My two cents… and a very long post - Posted by ray@lcorn
Posted by ray@lcorn on March 25, 2010 at 16:40:28:
Mike,
As Mark (SDCA) noted below, the much-hyped “crash” in Commercial Real Estate (ComRE) is more like letting the air out of a balloon through a very small valve. Current activity indicates that the worst may actually be behind us.
Here?s the short version:
Transaction volume for >$5mm assets was down 90% in 2009 from 2008. It fell so close to zero that any activity at all would produce an impressive percentage increase and still not be anywhere near normal, but volume has picked up considerably in recent months.
Valuations for healthy assets are down about 20% from the peak, and 40%-65% for distressed assets, and seem to have found a plateau if not quite a perceived bottom. The wild card is rampant uncertainty in the capital markets about the short- and long-term economic outlook. Think health insurance reform, uncertain tax policy, financial regulatory reform, energy costs, and gov’t deficits.
As an aside, there is an old-school sales axiom that says, ?a confused mind says no?. The current political climate has paralyzed not only the capital markets, but made decisions by the private sector regarding what investments to make, defer or cancel, and which jobs to create, maintain or eliminate virtually impossible to evaluate. For that reason I am not optimistic we will see anything close to a strong rebound in 2010. The elections may or may not settle things down, and the best case is for some clarity in 2011.
Back to real estate… and the looong version:
The increase in transaction volume is due to several factors. The negative economic conditions have persisted for so long (27 months and counting) that over-leveraged owners can’t hold property off the market any longer. So listing activity has picked up and sales activity will follow as the bid/ask spread narrows between buyers and sellers.
The good news is that supply is firmly in check. Unlike past recessions, changes to banking regs have prevented a flood of foreclosures so the damage to valuations is contained to the most egregious cases, mostly among the mega-deals that have collapsed from the weight of debt.
Contrary to the hype, there is not a roaring market in bank-owned short sales in ComRE. The FDIC and Fed continue to tweak the regulatory guidelines to avoid a wholesale write-down of ComRE bank loan portfolios. In all but the worst cases banks can now look at a three- to five-year time horizon to deal with problem credits without increasing reserves (a critical point), as opposed to the former requirements for anticipatory loan loss reserves and immediate liquidation of REO’s. As long as the property is producing some income the bank is able to avoid foreclosing, and hence has little incentive for a short sale, unlike residential assets which produce no income and decline in value the longer they are vacant.
That is an enormous relief valve to avoid the glut of supply that led to the total meltdown of ComRE in the late eighties and early nineties. The market has responded in kind. The benchmark for all commercial real estate (ComRE) assets are credit-tenant NNN lease (CTL) deals, which are now trading around 7.75%-8%, roughly about 175-225 basis points (bp) above the 2007 peak of 6% (as low as 5% on the west coast).
Everything else is valued at roughly a 150-300 bp spread above CTLs, which puts average assets at 9%-10% asking cap rates, 12% and higher for those with some “hair” on them (industry parlance for assets with short leases, high vacancy, heavy deferred maintenance, etc.).
It’s no coincidence that this valuation paradigm reflects an almost perfect “reversion to the mean” of valuation over the last twenty years. It also returns the focus of valuation to cash flow vs. appreciation. This is the fundamental attraction of ComRE in the first place, which was lost in the go-go years. I am personally glad to see it because I ran out of stuff to sell, and have waited a very long time to buy at values that make money.
Capital is available, but selective. Community banks are aggressively chasing market share they lost to Wall Street investment banks in the boom years. Underwriting is generally tight, but there is a lot of capital these banks need to put to work, and as the market regains momentum the terms are already easing. I?ve gotten a couple of very attractive quotes from banks in recent weeks in the range of 4.75% fixed rate, 20-year am, three-year reset, with limited recourse.
The major headwind holding back activity in ComRE is the lack of securitized financing, known as commercial mortgage backed securities (CMBS). There hasn’t been a multi-payer CMBS issue since July 2008, after a peak of $307b in 2007. This is important because CMBS is the major take-out finance vehicle that provides non-recourse financing to the investor, and allows the bank credit used for development and turnarounds to be recycled into new deals.
Recently there have been nascent stirrings of new CMBS issues. But the recent activity is only for the top end of the market (>$10mm) and with very conservative LTV’s of about 65%. Restoration of CMBS is the key to recovery in ComRE transaction volume, and forms the foundational footings for stable valuations. I talk to a number of capital sources on a regular basis. No one I’ve spoken with expects a return to normalcy in CMBS for at least another year.
This problem is also the key to opportunity. I?m using strategies that utilize blended or mix-and-match structures to get deals done. These include bank financing (see the ?white-knight? discussions here on the newsgroup), private lending and equity, equity-participation vs. straight seller financing, note purchases, JV’s, master leases, etc.
This is not an environment when any one technique is the magic bullet (if there ever was one). It’s an era where each deal must be structured to address unique characteristics of local market conditions, property condition, and seller motivation/needs to create an investment plan with multiple exit strategies that make sense.
In short, it’s a dealmaker’s nirvana, but you need a multitude of tools in your box.
No one property type is a ticket to success either. It’s all about your market. In his post below Mark warns against retail and office product, and in his market that is wise advice.
In my market in SW Virginia, retail tenant activity is also dead as a doornail (true in most markets nationwide) but office properties are doing quite well in certain sectors. Multi-family is suffering from lack of pricing power in rents and high vacancies, even (most surprisingly) in student housing. Single-family numbers here are abysmal… way too much supply, tight mortgage conditions, and a dearth of buyers due to employment issues. Even the ugly-house buyers and lease-option sellers have quit running ads.
Your market may have some of these attributes, or not. It takes research to find out. If you don?t know how to research your market, learn it before you do anything else. Above all don’t make such decisions based on hunches or what a broker or seller tells you.
Are we about to have a Depression? I hope not, but it is certainly within the realm of possibility if you consider no resolution of the uncertainties noted above. My strategy is to take a defensive posture, which translates into structuring deals for worst-case scenarios, a topic I have written extensively about over the last several years.
My own forecast assumes an extended period of low-growth, high-taxation, high energy costs and weak demand. But believe it or not, within those parameters are islands of prosperity. A few examples:
Three sectors of the economy that are experiencing above trend growth are adjunct health care services, legal/accounting services, and government agencies. We?ve targeted those sectors in several ways to fill office space and spur downtown redevelopment projects. Sale-leasebacks are very popular again. This is not as complicated as it may sound and used to be the bread and butter of the business. Office/warehouse properties that house service contractors are another sweet spot of demand.
There is also an opportunity to indirectly benefit from the growth of government in dealing with non-profits as tenants. A lot of the stimulus money that is yet to be deployed will be funneled through these organizations, and there are ancillary benefits to dealing with them; e.g. exemptions from property taxes (in some states, check yours) for the portion of the property leased to a registered 501(c)(3); state and federal subsidies and improvement grants; connections to sister agencies; like-kind tax credits and deductions; etc., and more to come. (The Senate bill passed last week contains the bulk of the tax breaks for this year but I haven?t read it yet. I?ve often said that our tax code is like a theme park that updates the rides each year, and from what I hear this one has some doozies.)
Hope this isn’t an overwhelming amount of information. I can’t give you a specific review on the programs you mentioned because I have not personally reviewed them. My own library has literally hundreds of books, courses and manuals on real estate and finance. I?ve gotten something from almost all of them.
As a shameless plug, I?ll offer my own book, ?Dealmaker?s Guide to Commercial Real Estate? for your consideration. I did my best to incorporate my 25 years of experience through five previous recessions (and three booms). The book is structured to take you from the very first deal to advanced deal structures and finance techniques. Included are a variety of tools, strategies and structures that can be applied in every environment. As a bonus you will also receive a copy of my 2010 Commercial Real Estate Forecast, a 50-page report with lots of pretty charts and graphs (and some ugly ones), with even more detail than offered above about my outlook. It?s available here on CRE Online, and you’ll find it is attractively priced for a comprehensive practice manual on the subject. The direct link is:
http://www.creonline.com/Ray-Alcorn/order-now.html
Best of dealmaking,
Ray
p.s. You can find reviews and comments from readers of the course by searching the archives here on the newsgroup (button at top of page) with the search term ?DealMakers Guide? (no quotes needed)