November 06 2014
Seeing Similarities to 2007, CRE Industry Debates Whether We’re Early or Late in Current Upcycle
Allegiancy CEO Steve Sadler is quoted sharing valuable insights on the middle market in commercial real estate.
Article by Mark Heschmeyer
The year 2007 still casts a long shadow over today’s commercial real estate market. Nearly every discussion among commercial real estate pros involving cap rates, investment sales volume, price/square foot, loan underwriting, vacancy, etc. ties today’s values back to the previous market peak, just before it all collapsed after the bubble in housing values burst.
As we enter the final quarter of 2014, it’s inevitable that current stats, which now approach or exceed the 2006-2007 numbers, are placed side-by-side as a cautionary legend warning that the end of this run-up may be nigh. In Icarus fashion, it’s as if some believe transaction volumes, values and yields collapsed because they got too high.
Throughout the industry, in meetings and conferences, the debate rages on.
“I don’t agree with the premise which is often stated by real estate pros that we are ‘late in the cycle,’” says Fred Shaffer, president of Saiko Investment Corp. in Manhattan Beach, CA.
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In fact, were it not for the residential housing subprime lending debacle, the CRE peak could have kept going up in 2007, he says.
“I believe that the residential crash brought down the economy, which then brought down all CRE,” Shaffer says. “The real estate cycle is fundamentally driven by the economic cycle. Given the slow but steady economic recovery we are in, we could well have another 3, 5, 7 or more years before the next downturn.”
If Shaffer is right, then it begs the question of how we could be in the third inning of the overall economic recovery but already back to previous peak valuations.
Shaffer says it’s important to recalibrate one’s persepctive on th emarket because of the increasing efficiency of capital allocation to real estate.
“When I started acquiring property for development in Los Angeles in 1998, there were very few institutional sources available,” he explains. “Today they’re tripping all over each other. The increased availability of smart capital has had the effect of turning real estate prices from a current or lagging indicator of the economy into a leading indicator, almost like the stock market has been for a long time.”
“This implies that real estate prices will start to decline before the economy tanks as the smart money anticipates such a decline and tries to get out in front on it,” Shaffer says.
We put the same questions to other real estate investors, brokers and analysts across the country and asked them where they believe we are in the CRE market cycle and where there are still opportunities for finding yields on real estate investment at this point.
For Shaffer’s part, while institutional players such as Blackstone and Starwood are off buying properties and operating companies on a global scale, he said, “a local LA guy may still find and create value converting old warehouses into creative office or adaptive-reuse residential.”
First Some Current Stats
Before going further in to where the CRE market stands vis-à-vis 2007 and where there is a yield play still left, here are few benchmarks of current market conditions beginning with loan underwriting.
“Loan originators continue to loosen underwriting standards,” says Tad Philipp, Moody’s director of CRE research. “The use of aggressive and pro forma underwriting, which presents a property’s net operating income as higher than sustainable levels, is on the rise.”
Moody’s loan-to-value (MLTV) ratio for conduit collateral increased to 112.2% in the third quart4er from 108.3% in the second.
“At this rate, MLTV will exceed its pre-crisis peak of 118% well before the 10th anniversary of the previous peak in Q3 2017,” Philipp says.
According to Nomura Securities International research, the proportion of loans underwritten with pro forma financials has reached its highest level since the restart of securitization. Approximately 40% of all loans securitized in the third quarter were underwritten more than 10% above historical income levels or were underwritten without historical financials.
“Loans underwritten more than 10% above historical levels or with no historical basis have underperformed underwritten projections by 4% to 5%,” says Nomura analyst Lea Overby. “Because these loans are given credit for unproven income, we view pro forma underwriting as a strong credit negative, and its inclusion signals additional deterioration in credit standards.”
Ken McCarthy, senior managing director of Cushman & Wakefield Economic Analysis and Forecasting Research, said he believes the U.S. economy has shifted to a higher-growth trajectory over the past year.
“Recently released economic reports suggest that this stronger growth will be sustained in 2015, which we expect to be the best year for the U.S. economy since 2004,” McCarthy states. “Commercial real estate markets across the country are beginning to reflect this improving environment and we expect the coming year to see healthy performances across all property types. We are now in the sweet spot in the commercial real estate cycle.”
According to Cushman & Wakefield, office vacancy rates have recently fallen at the fastest pace of the recovery, down at an annual rate of -1.4 percentage points, more than double the pace of the preceding three years. And, industrial markets have already seen a significant decline in vacancy to 7% in the third quarter of 2014, the lowest overall vacancy rate for industrial space in the U.S. since the first quarter of 2001.
McCarthy said the steady improvement in the industrial market reflects the healthy increase in consumer spending as well as the continuing shift in spending from stores to the internet.
Meanwhile, JLL also reports that strong fundamentals and investor interest in commercial real estate should propel all CRE sectors in 2015.
Secondary markets are getting their day in the sun, as increasing job growth and economic improvement expands beyond the major ‘gateway’ cities across the U.S.
“One of the biggest shifts we have seen is the amount of capital flooding into the secondary and even tertiary markets, and we expect investor interest in those markets to remain high in the year ahead in all asset types,” explained Steve Collins, president of JLL’s Americas Capital Markets business. “It’s the result of the enormous level of investor interest in primary market real estate, with a swell of new foreign buyers pulling out all the stops to acquire assets.”
Only Just Now Seeing an Uptick in Fundamentals Improvement
Paul J. Ruff, president of Triumph Real Estate Corp. in Denver, says there are yields still worth chasing in certain of the fastest-growing secondary markets due to meaningful changes in demographics and the movement of goods. Right now, Triumph is focusing on industrial properties in growing markets nationwide and office deals in Denver or San Francisco.
Ruff said he sees a lot of evidence for strong fundamentals in his markets: vacancy is falling, demand is growing and the lack of new construction provides reason to underwrite future rent appreciation.
“Cycles have varying lengths, and this one is marked by anemic economic growth and virtually no new construction. This is likely to extend the up-cycle beyond average,” Ruff said. “Right now industrial demand is outpacing new supply 2:1. So rents should continue to rise with asset values pushing toward replacement cost until a meaningful amount of new development commences.”
Stevens M. Sadler, CEO of Allegiancy, an asset management firm in Richmond, VA, said he believes there continues to be a real bifurcation in the market, which creates opportunities for price recovery in secondary and tertiary markets.
“In many markets, we are only just now beginning to see any real uptick in rents on new leases, so I think there is certainly room for asset value to move to the upside, particularly in secondary markets,” Sadler says. “Naturally cap rate compression has its limits and is impacted by the interest rate climate, Fed policy, QE and the like, but the real estate fundamentals are still improving in the vast majority of U.S. cities.”
In Sadler’s view, multifamily is fully valued and in some cases over-valued, particularly in light of all the new construction coming on-line in the near term. And he said his firm is skittish about retail as well with the exception of grocery-anchored assets.
“We continue to see value in office and more particularly multi-tenant office in secondary markets where the fundamentals are strong. Selected port cities offer attractive opportunities in the industrial and warehouse asset class,” Sadler said.
Scott Rogers with Colliers International – Investment Sales in Jacksonville, FL, said every market has opportunities at the right price — and pricing is still being helped substantially with interest rates still hovering in the 4% to 5% range.
“In Jacksonville, we have seen four downtown office towers trade in the past eight months, and all at prices 50% to 70% off what replacement cost would be,” said Rogers. “There are still pockets of opportunities for savvy operators to add value and sell at or above replacement cost, especially while interest rates are low.”
Like Shaffer in Los Angeles, Rogers says the opportunities appear more evident to local and regional players.
“Let the big boys play in the institutional sandbox but there are still opportunities for local deal and mid-priced (less than $10 million) deals that the institutional guys won’t chase,” he said. “As long as lenders treat debt spreads as generally no different between a primary city and a second/even third tier markets, pricing will remain strong in the second and third tier markets.”
Rogers said he sees similar opportunities in markets such as Jacksonville, Charleston, Charlotte, Atlanta, Raleigh and Greenville.
We’re Way Out Over the Ski Tips
An equal number of CRE professionals weighed in saying they feel much of the current upcycle has already run its course and that only limited options are still available to investors for capturing yields like those from the past couple of years.
Dan Becker is acquisitions and financial analyst for Regency Apartments, which owns, manages and develops apartment communities in Illinois and Indiana. He believes cap rate compression will not be a factor going forward, which means values must go up from a combination of higher rents and more efficient operations.
“We think markets are extremely competitive,” Becker said. “We have to look a long time to find a deal that we can accept the return on. Seems like you need to have some kind of angle or special motivation to be willing to do what it takes to win.”
Right now, he said the firm is looking for acquisitions in tertiary markets at a year-one cap rate of about 6.5% and hoping that the year-two cap rate is in the 6.8% to 7% range.
“The disposition cap rate we use is 7, so appreciation does not play a big role in our anticipated returns,” he added. “I don’t think buyers anticipate further cap rate compression going forward. If lower cap rates are off the table, I don’t see how they could be looking for major appreciation unless it was a value-add deal.”
Scott W. Elkins, managing member Elkins Lane Realty Advisors LLC in Alexandria, VA, said he believes the combination of off-shore/foreign investors attempting to park their money in the U.S. and stock investors possibly retreating from equities, cap rates could drop lower in the near term, but not forever.
“As long as inflation is nil and money plentiful, investors will continue to feed,” Elkins says. “However, locked-in at the low cap rates, the exit strategy for investors will be extremely limited, which could be precarious down the road. Honestly, at these levels, the market appears to be approaching being ‘a-fundamental,’ if you will, unless there is something I’m missing. My advice is beware the ‘new normal,’ we’ve been bitten before.”
By all means stay away from net leased properties, Elkins added, where the risk vs. reward doesn’t meet what he called the ‘sanity test’ for the expected return and underlying real estate. He believes future problems in net-lease retail product could be exacerbated by the “less sticks and bricks” trend among retailers, primarily due to internet buying trends. Instead, Elkins suggests, buy a fulfillment center.
Aynsley Catalano, principal of Catalano Associates LLC, a real estate market research and appraisal firm in the Boston suburb of Duxbury, said he has been scratching her head about the chase for yield that has been going on since back as far as the fourth quarter of 2013.
“I think everyone understands the factors driving demand for stabilized CRE, but what’s different from 2006/2007 is the market bifurcation,” said Catalano. “There are fewer core assets for the increase in investors chasing yield. With all the sources of domestic and foreign equity combined with the dynamics within capital markets it is no surprise that there is significant short-term arbitrage in stabilized, core CRE.”
At what point do investors decide that the spread between traditional financial instruments and equities and relatively illiquid CRE is simply not enough, he asked rhetorically. “Investors are now driving down yields in the secondary and tertiary markets, and that is a historic sign we have reached the end of the cycle.”
With 3 and 4-handle cap rates for prime assets in markets such as Boston, there are not many exit strategies for investors, and that is something investors need to think about, he added.
“While it’s true that a rising tide raises all ships, the question is what type of vessel would you like to be in when the squall or storm rolls in? A big boat, small boat, old boat, new boat, restored classic or a warship?”
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