Real estate fundamentals may still be shaky. We may be bumping along the bottom for some time, but panelists and attendees at NAIOP’s recent Development ’10 conference in Orlando were buoyed by renewed leasing and sales activity in some markets. Attendees also noted a clear improvement in the availability of capital – even if that capital is veering mainly to what the pros call "trophy or trauma."
Consensus at the conference: Don’t expect to see new development starting again until at least three years from now, or to see rents increased by the double-digits over current levels, any time soon. Don’t expect to get 20 percent returns on acquisitions of distressed properties. Do expect to see investors and lenders continuing to look (often in vain) for high-quality, well-located and well-leased properties, and then expanding their risk horizons to get a higher yield. Do expect to see more troubled properties come on the market in 2011, but don’t expect a flood of distressed sales.
Developing Leaders Jaime Northam and Erica-Nicole Harris enjoy networking.
Mark Vitner, senior economist with Wells Fargo, in presenting the keynote address on the economic outlook for 2011 at the conference, outlined three possible scenarios for 2011: a 30 percent risk of a double-dip recession; a 60 percent probability that we continue to grow the way we have been doing; and a 10 percent chance that we could grow more rapidly. Vitner’s prediction: 2 to 2.5 percent GDP growth in 2011 and three percent in 2012. He believes that unemployment will increase to 9.8 percent and rise into early next year, mainly because re-entrants and new entrants into the workforce will account for a larger share of the unemployed. He warned conference attendees that "there will be talk of a double-dip recession in the next several months. Don’t let it scare you into doing things you shouldn’t do."
More than half of the three percent GDP growth from mid 2009 to mid 2010 was from some kind of government stimulus, he noted. The rest came from rebuilding of inventory, and factory output has begun to slow. Vitner also observed that "core inflation is running at or slightly below the lower bound of the Fed’s comfort zone. But deflation is not going to happen like it did in the Great Depression. The Fed is going to be proactive.
Education session participants listen closely to various panel discussions on the state of the office, industrial and capital markets.
"A lot of the downside has already been taken out," he continued, "and there has been improvement in things not counted in the GDP. Corporate profits are up and balance sheets have improved. We are in a position to expand when risk/ reward is favorable."
In the office sector, leasing activity has picked up because there is a business sense that the window to upgrade space is drawing to a close.
How the Office Market Is Faring
"There has been a big change in the last 10 months," said Michael McDonald, managing director, Eastdil Secured and moderator of the session on the current state of the office market. Equity and debt capital returned, although "it’s a barbell market," he said, referring to investors’ preference for "trophy or trauma." McDonald noted that this will continue in 2011 and there are three to four times as many lenders active in the market today versus a year ago. He expects that total investment sales this year should be comparable to 2003 ($75 billion) and in 2011, comparable to 2004 ($133 billion). He expects that low debt cost will drive cap rates down further on well-leased deals. While there may not be much capital available for, say, a suburban office that is 75 to 80 percent leased, there will start to be transactions in this category by Spring 2011, he predicted.
McDonald reported that what has also changed is how deals are evaluated. Although in-place NOI is still key, investors are also looking at pro forma rents one year out as well as considering a "normalized" NOI, not just in-place; and some investors are assuming rent spikes for 2013 to 2015. Pension funds, which were looking for reasons not to buy in 2009, have changed their view. For core assets, he said, "there is no bid-ask spread."
Mark Vitner, senior economist, Wells Fargo, gives a cautiously optimistic view of the economy noting, "Commercial real estate has improved in every sector with multi-family leading the pack."
James Ingram, executive vice president and chief investment officer of Parkway Properties, a REIT that is also working on behalf of the Teacher Retirement System of Texas, said, "We’ve been trying to put $750 million to work for two years. Fortunately, we were not successful in our offers in 2008.
We have made 15 to 20 offers this year; the market is bouncing along the bottom."
For Michael Harrison, senior vice president of Hines Interests LP, managing office properties today requires "Going back to the basics and blocking and tackling, and working with existing tenants to keep them satisfied and renewing their leases. We’re trading occupancies over rates," he remarked.
The dearth of core properties for sale in "gateway" markets has prompted an expansion of investors’ geographic targets. Ingram noted that Parkway is active in the Southeast, Southwest and Chicago. Besides Washington, D.C., they would like to get into Austin and Raleigh. "We’re chasing population and job growth," he said.
Harrison said that having been priced out of Washington, D.C. and New York City, he is looking at opportunities in Durham, Tampa, Orlando, Boca Raton and Ft. Lauderdale. "The product spectrum is broader, too," he said, including office flex and some industrial in addition to office.
CEO Insight sessions, educational panels and keynote speakers gave Development ’10 attendees much to contemplate.
Regarding the impact of loan maturities next year, Nick Pappas, managing director of Eastdil Secured, said that "it’s not the catastrophe we thought it would be." McDonald expects that servicers and balance sheet lenders will not be afraid to take properties back in 2011. They are better staffed and better equipped to deal with troubled properties.
Industrial: Where Would You Build a Distribution Center?
If you could only build one distribution center (DC) to serve the entire company, where would you build it? That was one of many topics addressed at a Development ’10 session on office and industrial space. On the panel were Craig Robinson, president/corporate services, Cassidy Turley Commercial Real Estate Services; Douglas J. Swain, senior director, real estate solutions, Exel Supply Chain; Thomas H. Walker, PE, managing principal, Thomas H. Walker Consultants LLC; and Sarah P. Bagby, domestic real estate leader, Genworth Financial Inc.
The best location obviously depends on a lot of factors like supply chain, industry and inbound and outbound factors. According to the panel, the optimum one-distribution network would be around Anderson, Kentucky, just south of Evansville, Indiana. That is the population center of the country.
Larry Pobuda, 2010 Chairman (left), passes the gavel to 2011 Chairman Alex Klatskin.
For better coverage, you might want a two-distribution-center network. In that case, they would be in southern California and Ashland. Since there is not a lot of real estate in Ashland, you might move that facility to Cincinnati, Columbus or Indianapolis.
Typically, a consumer goods company that is national in scope wants a five-DC network. To optimize such a network, it would need facilities in southern California, Dallas, Georgia (around Atlanta), Chicago and New Jersey.
The logistics business is dynamic and constantly changing, especially given the sputtering growth of the economy. According to a panel on logistics at Development ’10 in Orlando, which included Curtis Spencer, president, IMS Worldwide Inc.; Vance Bennett, director of port development, CSX Real Property Inc.; and Kevin D. Burwell, director, Virginia Port Authority, here are some key trends to watch:
- Location, location, location …"Near my customers/stores" is still driving the DC location decision.
- Balance will be created between West Coast to East Coast and impacted by slow steaming, all-in costs and wide rate swings.
- The Bayonne Bridge (Bayonne, New Jersey) issue will be resolved, so expect serious turf battles between the ports of New York, New Jersey and Norfolk.
- Savannah will lead the Southeast Atlantic because Jacksonville will be delayed in dredging and Charleston has limited rail outbound.
- A new alignment of Gulf ports, with rail services inland could shift market share; Gulf ports could compete with East Coast and West Coast ports.
- Shippers are very sensitive to labor issues on the West Coast.
- The Panama Canal will have an impact; West Coast rail carriers will respond to retain market share.
- Central Ohio continues to be a positive, growth region for the "one DC" site, but Harrisburg- Eastern PA is competing for the title.
- Rail intermodal terminals remain sites that present opportunities.
- While watching intermodal trends, keep an eye on railcar logistics developments.
Small Window for Distressed Investments
At the industrial panel at Development ’10, moderator Christopher Riley, vice chairman, CB Richard Ellis, asked his audience how many had purchased properties in 2009. A few people raised their hands. His panelists, on the other hand, including Robert L. Chagares, president and chief investment officer, High Street Equity Advisors; Lewis D. Friedland, founder and managing partner, Cobalt Capital Partners; and Jeffery E. Kelter, chief executive officer and chairman, KTR Capital Partners, had all purchased properties in 2009.
The Capital Connection event at Development ’10 provided the opportunity to interact with investors, REITs, fund managers, banks and other lending institutions during a special roundtable session.
What surprised the panel when each member entered the market in 2009 was how quickly the window closed on the best deals, as major players pushed back into the market. "We stayed in the market and started looking at deals," said Chagares. "Around the middle of 2009 we bid on a Chicago portfolio that we liked. The cap rate was in the 9.5 percent range. It was grade A real estate, well located and leased with the average lease term of seven to eight years. We did not get that deal because a number of people were bidding for it. There was another deal on the market about a month later by the same group that had a cap rate of 9.2 percent. We figured that with all of the distress out there these deals should be around 10 percent. That wasn’t happening. So on that basis we went in and made our first deal in October of 2009."
Said Friedland; "2009 was really such an unusual market. At first, there were only a few competitors looking at these projects, so we made some good deals. The thing that shocked us was how short that window of opportunity for distressed properties really was. It was probably a six-month to nine-month opportunity before capital started flowing in."
When is the distress going to show up? That was one of the questions posed by Al Pontius, senior vice president and managing director of Marcus & Millichap, at a session on "Distressed Real Estate: Examining the Current and Future Impact of the Distressed Asset Market on the Industry." Pontius noted that in Las Vegas, nearly 40 percent of what’s selling there could be categorized as distressed.
Mark Myers, executive vice president of Wells Fargo, pointed out that banks represent 50 percent of the distressed marketplace; and that the top 25 banks hold 50 percent of bank assets. He believes the "cleansing process" will take a couple of years.
"Our problems have peaked," he said. "Small banks are probably in the ‘hope and pray’ stage." He also said that Wells Fargo can extend and modify loans if the borrower has the "willingness and ability to continue with the asset. That’s the preferred route." This might involve a quality asset in a quality market that is not leased well.
Jason Hull, managing director and head of commercial real estate for Trigild, a nationwide receivership and management company, said the firm took on nine properties totaling 3.1 million square feet in one week’s time. The firm has doubled its staff in the last two years and manages a mix of A and B assets. As to where the industry is in the cycle, he said "it changes from month to month, as to property types. But I’d say we’re in the second or third inning and we have a lot farther to go."
Thomas Dwyer, managing director, special servicing, CWCapital Asset Management LLC, said that the firm has $20 billion in special servicing now versus $2 billion two years ago, with a half-billion dollars coming into special servicing every month. "We expect to see a leveling off in 2011," he said, adding that 2012 is of concern because of five-year loans done in 2007 coming due. He said this firm does not manage a lot of core assets, although it does have some Class A office properties; these were ’07 deals that were overleveraged.
Moderator Jim Carpenter leads a panel on investing in the current cycle. From left: Jim Carpenter, Lewis Friedland, Elizabeth Propp and Darcy Stacom.
Myers said "What’s unique is the amount of liquidity in the market. We didn’t see that last time around and it’s pretty close to collateral value. Concurring with other speakers’ assessment of the "trophy or trauma" investment picture, he said that "lenders are more knowledgeable about their assets; but investors need to bring yield expectations inside of where they’ve been. They shouldn’t come with a 20 percent yield expectation."
Changing Investor Appetites
Jim Carpenter, senior director of Cushman & Wakefield in Illinois, who moderated the session "Equity Investing in the Current Real Estate Cycle," said that there has been a notable uptick for B product in good markets or good product in secondary markets. He said, "if you buy an office at a five cap, there’s only way to go and that’s south. So more investors are looking at value-add properties."
Investors’ appetites vary according to their goals. Asian investors, for example, need to double their equity after a 10-year hold, said Darcy Stacom, vice chair of CB Richard Ellis. REITs want the best quality product and they want to "lock it away forever," she said. In a recent transaction, Teachers bought a vacant building for half of replacement cost because "they need value-added return," she said. Pension funds look at cash-on-cash and total returns.
Elizabeth Propp, managing director of JP Morgan Asset Management, said that "We’re mostly core. Pricing on a yield basis is pretty close to where it was at the peak."
Panelists agreed that opportunity funds seeking 20 percent returns are being unrealistic. Stacom said, "They shouldn’t expect more than 13 to 15 on a leveraged basis."
Regarding the issue of overleveraged properties being resolved, Stacom said she expects that in 2011, "assets will really hit the wall," adding that "we’re seeing a ton of people looking to recapitalize existing properties."
Looking for New Opportunities
If distressed properties aren’t your cup of tea and you don’t want to sit idle waiting for office demand to pick up with job growth, NAIOP offered several sessions on the topic of where to find other avenues, such as working with the Federal government; student housing; and healthcare. At a session on "Exploring New Markets," Kent Carlson, executive vice president, Ryan Companies U.S., Inc., explained how the firm has expanded over the past five years into a variety of new markets, including senior housing, hospitality and the renewable energy sector. However, as experienced as the Ryan people were in their core businesses, they lacked technical expertise in the three areas it sought to go into including fuels/ gasification, wind construction and solar construction. "In each of these cases, we did not have the core skills we needed so we formed partnerships. For fuels, we formed a partnership with Corval; for wind, Carstensen Contracting, Inc.; and for solar, Hunt Electric."
Editor’s note: More news and industry insights from Development ’10 can be found in the Inside Finance, On Business and Under Development columns in this issue.
Fourteen sessions from Development ’10 are available for purchase and instant download through NAIOP’s E-Library. Questions? Call (800) 666-6780.