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’08 Prognosis: ‘There Will Be Transactions’…
The investment sales climate is “in a state of confusion,” in the words of Al Pontius, senior vice president and managing director of Marcus & Millichap’s National Office and Industrial Properties Group. And no one really knows if valuations are going to soften further as 2008 progresses. In general, buyers are “a little more aggressive than is reasonable or realistic” and many sellers feel that there’s no rush to sell right now. While these conditions prevail, he said, “we’re in choppy waters.” So it’s no surprise that transaction volume is down considerably from the last two years. At press time, Marcus & Millichap had recorded a drop of 35 to 40 percent in the volume of transactions above $5 million between summer 2007 and the fourth quarter of the year — and a drop of 50 percent between fourth quarter 2006 and fourth quarter 2007. Pontius remarked that “The competitive climate is not what it was” in mid-2007. Nevertheless, Pontius said, deals are coming together, and they’re not “fire sales.” Rather, they involve sellers trying to achieve specific goals and buyers who recognize there is no wholesale drop in value.
Transactions that have changed the most since mid-‘07, he pointed out, would be the 70 percent occupied buildings that had looked like nothing but upside potential. Vacancy had value if properties weren’t encumbered by a lower rent rate. Lenders provided 10-year, interest-only, 85 percent loan-to-value (LTV) financing. By contrast, according to Pontius, “now the lender values what’s in place today and underwrites the loan on an amortized basis, so the net effect is 50 percent LTV. That’s a dramatic change in leveraged rate of return potential. Vacancy may not be looked at as a value.”
Cap rates on investment sales have changed since mid-2007 too, although not as dramatically as some may think. Depending on the market, remarked Pontius, cap rates may be higher by 15 points on the low end to 100 or more. For “reasonably good product in healthy markets there could be a 30 to 60 basis point spread versus white hot times. For Class A real estate, with solid credit tenants in primary markets like San Francisco, New York, Washington, DC, or Miami, there’s been little movement. For B-minus or C product in secondary markets, there’s a 100 basis point spread versus mid-2007, reflecting a significantly higher risk. You’re not going to attract tenants because of the property’s quality and there’s a thinner tenant pool.”
Taking the case of a hypothetical $20 million, 100,000-square-foot office building in a healthy market, Pontius said, “the mortgage rate would be a little bit higher than it would have been until mid-year ‘07. Beyond that, the deal might look very similar, especially for a stabilized asset. The buyer might be a high net worth investor whose equity matches up with the deal itself; that is, the investor would put in $8 million equity regardless of when the deal was done.” Pontius also commented, “I don’t believe we’re going to a higher yield environment.” On the other hand, these days the mood of the market can change quickly. And opportunities can be found, especially if supply/demand fundamentals are good in a particular market and properties’ leases signed between 2001 and 2003 are rolling over.
What is the key to navigating the current market’s “choppy waters”? Remember to keep your eye on the fundamentals, Pontius said, and your own investment or property goals and bear in mind that “it’s not cut and dried.”
For more information
Marcus & Millichap:
www.marcusmillichap.com
…But Not Until Sellers, Buyers Agree on Value
How quickly have the finance climate and the industry’s attendant mood shifted since fall 2007? One indication is the September 2007 “State of the Market” survey of several hundred real estate executives conducted by the law firm DLA Piper which revealed:
- 63 percent of respondents reported investment deals delayed or cancelled due to the credit crunch;
- 78 percent reported that loan underwriting standards had been tightened;
- nearly two-thirds reported that equity requirements had increased;
- more than 68 percent reported that spreads had increased;
- nearly half reported that lenders had modified loan terms prior to closings (mostly by raising spreads or reducing loan amounts); and
- 61 percent said it would take six to 12 months for real estate markets to stabilize from the effects of the credit crunch.
Those findings represented a dramatic shift since Spring 2007, but since September, “things have gone from bad to worse in so many ways,” said Jay Epstien, chairman of DLA Piper’s U.S. Real Estate Practice Group. Although a formal follow-up survey has not been conducted, Epstien reported that a shift in dialogue occurred in discussions with clients since the September survey. That is, rather than believing that the markets would stabilize by this fall at the latest, it was clear that most now believe that 2008 in general will be challenging.
“My own sense is people have moved to the sidelines,” commented Epstien. “There will be a lot of watching in the first quarter. The market is unsteady, but not crashing.” Referring to institutional investors, he noted, “There was uncertainty from the lack of credit for two to three months at the end of ‘07. But investors had already met their goals for ‘07. Now it’s a clean slate and they have to do transactions.”
One looming question remains: when is the right time to return to the market? No one wants to make that leap prematurely but, “the capital hasn’t disappeared; there’s plenty of equity,” Epstien said. For investors making the plunge at pricing “plus or minus five percent at the bottom of the trough, there’s a sense that you’ll do well. It will be driven to a large degree by sellers adjusting their expectations. Until they do, it’s hard to imagine how transactions get done.”
Complicating the picture, Epstien noted, is that until fairly recently, fundamentals were strong, with good job growth, rent growth and low vacancies. “So people bought buildings based on the belief that rents would continue to rise,” he said, adding that “rents may flatten for a while, but not drop.” Still, given the consolidation in the real estate industry in the last 10 years, there are fewer players and they’re very strong. Properties are not as highly leveraged as they were in the early ‘90s, although Epstien observed that “we have seen some mezzanine debt workouts already.”
Epstien believes that cap rates will continue to rise and that there will be a correction from the last few years, although he doubts that cap rates for trophy office properties will shift dramatically or materially. Will they drop below four percent? “That’s hard to imagine, when the cost of capital is so much higher.”
For more information
DLA Piper:
www.dlapiper.com
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Where Green Fits Into the Value Equation
As if the questions of ever-shifting values and market uncertainties were not confounding enough, another key ingredient is part of the ‘08 stew: What about financing for green buildings? Is it growing? Contracting? Is sustainable development a more persuasive story for investors and lenders?
According to a recent research paper on “The Greening of U.S. Investment Real Estate: Market Fundamentals, Prospects and Opportunities,” published by RREEF Research, among the factors limiting green building investment is the fact that “institutional interest in green buildings has been constrained by the lack of a comprehensive and transparent set of operating and transaction data and reference material that are standard for real estate products. The appraisal profession also has yet to conclusively determine how green features translate into asset value, as lenders have yet to agree on how green figures into underwriting criteria.”
Yet, the paper pointed out, “All available indications suggest that green investment is poised for tremendous near-term growth.” There are already more than a dozen funds dedicated to sustainable development, including Revival Fund Management, Thomas Properties/CalSTRS, JPMorgan Chase and Forward Progressive Real Estate, the first REIT focused on green development. Moreover, major financial institutions and corporations have committed to sustainable practices and green technology in their own facilities and are demanding the same from their vendors.
To address the kinds of issues outlined in the RREEF report, among others, the Green Building Finance Consortium (GBFC), a group of leading corporations, real estate companies and trade groups, focuses on independent research and analysis of investment in green buildings. GBFC’s mission is to enable the private real estate sector—corporations, investors, lenders, and developers—to appropriately recognize the value and risk of investment in green buildings. The GBFC has embarked on an ambitious agenda to develop the underwriting practices, tools and valuations methodologies required to assess, from a fiduciary perspective, investment or lending on green buildings.
An indication that green development is showing up more regularly on the financial community’s radar screens is that the Pension Real Estate Association joined the GBFC in mid-2007, according to Scott Muldavin, executive director of GBFC. To Muldavin, the rapid pace of change in the green arena is the overarching theme of 2008: investor change; user change; and regulatory change. “The world has changed,” noted Muldavin. “A year from now probably 10,000 [regulatory agencies] will have green regulations, versus 1,000 now.” Those requirements can be a combination of carrots and sticks, that is, mandates to achieve specific goals and incentives for developers to achieve them. Space users are focused on recruiting, retention and creating business value; many look to sustainable buildings to help meet those goals. They are interested in achieving lower energy costs and boosting health and productivity. Precisely how tenant demand and health/productivity issues affect risk and value in green buildings is being studied by the GBFC.
“The rate of change is so rapid, you need to watch trends carefully because you may not be as up to date as you need to be,” commented Muldavin. Developers and financial sources alike must understand that the hard costs of building green (perhaps one to two percent higher than conventional hard costs) are not the only considerations. For example, there’s also the cost of the process itself and finding and working with subcontractors conversant with green building principles and technologies.
“Two years ago, no one in the private world was convinced sustainability was something we should consider,” Muldavin said. Now, sustainability can be a competitive advantage in seeking financing, but that alone would not make up for fundamental problems in a property, he said. “In underwriting, it’s about relationships and the mortgage lenders’ confidence in the borrower.” Developers seeking financing on a proposed green building should focus on their established relationships, even if it requires education about sustainability, rather than seeking out green capital sources.
The business case for sustainability to provide profits has been made, noted Muldavin. But the real challenge comes with the specifics of a particular property. For a hypothetical 100,000-square-foot building in Phoenix, for example, “You have to understand the studies, and determine how those conditions apply to the particular property.” Are that market’s tenants focused on sustainability? What is the impact if 20 percent of tenants think it’s important?
Muldavin likened sustainability – which is not one single element but a collection of many features – to air conditioning and elevators when they were introduced into office buildings: considered an option for space users at first, they soon grew to become standard. As for the specialized green funds, he believes that it’s too early to judge their track record commenting, “they’re looking for the same things that regular equity looks for: strong developers and operators.”
For more information
Green Building Finance Consortium:
www.greenbuildingfc.com
By Ellen Rand, co-editor, Development magazine
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