Real Estate Market Overview 2009

The Condensed Version: Serious dislocation has resulted in the following challenges:

1. A huge capital gap has been created (most debt has vanished, and all the available equity is not enough to fill the hole).
2. No one expects surviving financial institutions to ramp up lending once they finally stop their own mammoth balance sheet bleeding (even with gargantuan government bailouts).
3. Persistent risk aversion and new regulation could limit debt capital flows for the foreseeable future, muting transaction activity.
4. Many owners needing to roll over mortgages in the coming years can expect to face substantial refinancing hurdles, including higher lending rates, more stringent underwriting, increased equity requirements, and recourse terms.
5. The aftershocks of rampant “over-the-top lending” that batter the entire credit system leave property markets substantially overleveraged and vulnerable to significant depreciation.
a. Real estate value losses will average 15 to 20 percent off mid-2007 peaks, and could be more severe for lesser-quality commercial properties in secondary and tertiary locations.
b. For 2009, U.S. commercial real estate faces its worst year since the wrenching 1991–1992 industry depression:
i. Values will drop substantially
ii. Foreclosures and delinquency rates will increase sharply
iii. The limping economy will likely crimp property cash flows
iv. Lower growth going forward
6. In 2009, expected total real estate private equity investment returns will likely register in negative territory for the first time in nearly two decades.
7. In a classic flight to quality, those interviewed continue to favor familiar coastal global pathway cities as investment outlooks grow bleak—ratings uniformly decline for almost all markets.
8. Only apartments show some enduring strength—increasing numbers of young adults and people pushed out of the housing market keep rent rolls relatively healthy.
9. Always favored, industrial properties may weaken in the consumer downturn—fewer goods are shipped and distributed.
10. Businesses stop expanding or downsize, hurting office.
11. Hotels suffer as business and tourist travel is cut back in the recessionary environment.
12. Retail really hits the skids — cash-strapped Americans struggle with credit card debt, the mortgage mess, and gloomy employment environment.
13. Already savaged, homebuilders see little hope for improvement until mortgage markets come back and the job picture brightens—not in 2009.

Current prognostication: Expect financial and property markets to hit bottom in 2009 and flounder well into 2010.

Los Angeles Summary: Holding up the best in housing-ravaged southern California, L.A. benefits from a well-diversified economy and dense infill environment with higher barriers to entry than in nearby suburban markets like Orange County and the Inland Empire. An office building wave could weaken the market into 2010 after a falloff in demand—the financial services crash hurts prime west Los Angeles in particular. Downtown continues to benefit from condominium and apartment projects, which help nurture a more 24-hour environment amid hulking office towers, but Pasadena, Glendale, and west L.A. commercial centers still retain an upper hand closer to premier family-friendly executive neighborhoods. Driving to downtown gets more challenging every year and gas prices increase commuting angst. Overall, multifamily has legs: “It’s almost
impossible to lose money on apartment investments, if you have a five- to ten-year investment horizon.” Hotels benefit from the city’s global pathway location. But housing woes devastate homebuilders in previously high-flying San Bernardino and Riverside, where foreclosures spiral and home values drop like rocks. The once white-hot Inland Empire industrial market
cools temporarily—as nationwide consumer contraction hits warehouse demand near the nation’s largest port, L.A./Long Beach. “Bigbox warehouse developers pushed too far,” “building to the horizon.” Upscale Orange County—“ground zero for the mortgage collapse”—gets nailed by its exposure to home lenders, some of which go belly up. Absorbing shadow office
space “could take three to four years.” The O.C. housing picture looks even worse—prices dive. Weak household credit dampens shopping center outlooks throughout southern California.

DETAILED BREAKDOWN
1. Capital Deficiencies: For 2009, the multibillion-dollar questions become: When will money return to the suddenly strangled real estate markets, and who will be investing and at what levels? As markets deleverage and correct, the length and severity of the repricing process will influence the resumption and intensity of capital flows.

Markets went from inundated in capital to drastically undersupplied, especially for precious debt:
2. Credit Gridlock: The nation’s economic prospects and credit markets remained completely gridlocked with no signs of imminent recovery.
Most wish that financial institutions would “take their inevitable writedowns and clear the market,” but understand that the potential severity of losses in a sudden reaccounting could undermine more companies and crater confidence in a suddenly fragile banking system. Instead, lenders grasp for government handouts and buy time—letting buyers quietly cherry-pick
nonperforming loans and making allowances to many borrowers.

Not surprisingly in light of the credit cataclysm, it appears certain that capital availability for both debt and equity will be constrained in 2009 and investment will be “rather muted.” (See Exhibit 2-3.) In fact, overall capital availability ratings (on a one-to-nine scale) are the lowest in the survey’s history. Only opportunity funds and mezzanine lenders will have more
money to invest than in 2008, according to the surveys. Significantly, expectations sink for financing from commercial banks and CMBS. Many previously active private syndicates and tax exchange buyers without leverage leave the scene.
3. Transactions:
(A) Risk Adversion: Some wonder how they ever embraced the alluring notion that secular change in the capital markets had eliminated most cyclical investment risk. In hindsight, “there was never any structural change, just a temporary surge of capital into the markets.”
(B) Muted Transaction Activity: There is a vast bid-ask chasm separating buyers and sellers. 2008 deal volumes are 20 percent of those of 2007, and 2009 may not be much better. “It’s a terrible time for transaction people” after “some incredible years.” Most agree that sellers will blink first—“they need to get reality.” Underwater owners will almost certainly cave toward buyer expectations, hoping enough dollars come off the sidelines to buffer pricing in bidding for
distressed assets. Unlike in recent years, cash buyers will have the advantage—leveraged buyers and financial engineers “are gone.”
4. Refinancing Issues – Buy, Hold, or Sell:
(A) Significant Depreciation: “As long as you can sit with what you have you’ll be fine.” Taking all the bad news in stride, most real estate players, including homeowners, should uncomfortably ride out the storm. Owners who locked in debt on a long-term basis or shied away from heavy leverage—like pension funds and real estate investment trusts (REITs) — should have the staying power and cash flows to cover obligations to lenders and stomach paper losses.
For private equity real estate owners, “It’s too late to sell.” In fact, Emerging Trends surveys register the lowest sell signal in the report’s 30-year history (see Exhibit 1-1). Survey buy ratings continue to rebound off 2006 lows (when players should have retreated) as investors hopefully expect seller capitulation to meet their increased yield expectations. Many real estate owners just focus on holding on through the “rough sledding,” comprehending that
transactions are beside the point until the market takes its bitter medicine and suffers pain. “The best bet at this point is to ride out the cycle.”
5. Value Depreciation
(A) Cap Rates Readjusting: An interviewee consensus calculates that cap rates need to increase about 150 to 200 basis points on average from their recent lows to more normal 7.5 to 8.5 percent territory depending on property sector, market, and asset quality. That translates into a possible 15 to 20 percent value haircut. Trophy, 24-hour city properties should have less exposure—with their cap rates rising 50 to 75 basis points—while B and C product could
see increases of 200 to 300 points. Inflation and rising interest rates pose additional downside risk. Through 2008, Fed policy makers continued to keep interest rates well below historic norms to stave off economic turmoil despite energy cost–driven inflation and blame on low rates for creating baleful asset bubbles. Over the longer term, interest rates should rise, putting more upward pressure on cap rates.
(B) Buyers and Sellers can’t agree: “Sellers want prices available a year ago, while buyers want prices anticipated a year from now.” While lenders dithered and sidestepped marking down their convoluted portfolios, appraisers and private equity fund managers also avoided taking significant writedowns through most of 2008 despite the handwriting on the wall. They
pointed to the lack of meaningful transactions to gauge value declines and the yawning gap between buyers’ and sellers’ expectations, reminiscent of the housing markets circa 2006. Various opportunity funds have raised “a ton” of money—rumored at upwards of $300 billion—but managers don’t want to start acquiring anything before the market has finished sliding, and some commitments may not stick after the downturn. The dearth of transactions, however,
stymies devaluations. Owners won’t sell at “liquidation prices” if not forced, and lenders haven’t pushed troubled borrowers for fear of exacerbating recognition of their own problems. This circle will likely only be broken when banks and special servicers ramp up foreclosures. From the trickle of transactions, interviewees suggest that pricing levels had declined at least 10 percent off 2007 highs by midyear 2008.
(C) Limping Economy: Optimists had been hoping for offsets from rising property net operating incomes to help counter depreciation from rising cap rates. But the lackluster economy compromises their projections. Instead of rents rising or at least holding steady, owners resign themselves to a deteriorating leasing environment where concessions and tenant inducements proliferate. Higher energy costs and inflationary pressures ramp up operating costs, shrinking
bottom lines further. Total returns cannot escape negative territory—the depth and severity of the recession will determine the extent of losses. This downturn “looks like a long doubleheader,” bemoans an interviewee. “The first game is the credit crisis and we’re only in the middle innings. And now we have another game to play and that’s the poor economy.” “Every day that goes by without economic improvement increases the risk for real estate.”
(D) Lower Growth: Without as much leverage in the market, any pricing increases over time will be more “moderate.”
“The impact of lower debt levels and more expensive debt is lower growth assumptions.” Underwriting will be based on 12-month trailing cash flows, not dreamy forward projections. “
6. Private Equity Model: Opportunity funds need to reorient their formulas and expectations—returns and promotes won’t be as high without a boost from debt. Money will be made on riding markets back to recovery and releasing properties, not on cap rate compression and financing structures.
• Cash and low-leverage buyers will be king;
• Surviving banks will impose strict lending guidelines, requiring more recourse and equity;
• Left-for-dead commercial mortgage–backed securities (CMBS) markets will revive, but in a more regulated form;
• Opportunity funds will need new investment models that can’t rely on massive leverage and cap rate compression to boost returns and promotes.
7. Global Pathway: The favored 24-hour coastal cities—D.C., San Francisco, New York, L.A., Boston, and Seattle—will hold value better and bounce back more quickly. Core players and offshore investors gravitate to these elite business and cultural centers linked directly to Asia and Europe commercial capitals. Hot-growth Texas markets—Houston and Dallas—show temporary strength as long as oil prices stay high.
8. Buy or Hold Multifamily: Apartment investments get a boost from a host of significant trends: increasing numbers of young adults who leave their parents’ homes, more aging baby boomers looking to downsize from suburban lifestyles, and stiffer mortgage costs/requirements that make homeownership too expensive for some prospective buyers. Increasing renter demand helps blunt ongoing recessionary impacts and ensures solid cash flow increases when the economy improves.
9. Buy or Hold Industrial: Despite near-term softness in availability rates, coastal gateways and primary international airport hubs will consolidate their positions as prime warehouse markets operating along global pathways. Watch for distressed owners and pick off bargains in top markets.
10. Hold Office: Long-term leases can bridge the downturn.
11. Hold Hotels: Occupancies decline and room rates suffer—it’s no time to sell.
12. Pray for Retail: Mall owners hope consumers haven’t collectively shopped till they dropped. Neighborhood centers with stronger grocery anchors and chain drugstores should fare best: people still need to eat and purchase more Advil for all their headaches.
13. Buy Residential Building Lots: The market collapse mauls homebuilders—increasingly, they capitulate and give up inventoried land tracts in bankruptcies and foreclosures. Prices are cents on the dollar from market peaks. But investors must be prepared to hold for a while.
Purchase Distressed Condos: At the right prices, these projects can be transformed into profitable rentals. Properties in urban areas near transit hubs make the best bets. Once markets recover, units can be converted back for sales.
Dire Effect of Jobs Market: The dreary jobs picture stirs particular apprehension about the country’s ability to bounce back from its current slump. Although overall U.S. employment had been healthy from 2002 to 2007, job creation and wage growth trailed other economic expansions. High-paying manufacturing jobs continued to migrate overseas, replaced
by lower-wage/lesser-benefit service sector “discount store” jobs. At the margins, many white-collar companies steadily transferred more “knowledge-based” work overseas to lower-cost markets thanks to telecommunications and Internet technologies. While high-tech jobs have rebounded off 2001 lows, the important financial services industry “is a train wreck” and its prodigious Wall Street bonus machine in shambles. To make matters worse, the government sector will scale back in 2009, as state and local agencies face severe declines in tax revenues. Slashed budgets translate into reduced government hiring and layoffs as well as reductions in contracts to private firms and funding for nonprofits. For the short term, rising unemployment and additional consumer distress appear unavoidable. Interviewees, meanwhile, continue to
scratch their heads about new job growth engines; most mention energy, health care, and education. Initiatives to recast the country’s increasingly obsolete infrastructure (roads, rails, transit, airports, electric grid, water/sewage systems) as well as securing greater energy independence through new technologies may key an eventual resurgence. But such programs have no chance to gain immediate traction, given various political, business, and financing roadblocks — certainly not in time to help in 2009.
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