Commercial Real Estate Forecast Brighter

Commercial Real Estate Forecast BrighterImage via Wikipedia

After three years of dislocation and unprecedented loss, commercial real estate industry investors and professionals hint at hopeful signs of tempered commercial real estate market improvements, according to respondents of the Emerging Trends in Real Estate® 2011 report, released today by PwC US and the Urban Land Institute (ULI).

Survey respondents indicate a lowering of performance expectations, anticipating high single digit returns for core properties and mid-teen returns for higher risk investments.  Without ample leverage and attendant risk, real estate assets cannot sustain higher performance, according to survey respondents.  The survey finds that lenders with strengthening balance sheets finally step up foreclosure activity and dispositions of properties during 2011 and 2012, helping values reset 30-40 percent below 2007 peaks.

“The market is predicting extreme bifurcation as the capital flight to quality creates a greater separation between the trophy and less desirable assets,” said Mitch Roschelle, partner, U.S. real estate advisory practice leader, PwC.  “Well-located and well-tenanted properties that can generative strong cash flow over the next several years are exactly what buyers and lenders want, according to survey respondents.  As a result, prime apartments and office buildings in gateway cities are generating the most attention from the increasing pent-up sidelined capital.”

Debt Market Loosens Further in 2011

The report indicates debt markets thawing further in 2011 as banks continue to strengthen balance sheets, take their losses and step up lending, resulting in higher transaction volumes.  Borrowers are expected to have improved chances to obtain refinancing if they own relatively well-leased cash flowing properties.  But overleveraged owners dealing with high vacancies and rolling down rents may face more uncertain prospects in the credit markets, including the increasing likelihood of foreclosure.

Real Estate market participants continue to see a gulf between buyers and sellers, however, there is an expectation that the ‘bid-ask’ spread will begin to close in 2011 as selling sentiment improves dramatically from last year’s all time survey lows and buyers temper expectations for giant discounts,” said ULI Senior Resident Fellow for Real Estate Finance Stephen Blank.  “Investors with cash could have excellent opportunities to seize market bottom plays by recapitalizing cash-starved owners or buying foreclosed assets.”

Respondents to the Emerging Trends cite the best investor bets for 2011 which include:

  • Temper expectations – Buy well-leased core assets and look for 6 to 7% cash flows.
  • Lock-in leverage – Mortgage rates can’t get much lower and cyclical bottom is the optimum time to leverage properties in order to magnify future value gains as property fundamentals ameliorate.
  • Provide debt and recap equity – Players who fill the gap on assets with lowered cost bases can obtain excellent risk-adjusted returns up and down the capital stack, including mezzanine debt and preferred equity, if not loan to own opportunities.
  • Focus on global gateways, 24-hour markets – Everybody wants to be in the primary coastal cities with international airport hubs.
  • Favor infill over fringe – The ‘move back in’ trend gains force as twenty-something Echo Boomers want to experience more vibrant urban areas and aging Baby Boomer parents look for greater convenience in downscaled lifestyles.
  • Patience is a virtue – Transaction activity will increase and more value add and distressed deals will appear.
  • Buy or hold REIT – Survey respondents expect solid cash flowing returns.
  • Buy land – It won’t get any cheaper than now, but prepare to wait for the right development opportunity.
  • Exercise caution on distressed loan pools – They could be a recipe for disaster if you don’t underwrite the assets properly.

Markets to Watch

Survey participants believe the 24-hour cities will always dominate and outshine secondary markets.  This year, the top Emerging Trends markets selected by survey respondents offer no surprises – Washington D.C. pulls away from the pack, followed by San Francisco, Boston and Seattle, as the pre-eminent gateway cities.  Houston and Denver solidify rankings and respondents show faith in South California’s resiliency, despite recent setbacks.  While ratings improved for markets from coast to coast over 2010’s results, the gap between top and bottom continues to widen, and more than 60 percent of surveyed cities still fall below “fair” ratings for commercial and multifamily investment prospects.

A snapshot of the top five markets ranked by survey respondents:

Washington D.C. Never far from the top, the nation’s capital will hold onto its top ranking as long as the economy labors. The federal government never downsizes while lobbyists and consultants swarm legislators and agencies hoping to influence or stop regulatory changes.  All the activity cushions property markets and attracts investors and no market benefits more from core buyers’ recent flight to quality, driving prices back up.

New York. TARP and Fed funds directed at banks helped financial markets and eased job cuts, triggering the biggest ratings jump for New York.  As major financial employers enjoy record profits, ramp hiring and foreign investors remaining active, lenders are loosening purse strings for trophy office owners.  Apartment rents rebound along with coop/condo prices, which registered only minor drops in top neighborhoods, and retailers begin to fill in gaps in empty streetscape storefronts.  New hotel completions could temper a recovery in occupancies and room rates, but tourists and business travelers are back in droves.

San Francisco. The country’s most volatile 24-hour market, the City by the Bay now offers investors excellent near-market bottom buying opportunities, particularly in apartments and hotels (ET survey #1 buy), office (ET #2), and retail (ET #3).  The market also sidesteps some of its state’s fiscal mess, performing better than Southern California.  Tech and life science industries flourish around top flight universities (Stanford, UC Berkeley), help attract brainpower, and sustain expensive regional living standards.

Austin. A smaller Texas market that scores highest ratings and survey participants note “everyone wants to live in Austin.”  As the state capital and home to a major university (hook ’em, Horns), Austin is one of the few cities in the Sunbelt with growth restrictions.

Boston. This venerable 24-hour city registers high marks for livability, controlled development, and a highly educated labor force, but lacks economic vibrancy.  Office rents didn’t drop precipitously off pre-crash 2007 highs, but remain well below 2000 peaks, and local brokers predict only a slight turnaround in 2011. Apartment rents will track back up as expensive for sale housing keeps tenant demand high for multifamily units, and hotels show life.

Rounding out the top ten markets to watch:

  • Seattle gets a boost from in-migration to the area adding 160,000 new residents since the recession.
  • San Jose aligns with San Francisco gateway benefits, including a flourishing tech and life sciences industry.
  • Houston is expected to come out stronger from the recession than most states, creating more real estate demand.
  • Los Angeles remains an attractive location with Southern California serving as the most important gateway to the Pacific Rim and Latin America.
  • San Diego tracks closely to Los Angeles with its desirable climate albeit the gateway status.

Among property sectors, the survey finds that apartments outrank all other sectors—favorable demographics and the housing bust should increase renter demand and some interviewees forecast rent spikes by 2012 in some infill markets where development activity has ground to a halt.  Readily available financing from Fannie Mae and Freddie Mac bolsters buying activity.  Core players also like warehouses and infill grocery anchored retail, while full service center city hotels remain the top choice for opportunity investors.  Suburban office gets the cold shoulder in the survey.

Now in its 32nd year, Emerging Trends is the oldest, most highly regarded annual industry outlook for the real estate and land use industry and includes interviews and survey responses from more than 1000 leading real estate experts, including investors, developers, property company representatives, lenders, brokers and consultants.

A copy of Emerging Trends in Real Estate® 2011 is available at www.uli.org/emergingtrends or www.pwc.com/us/realestate.

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