Forecast '13: Slow Growth Expected

Winter 2012
Development ‘12 attendees enjoy networking and opportunities to discuss current challenges facing the commercial real estate industry during receptions following educational sessions.

The Presidential election, the national deficit and the fiscal cliff were looming issues on the minds of speakers and attendees at NAIOP’s recent Development ‘12 conference in Washington, D.C. Nevertheless, several speakers focused on the state of commercial real estate, assuring attendees that fundamentals are improving, financing is plentiful and forward-thinking investors and owners are finding value-add opportunities in non-gateway markets.

A Case for Changing CMBS

Keynote speaker at the Chairman’s Session at Development ‘12, Ethan Penner, chief investment officer of Home Investment Partners, told conference attendees that the resurgence of the CMBS market in the last 18 months will continue, but cautioned, “It is entirely dependent on a structure that doesn’t make much sense.” Penner was referring to the “dirty little secret of the industry” — the concentration of risk among B-piece holders to protect senior bondholders — needs to change.

“There are no more than a half-dozen buyers of that kind of risk,” he said. Assuming CMBS volume of $40 to $50 billion in 2013, “There will be four or five money managers trying to find OPM [other people’s money] to buy that risk. I’m not bullish on the long-term potential of that proposition,” remarked Penner.

Why not? He said that a quoted yield of 18 percent, assuming no defaults, is “probably the wrong assumption,” explaining that “Loans are 10 years long. You’re getting six or seven percent on a current basis. For 120 months, if loans don’t repay, or there is a default or losses, six or seven can turn to negative pretty quickly. That capital is not something you want to count on for the long haul.”

He also explained that 10-year, non-amortized loans and balloon payments are another structural flaw of CMBS because it puts undue pressure on the industry. Penner would rather see fully amortized loans.

the adaptive reuse panel at the Development 12 conference

The “Adaptive Reuse:  Office to Multifamily” panel discusses the reconstruction process including economic savings and green design techniques.

Penner went on to observe that real estate shouldn’t be considered a high-yield asset class, noting “Return expectations have begun to shift and that’s good for the industry. Only in the last couple of years have we started to see some reconciliation with reality — that will lead to less disappointment.”

Penner expects that rates will stay low for a long time and bemoaned the fact that “inefficiencies no longer exist” in commercial real estate. Asked what his company is focused on now, Penner explained that the residential sector is similar to commercial real estate in 1990 to 1992, characterized by inefficiencies and dislocations that translate into long-term opportunities.

Knight Kiplinger, editor-in-chief and president of Kiplinger Financial Media Company, remarked, “It’s no mean feat for the largest economy in the world to chug along at three percent a year. That’s a solid, doable growth rate.” What would improve that rate? “There’s no silver bullet, but selling to faster growing nations is the trump card. The United States has to be more export-oriented, keep innovating in technology and rein in labor costs.”

As for commercial real estate, Kiplinger expects continued improvement in 2013, with rents and absorption increasing during the year. Regarding new supply, he forecast a modest increase in 2013, followed by increased construction in 2014 and 2015. He also expects that interest rates will remain as they are through 2013, rising after that time, resulting in a flattening of pricing. Kiplinger noted that reduced demand for office space due to job sharing, hoteling and teleworking is an ominous trend developers must be aware of. However, Kiplinger noted, “Compared to other asset classes, real estate continues to be very attractive for foreign investors.”

Value-Add Opportunities Outside the Major Markets

Numerous speakers outlined examples of how secondary markets, excess corporate properties and repositioning older properties represent excellent value-add opportunities. For example, two years ago, Campanelli Companies, a full-service commercial real estate development and construction firm, formed a joint venture with Dallas-based TriGate Capital, an opportunity fund, to identify value-add investment opportunities in the New England region. The venture has acquired eight properties from a portfolio in receivership, as well as one from Analog Devices, totaling more than 500 million square feet.

Office Building of the Future panel at the Development 12 conference

The four winners of the inaugural Office Building of the Future design competition presented their concept plans and designs for achieving operational efficiencies, while meeting the needs of the workforce of the future.

Dan DeMarco, a partner at Campanelli, said that the partnership gives the company increased flexibility and speed in decision making and completing transactions.

Campanelli Companies and TriGate Capital acquired 30 Perwal Street, roughly 100,000 square feet of office/flex/R&D space in Westwood, Mass., in September 2010 for $3.8 million. The single-story, 40-year-old building is located in the Boston suburbs, close to Route 128. The property was totally vacant at closing, but within two months, a net long-term lease had been executed by Steward Health Care. Renovations were completed in May 2011. DeMarco noted that the levered current cash return is 55 percent and Campanelli’s percentage of total deal equity is four percent.

Erik Kolar, president and CEO of Patriot Equities, reported that the company has acquired 20 million square feet from corporate tenants in secondary markets, for adaptive reuse. Patriot owns and operates a variety of corporate real estate property types, including office, industrial, retail and mixed-use space, as well as raw land, throughout the United States.

Recently, Patriot recapitalized seven assets, totaling 625,000 square feet, in three locations. “Patriot did the deals with their own capital, arranged discounted payoffs to existing lenders and extended tenant leases,” noted Kolar. “We solve problems for the corporation and create more energetic and productive workplaces,” he said. In many cases, single-tenant properties are transformed into multi-tenant facilities. The company has also transformed older manufacturing facilities into modern, multi-tenant warehouse and distribution centers.

Andrew Moss, director of leasing and acquisitions for Forsgate Industrial Partners, noted, “We like bad buildings in good locations.” Moss cited several examples of older industrial properties in northern New Jersey that the company acquired, substantially renovated and leased, achieving handsome returns. One building Forsgate redeveloped in South Hackensack with 34-foot ceilings, 20 tailgates and ESFR sprinklers was leased for 15 years to ABC Carpet in May 2002. “The property is generating an 18 percent return on investment, much better than if it were built new,” said Moss.

Marc DeLuca, director of Clarion Partners, detailed the repositioning of the McPherson Building in Washington, D.C. The 12-story, 185,000-square-foot office building was built in 1988. Facing vacancies in 2007, Clarion proposed a $9 million renovation to its sovereign wealth client. The renovation involved the exterior facade, exterior entrance canopy, main building lobby, typical floor common areas, elevator cabs and lobbies, bathrooms and management office, as well as a new fitness center. Post-renovation, the first lease was executed by Apple.

attendees networking the the Development '12 conference

Networking events at Development ‘12 provide attendees with time to engage in conversation on a variety of topics and catch up with their busy colleagues.

“Steve Jobs wanted something nice, but not over-presumptuous,” DeLuca remarked. Two major tenants renewed leases that were expiring. The company is targeting rents of $38 to $45 per square foot full service. Recently, Clarion received an offer of $945 per square foot for the building.

What’s the difference in office pricing between the Central Business District (CBD) and the suburbs? Ashley Powell, former managing director, acquisitions, RREEF Real Estate, compared two office properties in Seattle, one in the suburbs and the other in the CBD. The CBD building attracted twice as many tours and offers as the suburban property, and a cap rate of 5.4 versus 6.5 percent in the suburbs.

State of the Capital Markets

Development ‘12 attendees took heart from Robert White, Jr., founder and president of Real Capital Analytics, relative to investment sales. While the third quarter of 2012 was flat for industrial and retail product types, office sector volumes posted an increase in September. White also noted that private investors are re-entering the market and sales in suburban markets have been accelerating.

Who’s buying? “Institutions still have deep pockets, and REITs are incredibly well capitalized,” said White. Buyers from Canada, South America, Europe and Asia are also abundant. “We’re just seeing the tip of the iceberg with China,” he noted, referring to high net worth individuals eager to buy United States real estate who are not investing in gateway markets. “The private buyer — the local owner/operator — has also made a comeback,” commented White.

According to White, cap rates are in the low five percent range for Class A office buildings in Manhattan; higher at about 6.25 percent in secondary markets such as Seattle, Denver and Houston; and an additional 100 to 200 basis points higher in tertiary markets like Montgomery, Ala.
Speakers participating in the capital markets session agreed that secondary markets with technology, education and medical centers, as well as ports, are faring better than those without these attributes. “Houston is doing very well, Phoenix is starting to rebound, but Atlanta is still out of favor,” said White.

Mark Gibson, executive managing director of HFF, LP, reported that in 2011, commercial real estate sales amounted to $230 billion. The company predicts sales of $250 to $300 billion in 2012, not unlike 2004 and 2005. As for CMBS volume, HFF is predicting $40 billion in 2012, a “great sign for all of us,” he said. Banks are “re-equitized,” he added, pointing out that their assets are at all-time highs, with low loan-to-asset ratios. Most banks have worked through their real estate problems, although European banks are in a different position. Moreover, there has been a resurgence in non-recourse and recourse lending, and loan terms of seven years. “Pricing, not capital, is the issue,” said Gibson. “If you are buying today at a cap rate of five, what is the future going to look like? We’ve never seen this, so pricing is interesting. For every rise in interest rates of 100 basis points, net operating income has to increase by 15 percent to stay even,” he noted.

Outside the Box Industrial Strength panel at the Development 12 conference

In the concurrent session, “Outside the Box:  Industrial Strength Challenges in the 21st Century,” panelists address the impact of e-commerce, supply chain optimization, transportation infrastructure and more in committing to an industrial location as a user, investor or developer.

Got a Lemon? Make Multifamily

Speaking at a session on adaptive reuse, Mitch Bonanno, senior vice president, development, Vornado/Charles E. Smith, described an adaptive reuse project in the Crystal City submarket of Arlington, Va., where an existing empty office building was converted to multifamily.

Bonanno said that Crystal City was developed by the Charles E. Smith Company starting in the 1960s. About 10 years ago, Vornado purchased Smith’s commercial assets while Archstone bought the residential properties. In total, there are 12 million square feet of office space, 5,000 residential units and approximately 5,000 hotel rooms.

Vornado experienced a number of challenges on the office side, one of which included the departure of the U.S. Patent and Trademark Office (PTO). “We actually had several buildings vacated by PTO, totaling about two million square feet,” said Bonanno.

Vornado converted the building to multifamily and modified the streets around the Crystal City project to make them more pedestrian friendly.

Regarding the decision to change uses, Bonanno commented, “The first test is financial. If there is an office building that can be re-leased at a reasonable rent, it will work better financially to retain the structure for office use than rework it as a residential building. Vornado had a fair amount of vacancy and some other buildings that lent themselves to renovation as office buildings, but the former PTO property lent itself better to multifamily.”

What Do Corporate Tenants Want In New Space?

Developing Leader Award winners

Chairman Bill Hunt and NAIOP president and CEO Thomas J. Bisacquino with the 2012 Developing Leader Award winners.

A panel of corporate space users was asked what they contemplate when leasing new space. Joseph Burke, senior director, facilities management and real estate services, Endo Health Solutions Inc., explained that the firm looks for new space within 20 to 25 miles of its current location so as not to negatively impact its current employee base. “When attracting and retaining new employees in the pharmaceutical industry, look within other pharmaceutical companies,” said Burke. “It is important for Endo to locate within an area where we can readily do that.”

Joe Probst, director, global office management, Hess Corporation, said the firm wants space near peer companies, vendors and consultants. Another key factor is to be in a LEED building and located near mass transit. Today, Hess is in one of the only LEED Platinum buildings in Houston. “As an energy company, being energy conscious is extremely important to us,” noted Probst.

Brian Johannes, facilities director, MedAssets, said that having all employees under one roof, in an open floor plan for interaction and collaboration, was critical. “In a building with walls and offices, you typically don’t run into people for a chance meeting.”

Sessions from Development ‘12 are available for instant download through NAIOP’s E-Library. Questions? Call (800) 666-6780.

Editor’s note: More industry insights from Development ‘12 can be found in the On Business and Under Development columns of this issue.