplaced; you can't get a systematic rise of inflation in an environment of economic weakness.”

Edward Leamer: Director, UCLA Anderson Forecast
Prediction: “No relief from rising foreclosures through all of 2008.”

Josh Scoville: Director, Strategic Research, Property & Portfolio Research Inc.
Prediction: “In 2008 there could be some opportunities to be a contrarian and to buy on the bad news. It's not an easy thing to do, but have faith in the future and I think you'll be rewarded.”

James Smith: Chief Economist, Parsec Financial Management
Prediction: “The big job increases will be in small business, mostly in the service sector, as always.”

yield (%) ($ per barrel) GDP (%) Core CPI growth inflation rate (%) Monthly 10-year job growth Crude oil Treasury
Bach 1.5 2.2 75,000 4.5 $85
Johnson 2.2 1.9 97,000 4.45 $90
Leamer 2.4 2.2 80,000 4.5 $80
Scoville 2.1 2.0 80,000 5.1 $65
Smith 4.1 1.1 173,000 4.56 $60

Shrinking U.S. dollar proves to be a double-edged sword

The credit squeeze is confining many high-leverage buyers to the sidelines in the United States, but international equity players will likely take up at least some of the slack in 2008. Due to a declining U.S. dollar, investors have seen their buying power in the U.S. increase as much as 30% in the past six months.

“It's made American real estate look like a screaming bargain to people with European or Canadian currency,” says Dr. Mark Dotzour, chief economist at the Real Estate Center at Texas A&M University.

The dollar has declined against the European currency for five of the past six years, equaling just 0.68 euros in November. That same month, the Canadian dollar had climbed to $1.07 U.S. from about 85 cents last spring.

That helps to explain why Canada's TD Bank Financial Group readily agreed to buy New Jersey-based Commerce Bancorp for $8.5 billion this fall. “They're buying Commerce Bank for 20% to 25% less than it would have cost them just a few months ago,” says Dr. Sam Chandan, chief economist at data researcher Reis.

The Fed's decision to lower short-term interest rates on Oct. 31 further depressed the dollar against other world currencies. Why? Essentially, smaller yields on U.S. Treasuries and the increased prospect of inflation make dollar-denominated investments less desirable. In addition, the Fed's action confirmed fears that the housing-worn U.S. economy needed help to avoid recession, and that knowledge erodes confidence in the domestic economy as a safe haven for investments.

Still, the weak dollar is a boon to manufacturing exports, fueling a 23% increase in output in the third quarter and contributing 1.73% to the overall GDP rate of 3.9%.

Some economists fear that concern over the crumbling U.S. housing industry and subsequent financial market turmoil will sour international investors and foreign central banks on U.S. securities. On Nov. 18, for example, Iranian President Mahmoud Ahmadinejad said OPEC members are considering diversifying their cash reserves away from U.S. dollars, which he called a worthless piece of paper.

But for now, China and other nations continue to reinvest billions of dollars in U.S. Treasuries, which has helped to keep long-term interest rates low and fueled economic expansion here. A reversal of that trend would pressure interest rates to climb and could lower prices on U.S. assets, including commercial real estate.

“When the people that have control over international wealth decide that they want less of that wealth in the U.S. and put it elsewhere, like in euros, that's a very serious consequence,” says Dr. Julian Diaz III, chair of real estate at Georgia State University.

On a brighter note, Dotzour of Texas A&M says domestic real estate investors needn't convert to euros to avoid losses in 2008. “If there's anything in the U.S. that's a real hedge against runaway, central-bank-induced inflation, it's good-quality commercial real estate or land.”
Matt Hudgins

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