Which Way Out? INDUSTRY EXPERTS LOOK AHEAD

[ By Ellen Rand ]

Did the rapidity and depth of the nation’s economic crisis take you by surprise? How about the subsequent and severe chill in leasing, financing and sales in most markets? If the answer is yes, you’re not alone. Some of the best researchers and analysts in the business also found themselves shocked by the dismal course of events. In brief, a typical observation was, “we knew it would be bad, but….”

What surprised the researchers most? The scale of the financial crisis and the way the entire economic system is so interwoven that what started as a problem in the realm of residential subprime mortgages spread quickly and devastatingly to the rest of the economy. If there is a saving grace in this downturn, they agreed, it is the lack of overbuilding that haunted the industry in the early ‘90s. They also agreed that the office sector will fare more poorly than industrial.

If real estate’s mantra has classically been “location, location, location,” the watchword now is “employment, employment, employment.” The discouraging loss of a whopping 3.6 million jobs since the recession began – many of them in office-using sectors – and the prospect of additional job losses in 2009 suggest that the return of demand for space is far down the road. There is no consensus as to just how far that might be; forecasts range from grim to grimmer. On the investment sales side, researchers agree that the direction of valuations (diminishing) and cap rates (rising) will continue, but again, there is no consensus as to how long the uncertainty and turbulence in the market will last. The most optimistic forecast calls for a possible increase in GDP growth in the second half of 2009, with modest job growth in 2010, but the risk, some say, is that we will have a jobless recovery.

There’s no big secret to how the researchers do their jobs, no odd and quirky indices they follow (such as the cost of a slice of pizza versus subway fares, or the direction of hemlines versus the economy). Employment statistics (including temporary employment versus actual employment) and regional in- and out-migration are paramount. Other sources of information include:

• the Institute for Supply Management’s manufacturing index and the Baltic Dry Index, for manufacturing and distribution trends;
• shipping volumes (i.e., FedEx, because as companies become cautious one of the first things they think about is ground vs. air delivery); and
• consumer spending trends, including car sales.

The researchers also stressed that owners and developers should not rely solely on advice and research on macro trends in employment, consumer spending and finance; they must be equally knowledgeable about their own individual markets. Among their recommendations: read local business journals, including the want ads, to find out what companies are hiring or laying off workers. Watch buildings under construction to see if they are leasing up or not. Look at what might be in the construction pipeline two years out. Every market has its own story about supply/demand, rent rate trends, differences in Class A and Class B rents, as well as dominant businesses. For opportunities, keep an eye on the life sciences sector, medical office buildings and warehouse development around inland port areas.

During the early days of the recession, some markets (such as Houston and the Great Plains states) fared better than other markets that had experienced prior dramatic upswings in rental and sales rates, but as Robert Bach, national director for market analysis at Grubb & Ellis, pointed out, “Now there’s not really any area that will escape.”

He expects that the year-end 2009 vacancy rate nationally will peak at about 17 percent. For him, the financial crisis is not simply a matter of lack of confidence. He observed that “the global repricing of risk that’s going on is not in people’s imaginations. Real losses are happening and there is more pain to follow.” After January job loss figures were announced, Bach remarked, “We’re not at the bottom yet; I’m afraid it will be a long, slow and halting recovery.” However, he believes that “we’ll get through this; 2009 will be the most difficult year in terms of recession and an unstable credit market.” He also offered a bit of perspective: “Things are never as bleak or as good as they seem.”

Navigating in Uncharted Waters

Hessam Nadji, managing director, research services for Marcus & Millichap, expects higher vacancies across all property types this year, with retail being the worst hit sector, followed by office (with sublease space expected to rise dramatically), then industrial. Apartments will fare best but are not immune to job losses, especially now that the rate of monthly job cuts has reached extreme levels.

“Things have changed very quickly after the credit crunch turned into a global financial crisis in September 2008. Prior to that, job cuts had been below trend and commercial real estate, which the exception of retail, had shown resilience, he said. Nadji believes that the scale of the downturn could have been curtailed if there had been a systematic approach to dealing with toxic assets from the beginning instead of the one-off attempts. But he acknowledged that “the scale of the financial crisis was much bigger than we expected. The subprime risk, as an isolated issue, was a $450 billion problem but it rippled through the entire system because of the magnitude of financial instruments and over-speculation which created a snowball effect.”

Still, with an unprecedented amount of government stimuli at work -- $750 billion to $1 trillion in the new package aimed at long-term job creation – in addition to the tremendous levels of liquidity already pumped into the system at work, he said it is only a matter of time before there is a ripple effect throughout the economy. A beneficial outcome may be noticeable by late 2009 or early 2010.

Nadji noted that mathematical and logical methods of forecasting are difficult to do now. For example, over a three-month period at the end of 2008, he revisited forecasts weekly including how he thought about property types and geographic areas. “We’ve been revisiting and revising the numbers since August. I don’t imagine we can go back to quarterly in 2009 because conditions are still volatile.”

Nadji is advising a property-by-property review and strategy for owners to determine the best strategy by asset. “If a property doesn’t fit into a long-term portfolio or investment strategy and should be sold, the sooner it is marketed the better given the pressure on pricing,” he noted. For those who choose to sell assets, he advised being realistic about pricing in this environment. For long-term holders, he advised working to retain tenants, shoring up cash flow and doing all that is possible to get through the downturn. Opportunistic investors will have buying opportunities, but timing will be the challenge for them. “Buyers miss out because they’re waiting for massive discounting and in this cycle a clear and central vehicle such as the RTC in the early 1990s may not materialize in the same fashion. In the meantime, as prices adjust, there are buying opportunities now,” he said. Nadji remarked that two-thirds of the potential risks referred to in the company’s forecast for 2008 came to pass, which showed that “the unlikely becomes likely. For 2009, the risk of more shocks is still there and we’re still not out of the woods in unwinding the over-leveraging of the market that went on in 2005, 2006 and the first half of 2007. Amid a serious recession, it is common to think the bottom will never come and recovery is years off. However, one significant positive factor is that most property sectors were not over-built going into the downturn. Once the economy starts expanding, even with moderate job growth expected to start in 2010, commercial real estate will start to see a correction soon after. Apartments and industrial will lead the recovery as office and retail trail.” Researchers see their role as educators for their colleagues and clients who are trying to make sense of the market. Among Nadji’s responsibilities, for example, is running a monthly research webcast for clients; an indication of their hunger for information and perspective is that the webcast now draws 1,500 people.

Michael Knott of Green Street Advisors, an independent research firm that analyzes and sells stocks of REITs and other publicly-traded real estate companies, was among the more bearish. He stated that “this is turning into a white collar recession unlike any we’ve seen and I think the impact on office landlords will be quite severe. And that’s before considering the diminution in values in conjunction with many highly levered owners. Therefore, the industry needs a volunteer to put a creative hat on and come up with a catchy phrase like ‘stay alive till 95’ that was used in the last real downturn in real estate values. The trouble is, not much rhymes with 2013!

“The other nebulous factor in underwriting real estate today is: how should one think about the risk of residual values?” he continued. “With the Fed firing up the dollar printing presses to inflate away liabilities, the prospect of material inflation five to seven years from now seems high. So does that mean that the ‘right’ exit cap rate to use in an honest underwriting of real estate today is far higher than most are using? That could well be the case. But in that context, real estate would still likely prove to be a better inflation hedge than many asset classes.

“The uncertainty of the stimulus package and overhaul of the banking rescue program adds a significant challenge to deciphering what lies ahead of commercial real estate. Will the primary lending market be fixed, like the commercial paper market seems to have been fixed? Will the government backstop the CMBS market? These are all big issues.”

Jon Southard, principal and director of forecasting for Torto Wheaton Research, owned by CB Richard Ellis, pointed out that forecasting in this economic climate is difficult because so much seems to be governed by fear in the marketplace.

“It’s the opposite of irrational exuberance,” he said. “There’s a clear difference in property types, but no one completely escapes what is a deep downturn.” He went on to comment that “there is such a tangled web in the financial world. Who would have thought the college loan business would be affected by housing?”

At the time of Development’s interview with him, Southard pointed out that the office sector had not yet experienced negative absorption; that was still to come. For the office sector to return to robustness, “we’re clearly talking years.” A more optimistic case can be made for industrial, on the other hand, because of increased openness to internationalism and an inevitable increase in shipments here and overseas

One irony in the current climate, Southard said, is that for many existing properties there will be income increases for tenants that signed leases from 2002 and 2004, resulting in a case of higher revenues but lower values. Regardless, Southard believes that 2009 will be more challenging than 2008.

Maria Sicola, executive managing director, research, for Cushman & Wakefield, observed that “for there to be a glimmer of turnaround, layoffs have to cease and the housing market has to stabilize.” Once we see an easing of credit, the appetite for real estate investment will return, as capital is on the sidelines, waiting, she said. Like some of her industry colleagues, she said, “we’ve been revising forecasts at least monthly.”

Sicola echoed other economists and researchers in their assessment that financial services and ancillary services will take the hardest hit into ’09, while petroleum products markets have been buoyant but slowing down. “Every market will be affected in some way before this is over,” she said, but some markets have inherent strengths. Boston and San Francisco, for example have many technology businesses as well as financial services as part of their tenant base. Seattle and Los Angeles may also be somewhat insulated, much as Washington, DC, had been insulated during the last downturn. “Maryland and Virginia will come through this better than others,” she predicted.

She believes that secondary and tertiary markets can be affected if they have one or two major employers; but unless an event occurs with one of them, these markets should not see wide swings in absorption or rents.

Sicola expects that there will be rental declines for a year or two. As a lagging indicator, real estate “hasn’t taken the hit yet,” she said, noting that the company’s five year forecast calls for no big rental increases or spikes. What might drive demand, when it returns? In Washington, DC, that would include government – as well as the impact of government spending for infrastructure, according to Sicola. She also included industries that will support the baby boomers, such as healthcare, pharmaceuticals, life sciences, education and other elements of technology.

Looking back at the credit crunch, the recession and the commercial real estate downturn, Sicola said, “We saw this coming; we know that the business operates in cycles. We should have been more prepared. But the depth of it and how interwoven everything is, that’s what we didn’t see. That was the insidiousness of it.”

Quantifying the Trouble
One indication of the reach and function of real estate research is a new “Troubled Assets Radar” tool developed by Real Capital Analytics, which tracks mortgages and properties that are troubled or likely to be. Recently it showed at least $107 billion worth of income-producing property — including hotels, offices, apartment complexes and warehouses — in distress or headed in that direction.

Robert M. White Jr., president of Real Capital Analytics, noted “the trouble that’s emerged is bigger than most of us expected and the size of the problem that is potentially out there is much greater than we thought we would be able to quantify at this point.”

Securitized loans make up just under one-third of the company’s database, which also includes condominium construction loans, bank loans that were not securitized and debt issued by insurance companies and mezzanine lenders. White said that more than 1,000 properties are clearly in trouble and owners of about 200 properties have surrendered the keys to their lenders. Another $21.2 billion worth of buildings are categorized as troubled if foreclosure proceedings have been started, the property owner has received a notice of default, a receiver has been appointed, and/or the landlord or sole tenant has filed for bankruptcy protection. Another 3,700 properties, valued at $80.9 billion, were on the brink of distress, according to White. This includes $26 billion worth of buildings with loans maturing next year.

In addition to New York, other areas with a large inventory of troubled properties include Los Angeles ($11 billion), Las Vegas ($6.6 billion) and southern Florida ($4.2 billion). White expects values to decline by 25 to 30 percent when owners who have been holding out are actually forced to sell. “People need to go into this with their eyes wide open,” he remarked. “Too many of us, me included, were too optimistic during the first part of ’08. I don’t want to be burned again. Unfortunately, these numbers are, if anything, conservative.”