What Does It All Add Up To?

After three years of recession-induced angst, the commercial real estate industry is finally on the mend. The U.S. office market has posted positive absorption over four consecutive quarters, reports Grubb & Ellis. Roughly 10 million sq. ft. of office space was absorbed in the fourth quarter of 2003 alone. Bob Bach, national director of research at Grubb & Ellis, projects that 25 million sq. ft. of office space will be absorbed between now and the end of 2004.

Still, there is some 260 million sq. ft. of vacant office space nationwide, an overhang that could take years to burn off. Worse yet for landlords, office asking rates nationally are still dropping. The average Class-A asking rent as of mid-June was $27.60 per sq. ft., down from $28.20 per sq. ft. at mid-year 2003, according to Grubb & Ellis, which tracks 47 markets with a total inventory of 3.3 billion sq. ft. Bach anticipates that asking rates will dip slightly by the year's end due to the excess space in the market.

“The surprise has been that with the exception of Washington, D.C. — which is an exceptional market because of government expansion and the related private sector expansion — we haven't seen the recovery translate into increased rental rates and increased leasing velocity,” says Stephen McCarthy, managing director of Atlanta-based WestWind Capital Partners. The private investment advisory firm, which invests German money in Class-A office buildings in the U.S. via KanAm Group's open-ended fund and several closed-end funds, has $3.5 billion of real estate assets under management totaling 8 million sq. ft.

McCarthy is hoping to see “real tangible evidence” of a full-blown real estate recovery in the third quarter. “I definitely feel that we've risen from the bottom, but I can't say that our viewings are up 30% or our rents are 10% higher. I can't give our investors the data point that makes them feel better.”

Improving Vital Signs

But no one disputes that continued job growth portends more good news for commercial real estate because the two are inextricably linked. Some 248,000 non-farm payroll jobs were created in May, which held the unemployment rate steady at 5.6%.

Payrolls swelled by nearly 1 million between March and the end of May, and employment figures were revised upward for both March and April. More good news: A June survey of chief executives from 150 large U.S. companies shows that 38% plan to boost hiring over the next six months, up from only 33% back in December 2003.

In the first quarter, the real gross domestic product (GDP) rose at an annualized rate of 4.4%, 20 basis points above initial projections and well ahead of last year's first-quarter pace of 3.1%. There's one caveat to all this robust economic data: The drumbeat is growing louder for the Federal Reserve to undertake a series of interest rate hikes designed to ward off inflation, which means the days of extremely cheap debt could soon be over.

“What we are seeing now is a horse race between rising GDP and earnings on one side, and rising interest rates on the other,” says Susan Hudson-Wilson, founder and CEO of Property & Portfolio Research. So which horse is she betting on? “The economy is going to expand at a sufficient enough pace to offset the rise in interest rates,” Hudson-Wilson says confidently. She predicts that the unemployment rate will dip to 3.5% over the next two years, despite the corrosive effect of U.S. companies sending jobs offshore.

As this issue went to press in late June, the conventional wisdom was that the Fed funds rate would rise by 25 basis points to 1.25% Even an increase of 50 basis points wouldn't be enough to deal a crushing blow to most borrowers, believes Hudson-Wilson.

Expect the Fed to play a more active role in managing the economic recovery after the presidential election, says McCarthy, who believes interest rates will be significantly higher a year from now. “[The Fed] does not want to do anything that can be viewed as disruptive to the recovery prior to the election.”

Unprecedented Volume of Capital

While industry experts try to anticipate how fast and high interest rates will climb, commercial real estate remains awash in capital. LaSalle Investment Management projects that net new U.S. pension fund investments in real estate will tally $15 billion this year, up from $14.4 billion in 2003.

Offshore capital flowing into U.S. real estate is equally as strong. In 2003, foreign investors plowed $8.1 billion into U.S. real estate, according to the Association of Foreign Investors in Real Estate. Projections are that foreign investors will pour $10.3 billion into U.S. real estate assets this year.

Much of the capital that has inundated the commercial real estate market has been channeled into shares of unlisted real estate investment trusts (REITs). The so-called “Big Four” unlisted REITs — Wells Real Estate Funds, CNL Real Estate Advisors, Inland Real Estate and W.P. Carey — have attracted investors like a magnet.

During the first quarter of 2004, unlisted REITs raised $1.8 billion compared with $1.4 during the same period in 2003, reports investment banking firm Robert A. Stanger Inc. Their success has prompted five new unlisted REITs to go into registration with the Securities and Exchange Commission since the beginning of 2004.

So why have investors poured so much capital into real estate? Returns for core, unleveraged real estate in the U.S. hit 9.7% in the first quarter, which represented an increase of 70 basis points over the same period in 2003, according to LaSalle Investment Management. And given the volatile stock market, those steady, if unspectacular, returns remain enticing.

Douglas Poutasse, principal and chief investment strategist at real estate investment advisory firm AEW Capital Management, anticipates strong capital flows into real estate will continue for the duration of the year. He believes that more high-net worth individuals will pour capital into the sector, along with European investors such as the Germans.

“Only six months ago, most of the major U.S. metro markets were posting declines in [real estate] fundamentals,” says Poutasse. “But now most of them are back on the positive track once again.”

Repercussions for Borrowers

The burning question is how the convergence of these forces — job growth, rising interest rates and the plethora of capital — will affect investors. “Short-term rates will go up, and there will be some pain in the world,” predicts William Maher, director of North American research and strategy for LaSalle Investment Management.

Maher believes that since highly leveraged deals often include a mezzanine component, many of these mezzanine lenders could end up owning those properties, if interest rates rise sharply. Why? Mezz lenders typically secure their loans by holding the borrower's equity interest in the building as collateral. If a borrower defaults, the mezz lender can end up owning and operating the property.

Over the past few months, in fact, Maher has seen private investors take on increasing levels of floating-rate debt because the rates are still incredibly low. The three-month LIBOR (London Interbank Offered Rate) stood at 1.5% in late June, for example. There is a “speculative mentality” driving this shift to floating-rate debt, and that's not necessarily a good thing, Maher believes. With many owners seeking to flip their properties and exploit the sellers' market, Maher isn't too surprised that this opportunistic strategy appeals to some investors.

Still, a growing number of borrowers are feeling a sense of urgency to lock in fixed-rate permanent financing. John Pelusi, executive managing director at Holliday Fenoglio Fowler (HFF), says the firm's volume of fixed-rate deals has doubled over the past six months compared with the latter half of 2003. What's more, “the market has already priced one, maybe two, rate increases into their deals,” adds Pelusi.

Texas office developer Craig Hall, who owns and operates 100,000 apartments and more than 3 million sq. ft. of office space, has taken some precautionary steps to offset potential interest rate hikes. “We've hedged by swapping most of our floating-rate debt for fixed, and we also have a rate hedge in the futures market. But the reality is that nobody can predict interest rates,” says Hall, who foresees that over the next 18 months interest rates will rise faster than most industry players expect.

Hall's Dallas-area properties are already feeling the positive effects of strong economic growth. “Our tenants are now talking about expansions, and there has been renewed interest in leasing over the past few months,” says Hall, who founded his real estate investment and development firm in 1986.

A rise of 50 basis points in short-term rates could push some debt into distress, say experts, but to this point anyway that hasn't been a major concern. Fitch Ratings reports that delinquencies for U.S. commercial mortgage-backed securities (CMBS) fell by 16 basis points between the fourth quarter of 2003 and the first quarter of 2004. However, on a year-over-year comparative basis CMBS delinquencies increased from 1.39% in the first quarter of 2003 to 1.53% during the same period this year.

The biggest improvement in the delinquency rate occurred in the hotel and retail sectors, according to Mary O'Rourke, a senior director at Fitch. The multifamily sector didn't fare as well. According to O'Rourke, an additional $76 million in multifamily loans was reported as delinquent in the first quarter, double the amount over the previous 12 months.

While she doesn't expect the number of delinquencies to rise dramatically over the next six months, O'Rourke is concerned that increased competition among lenders could have an adverse effect on lending practices. “When the competition is fierce, firms find themselves making concessions that they wouldn't normally make,” she says.

Response to Bidding Wars

“You make your money on the buy” is an adage embraced by Ray Torto, president of Torto Wheaton Research, but he isn't convinced that investors are following that advice today. “In some cases, investors are facing negative IRR's (internal rates of return),” says Torto.

Roughly $4 billion of office properties traded in April, a 40% increase over the same period in 2003, according to Real Capital Analytics. Despite the threat of climbing interest rates, the sellers' market has shown no sign of weakening.

Instead, owners of stabilized assets are fielding numerous offers — many of them unsolicited — for their properties. That might explain why the first quarter saw an increase in direct (or off market) deals such as the Sears Tower, which sold to a group of Manhattan investors who avoided a formal bidding process.

Some overzealous investors are losing their heads in heated bidding wars for properties by offering unreasonably high prices for these assets, says James Smith, chief economist at the Society of Office and Industrial Realtors (SIOR).

“The troubling thing is that far too few investors recognize that they are in a bidding war and have the sense to bow out if necessary,” says Smith. Real Capital Analytics data shows that few property sales have fallen through since the beginning of the year, which suggests that ambitious bidders are winning properties and keeping them.

But the run-up in prices and reduction in cap rates, or the initial yield on a purchase, begs the question: Why aren't more buyers bowing out of the acquisitions game and seeking alternative investments? There's a simple explanation, emphasizes David Frosh, president of brokerage firm Sperry Van Ness in Irvine, Calif. “The stock market continues to be a treacherous place.”

The heated bidding wars are a source of frustration for institutional buyers, adds Frosh. “The private investors are willing to pay more for these properties [Class-A properties in prime CBDs], and because of that tertiary markets are coming into play.”

Robert White, president of Real Capital Analytics, predicts that private buyers — who typically are highly leveraged — will back off during the second half of the year as interest rates rise. In such an environment, Class-A properties should perform better than older, less centrally located assets. And institutional buyers, who typically prefer these high-quality properties, will likely emerge as the leading buyers of such assets, says White.

Because Westwind Capital typically doesn't employ more than 50% leverage on any of its acquisitions, a rise in interest rates will give the investment firm a distinct advantage, McCarthy believes. “To the extent that leverage becomes more expensive and cap rates go up, we should be in a position to bid more competitively on trophy and Class-A assets,” says McCarthy.

Where does WestWind Capital see opportunity? While continuing to invest in the top-tier markets of the East Coast such as New York, Washington, D.C. and Miami, the firm plans to branch out geographically. “The East Coast cities have held an attraction for German investors like ours,” explains McCarthy. “There is less historical German activity in the Midwest and West, and we will be focused on those regions.”

With so many wild cards at play this year, including a presidential election, the second half of 2004 promises to deal commercial real estate a very interesting hand.

Editor Matt Valley contributed to this article.


NREI asked six economists to predict the near-term direction of key indices. Here are their responses:

Dr. Rajeev Dhawan: Director, Economic Forecasting Center, Georgia State University

Prediction: “The core inflation rate will not approach the 3% mark by year-end.”

Douglas Duncan: Chief Economist, Mortgage Bankers Association

Prediction: “Britain will reject the European Union constitution. The consolidation of the EU as an integrated economic unit would establish it as a global trading block.”

James Smith: Chief Economist, Society of Office and Industrial Realtors

Prediction: “President Bush will be re-elected in a landslide as the economy grows at the fastest rate in 20 years.”

Diane Swonk: Chief Economist and Senior President, Bank One Corp.

Prediction: “The Dow will hit 12,000 by year end.”

Raymond G. Torto: Principal and Managing Director, Torto Wheaton Research

Prediction: “Twelve months from now, we'll be reminiscing about what was a great single-family housing boom.”

David Wyss: Chief Economist, Standard & Poor's

Prediction: “The dollar will slide sharply in late 2004 and early 2005.”

GDP (%) Growth* Job Creation (millions) 10-Year Treasury Yield (%) Oil ($ per Barrel)
Dhawan 4.6 2.2 5.2 $37
Duncan 4.7 2.8 5.25 $35
Smith 5.0 3.1 4.5 $28
Swonk 4.7 2.4 5.1 $36
Torto 4.1 2.3 5.6 $37
Wyss 4.9 2.4 5.2 $37
*GDP figures reflect total economic growth for 2004.

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