Question Topic: Real Estate Outlook 2010. We are seeing a lot of negative press about the real estate market. What is your outlook for the economy and commercial real estate market for 2010?
Yes, indeed, the commercial real estate market is receiving significant attention in the popular press. While some might adhere to the adage that any coverage is better than no coverage, the industry is likely to feel singled out and may emerge as the latest "bad boy" looking for a bailout. Unfortunately, despited aggressive lobbying, neither Washington nor the American public are likely to be in much of a mood to help. While the current bailout programs offers some respite on the residential and commercial side (thanks to the inclusion of commercial mortgages in the TARP program), the problems the industry is facing are daunting. Indeed, they are so pervasive and signficant that I will addres them in another question. In this response, I will focus on three major components to my 2010 Real Estate Outlook. Briefly, my outlook can be characterized by two phrases: Submerging Trends and Remerging Trends. The "Submerging Trends" moniker refers to my position that many elements of the commercial real estate market in the US may find themselves under water, with current market values falling below mortgage values and longer-term investment values.
The "Remerging Trends" label refers to the fact that despite protests to the contrary, the impending crisis in commercial real estate is not "unprecedented." Indeed, real estate is a cyclical industry that has periodically shifted from good times to bad times. Granted, the speed and severity of this "correction" is unusual and will break modern records, but it is not without precedence and hence "lessons learned." Indeed, I was lured out of the academic community by Prudential Real Estate Investors in 1987 and then recruited to Equitable Real Estate in 1989 to help address the previous crisis and asuage the concerns of angry investors stuck in the queues of two of the largest open-end commingled real estate funds, Prudential Real Estate's Investment Separate Account (PRISA) and Prime Property Fund (PPF), respectively.
Rather than getting too deeply immersed in the debates surrounding the plight of the real estate market, this response will provide a high level summary of three key elements including: the economy, the capital markets, and the spatial markets. Illustration 1 provides a snapshot of my view on the overall economic outlook. Despite many concerns, the economy is starting to show some signs of life, although consumers have remained on the sideline. While there has been some improvement, there is additional downside risk associated with a combination of a slowing economy, tighter credit, a renewed interest in risk, and weakening fundamentals. The next several quarters will be both interesting and challenging times with some opportunities for those willing and able to take advantage of the market malaise and lack of access to capital, especially credit.
Illustration 1: Economic Outlook
With respect to institutional capital flows, a number of trends create downside risk for the commercial sector. First, capital flows will decline, both from domestic and international sources distracted by credit crises sweeping the globe. Second, investors will search for value and eschew risk, looking a simpler structures and products. Third, investors will be patient and wait for signs the market is bottoming out; they will be indecisive and slower to act, especially those lacking a firm understanding of real estate fundamentals. While this capital environment will create problems for many, it does offer some opportunities. In general, cash will be king, especially if it is mobilized and can act in a preemptive manner as sellers and holders panic or are forced to action. A good source of product for such investors will be “channel sourcing” or looking at Real Estate Owned (REO) acquired through foreclosures or voluntary conveyances, Tenancy-in-Commin (TICs) and highly leveraged buyers with limited ability to refinance who will begin to recognize their plight. There will also be opportunities in asset takeovers as investors lose confidence in current advisors who got them into high priced assets, as well as in portfolio acquisitions where large blocks of product --both direct and securitized-- will be on the market and looking for a quick exit. Finally, players with real estate expertise may be able to swap talent for assets, taking over troubled properties or getting stakes through sweat equity and promoted positions.
Illustration 2: Real Estate Capital Market Outlook
Looking at both the economic and capital markets, there are a number of danger signals for commercial real estate. For the first time in years, capital flows may actually decline as assets are re-priced and owners forced to come up with more equity at higher yields that are commensurate with the attendant risk. That said, there is a lot of off-shore and domestic capital sitting on the sidelines, with the potential to start making a move in the next 3-6 months. However, the debt side of the industry will be a different story, with no obvious source of CMBS replacement capital.
With respect to the spatial markets, the commercial property sector is facing significant stress as market fundamental scontinue to erode in the face of a weak economy and tempered demand. Development activity has fallen off although some projects in the pipeline continue to cloud the market.
The market is likely to experience more erosion in fundamentals, more declines in values, and significant increases in vacancy rates which will hit record levels in some markets. Thus, it looks like the future will be characterized as even more of a “tenant’s” market than currently exists. With that, developers are likely to be on vacation for a while and, when they return, may be facing new rules on credit that involve real equity and recourse.
Illustration 3: Real Estate Fundamentals
In looking at the snapshot of the spatial market --supply and demand for real estate-- the bottom line echoes that of the broader economy and capital markets. That is, there is some additional downside risk associated with a combination of a slowing economy, tighter credit, a renewed interest in risk, and weakening fundamentals. That situation should prevail over the near-intermediate term, with commercial real estate lagging the broader economic recovery which is well into 2009 at best. These will be interesting and challenging times with some opportunities for those willing and able to take advantage of the market malaise and lack of capital.
For back-up data and more detailed commentary, see my Annotated NAIOP Forum Presentation: We Ain't There Yet, and Their Ain't No Net. For a more Seattle-specific version of this discussion, see: Annotated WASCAR Presentation: To Walk, To Talk, or to Walk the Talk. Gool luck in navigating these troubled waters.