What to Do, Now that the 'Reset' Button Has Been Hit?

Spring 2010

To Jim Costello, principal and director of Investment Strategy at CBRE Econometric Advisors (CBRE-EA), real estate is "always a good investment; it’s a matter of how you get into it." He made that assertion — answering a question about whether it makes sense to invest in office property in the face of declining rental rates — during a podcast based on the CBRE-EA paper, "The Upside of the Downturn: Opportunities in Commercial Property Investments."

The theme of the paper and podcast was "What Do I Buy and When?" His overarching conclusion: don’t sit on the sidelines waiting until cap rates rise to mid-‘90s levels, because for a number of reasons, they’re not going to.

Costello expects the apex of appraisal cap rates (which typically lag transaction cap rates) for office and industrial properties in 2011, and expects that they will stay near that peak for more than a year. At the same time, he expects that interest rates will remain comparatively low, aided by global capital imbalances, even as the U.S. economy swings toward recovery and ultimately, expansion. "The market expects low inflation moving forward," he said.

How far through the "correction" are we for office and industrial properties? Based on cap rates, the CBRE-EA estimate is that office is about 80 percent through the swing from trough to peak in cap rates, while industrial is more than 86 percent, retail more than 82 percent and multi-family, 75 percent.

One of the major differences between the current climate and the downturn of the early ‘90s is that in the early ‘90s, pain was confined largely to younger buildings; buildings six years and younger accounted for 40 percent of vacant space. So investors acquiring distressed assets were able to add dramatic value by leasing up these properties in a growing market.

What investors can "solve today, and thus generate wealth from today, is the dislocation in the real estate capital markets," Costello said. "This re-pricing is not only the biggest problem the market faces today; it also represents the greatest opportunity. Rather than focusing on half-empty assets, in the current environment investors will need to concentrate on solving the problems of undercapitalized owners."

Another difference between now and the mid-‘90s is that there is no Resolution Trust Corporation (RTC) in clearing the system of problem assets. The fact that there’s no RTC today will make the unwinding of difficult assets slower, he said, more like "peeling the Band-Aid a little bit at a time. So the clearing mechanism will be a slow, steady rollout into defaults and distressed sales." The good news in the face of a flood of debt capital maturing in the next couple of years is that thanks to re-pricing, significantly lower levels of debt will be required.

Costello expects that by 2013 the United States will be back to peak levels of employment, although he acknowledged that it will be "harsh to get to that level" in the meantime. For those seeking opportunities in distressed assets, Costello warned that "any distressed equity is only as good as the employment prospects that lie in the surrounding areas." Based on five-year employment projections and an analysis of the distressed assets reported by Real Capital Analytics, CBRE-EA sees these low-distress, high growth markets: San Antonio, Raleigh, Salt Lake City, Nashville, Charlotte, San Diego, Atlanta, Indianapolis, Houston, Seattle and Sacramento. High-distress, high growth markets include Austin, Tucson, Dallas-Ft. Worth, Fresno, Phoenix and Las Vegas.