Virginia Investment Real Estate

Talking Points by Bob Bach

noreply@blogger.com (John Gentry) — Tue, 30 Nov 2010 21:41:00 +0000

Q3 Leasing Market

Absorption has turned positive for all major property types: apartments in 2010 Q1 (Reis), industrial and office in 2010 Q2 (G&E), retail in 2009 Q3 (CoStar). Apartment absorption has been brisk, but the recovery is going to be slow for the other three property types.
The construction pipeline is largely empty, and there are few new starts.
Vacancy has peaked for all property types and is coming down at a moderate-to-brisk pace for apartments, very slowly for industrial, office & retail. Quarter-end vacancies: Apartments @ 7.1%, a very sharp decline from 7.8% in Q2 signaling that the apartment recovery will be more robust than many thought during the depths of the Great Recession. Industrial @ 10.6%, down from 10.7% in Q2. After a surge of demand in Q2, the pace of recovery pulled back in Q3. Office @ 17.8%, down from 17.9% in Q2. Market has barely budged in past three quarters due to anemic pace of recovery in labor market. Retail @ 7.4%, down from 7.5% in Q2. This sector is recovering earlier than was expected 12 to 18 months ago. Unemployment is high (9.6% in Sept.), but 90% of labor force is still employed, and some pent-up demand is driving the market. Upper income households are spending again, too.
Asking rental rates have broadly stabilized, and some Class A properties in certain markets such as Manhattan and San Francisco have been reducing concessions packages.
The labor market has added 874,000 payroll jobs year-to-date through October and 1.1 million in the private sector. Credit is readily available through the capital markets for large companies, but small companies continue to have trouble accessing bank credit. Facility consolidations are still happening.
Biggest risk: The economy continues to struggle. A double-dip recession is unlikely, but the rate of growth is weak. The economy’s immune system is compromised, meaning that unforeseen events could reduce the already-low levels of confidence. There is not much energy in the leasing markets, and there could be stops and starts. For example, second quarter industrial absorption was strong, reflecting growth in manufacturing exports beginning in the second half of last year, but third quarter absorption was disappointing.

Q3 Investment Market

Sales transactions year-to-date through Q3 totaled $60.4 billion of apartment, industrial, office and retail properties valued at $5 million and up – 82% above the same period in 2009.
Transaction volume has picked up every quarter this year on a sequential and year-ago basis. Compared with a year ago, volume was up 49% in Q1, 85% in Q2 and 105% in Q3.
Transaction $ still low by historic standards with further increases expected.
Prices appear to have stabilized overall judging from Moody’s/REAL commercial property price index and the NCREIF database.
Investors are focused on the upper end of the quality spectrum – core properties in primary markets. This is evident in the average deal size of $21.3 million year-to-date versus $14.1 million during the same period in 2009. Although the dollar volume of transactions has risen by 82% this year, the number of transactions is up by just 20%.
Biggest risk: Unforeseen spike in interest rates or a double-dip recession.

Forecast

Expect the leasing market recovery to be slow and uneven until the labor market picks up. Job growth could be disappointing in 2011, perhaps in the range of 1.5 to 2.0 million – which would leave a remaining deficit of around 6 million and a year-end unemployment rate of around 8-8.5%.
Expect the investment market to continue gaining momentum in 2011 unless interest rates rise unexpectedly. Federal Reserve officials and many economists think this is unlikely because there is so much slack in the labor market, real estate, factory utilization, etc. But there is a small chance – perhaps 10% -- that investors could pull back from U.S. Treasuries due to their meager returns, weak dollar and huge increases in supply, which could cause a spike in inflation and interest rates.

Jammin’ at the ULI

noreply@blogger.com (John Gentry) — Tue, 26 Oct 2010 20:35:00 +0000

I never fail to pick up some interesting market intelligence at the Urban Land Institute conferences, but at the fall meeting last week, the pickings were slim. It wasn’t because of the roster of seminars and speakers, which is always first-rate. I think it’s because the commercial real estate investment market hasn’t changed much in the last six months. There is still a flood of capital chasing a very narrow slice of the market – core properties in primary, supply-constrained markets. And the leasing market hasn’t budged much, either. All property types are positioned at or just past the bottom of the market and are recovering at a very sluggish pace, except for apartments (see below). Having said that, I picked up some anecdotes that are worth sharing:

One of my colleagues who works in the research department of an institutional investor came into the conference worried that his company is overpaying for core properties. By the end of the session, he said he was more at ease. After all, it’s his job to worry about overpaying. Still, he didn’t sound all that convincing.

In order to win the bidding contest, core property investors have to keep going-out cap rates very low, maybe 50 basis points above going-in cap rates or even flat. With the potential for higher inflation and interest rates in the future, this has some investors talking about increasing the holding periods, which is the norm in Europe for core property investors. The buy-and-flip strategy is risky if interest rates spike. Properties financed with long-term, assumable mortgages will benefit.

As an aside, my colleague, Jeff Majewski, executive managing director of Grubb’s capital markets group, says that most commercial mortgages (agencies, life companies, etc.) are assumable subject to lender approval and a 1 percent assumption fee. If a borrower locks in a 10-year Freddie loan today at 4.5 percent with 80 percent leverage, it’s safe to assume that rates will be higher in two years. Thus, a below-market, assumable rate for the eight years remaining could add value to the property. The rub is that an 80 percent loan in 2010 may be 70 percent in 2012. The agencies and the life companies will top off the tank and provide second mortgages behind the first for qualified deals. That is not possible for CMBS-financed properties, however.

In the closing general session, Donald Kohn, the recently retired former vice chairman of the Federal Reserve Board of Governors, said he doesn’t think inflation will be a problem in the foreseeable future because there is so much excess capacity in the economy (the labor market, residential and commercial real estate, factories, etc.), and the recovery is expected to be painfully slow with full employment – a jobless rate of 5 to 6 percent – several years away. However, he acknowledged a small chance for a blow-up if investors decide to stop buying U.S. Treasuries, which could cause a sudden spike in interest rates and change the strategy for investors on a dime.

The best news I heard came from J. Allen Smith, CEO of Prudential Real Estate Investors, who said investors will tire of paying premiums for core properties and will gradually take on greater risk. He termed this “bidding fatigue” and thinks the transition to a greater appetite for risk will happen at an orderly pace. This suggests a measured return to normalcy in the commercial real estate investment market and, by extension, the broader financial markets.

The apartment market is firming at a faster pace than most analysts thought possible 18 to 24 months ago despite the loss of 8.3 million payroll jobs peak-to-trough and the huge shadow supply of rental housing – unsold condos and foreclosed homes being offered for lease. This is due to a combination of factors: stricter standards to obtain a mortgage; uncertainty on the part of prospective buyers over whether home prices have bottomed and a more skeptical attitude toward the long-term benefits of homeownership; and a slowly recovering labor market with 863,000 private-sector jobs added so far this year.

By Bob Bach

Investor Zeitgeist

noreply@blogger.com (John Gentry) — Tue, 26 Oct 2010 20:27:00 +0000

Grubb & Ellis recently conducted a survey of its commercial real estate investment clients to determine their views on the market.

The economic mood turned darker over the past 11 months. In a similar survey conducted last November, 38 percent of respondents expected “job growth strong enough to reduce the unemployment rate” to return in 2011 – the most popular answer. In the survey just concluded, 43 percent said this will be delayed until 2012.
We asked investors which type of “-flation” most concerned them. In the earlier survey, respondents were split evenly in their concern over inflation and deflation, each of which garnered 38 percent of the votes. In the recent survey, stagflation ran away with 53 percent of the responses followed by deflation with 30 percent and inflation a distant third with 17 percent. This reflects a fear that the U.S. could be slipping into a “lost decade,” the label applied to Japan’s economic malaise in the 1990s.
Two other questions tapped the vein of economic angst among investors. From a list of eight potential drags on the investment market, just under half of the respondents viewed a stalling recovery as the biggest threat. Government actions and tax reform scored a distant second. In another question related to the economy, 48 percent of respondents do not anticipate a double-dip recession, but 41 percent said the Great Recession “never really ended.” Thus investors are skeptical of the recent declaration by the National Bureau of Economic Research that the Great Recession ended in June 2009.
The interest rate outlook of the respondents is even more pessimistic than the forecasts from mainstream economists. Respondents say the yield on the 10-year Treasury will increase 50 basis points by the end of next year, which would put it around 3 percent – about 50 basis points below the outlook from economists. This is very low historically and emblematic of an agonizingly slow recovery.
In terms of investment volume, respondents say that 2004 is the new normal. Properties valued at $223 billion traded hands that year according to Real Capital Analytics. By comparison, the peak of the market in 2007 brought transactions valued at $507 billion while a decade-low $54 billion traded last year. Through the first eight months of this year, just under $55 billion-worth of properties have traded. Although year-to-date investment volume is up substantially from the same period last year, it remains well short of the new normal, i.e. a level of equilibrium between buyers and sellers.
The pessimistic tone of the economic responses coexists with signs of optimism for the investment market. Eighty-one percent of the respondents view themselves as net buyers in the next 12 months. While core properties attracted the most enthusiasm, value-add and opportunistic investment strategies were the second and third most popular responses, a clear sign that the intense competition for core assets is pushing investors to take more risk.
Slightly more than half of the respondents said that apartments are their top choice for a “safe, secure investment” in core property. Industrial was a distant second.
Who are the biggest competitors vying for properties? Respondents say that private equity and private and non-traded REITs have the cash and are driving the engine down the track.

Source: U.S. Bob Bach, Grubb & Ellis

Coincidence or Leading Indicator?

noreply@blogger.com (John Gentry) — Tue, 28 Sep 2010 19:40:00 +0000

My colleague Matt Wright, Grubb & Ellis’ client services manager in the Philadelphia region, notes that the spread between the U.S. CBD and suburban office vacancy rates tends to compress until late in expansion periods and widen during periods of contraction. This makes sense conceptually; it takes less time for developers to plan and deliver suburban projects, which are usually smaller and less complex than projects in the urban core. Thus, the earlier delivery cycle in the suburbs pushes vacancy higher after the initial pent-up demand has been met, while the later delivery of projects in central business districts keeps the lid on vacancies until late in the expansion cycle. The result: a widening CBD/suburban spread until late in the expansion cycle.

During both of the most recent downturns, the spread began to widen seven quarters prior to the sustained run-up in the overall vacancy rate. Not only was timing consistent, but the degree of relative change between the two variables was as well. When controlling for this seven-quarter lag, statistical analysis indicated a very high degree of correlation, with R values of .91 and .98 respectively. A value of 1 would suggest that the two variables had a perfect linear relationship meaning they move in the same direction and at the same pace all the time. The take away is that once the spread began to increase, seven quarters later the overall vacancy rate did too and at a very similar pace.

Is there a reverse-correlation during recovery cycles? Four quarters before the most recent market turnaround in 2004, the spread began to compress. Guess what happened four quarters ago: the spread began to compress. If this correlation is to remain intact, it means that the third-quarter vacancy rate would need to decline. Could this happen? Absorption was low but positive in the second quarter, ending a string of eight consecutive quarters in the red. This suggests that overall vacancy could be at the peak and ready to reverse direction.

To summarize, the CBD/suburban spread began to widen during the last two expansion cycles seven quarters before the overall vacancy rate began to increase. And the spread began to narrow four quarters before the overall vacancy rate began to fall at the beginning of the last recovery cycle – and could be about to do so again. We will be watching carefully to see if the overall vacancy rate falls in the current quarter, which would keep this relationship intact.

Source: Bob Bach.Grubb & Ellis

Was it worth it?

noreply@blogger.com (John Gentry) — Tue, 31 Aug 2010 19:33:00 +0000

Some economists thought the recent financial crisis and deep recession would settle the debate over Keynesian economics. Was John Maynard Keynes accurate in prescribing large-scale government spending to pull an economy out of recession – to fill the hole in private sector demand – or is that the same as throwing money out the window? A new study purports to answer this question utilizing the model developed by Moody’s Analytics. The study is published by Mark Zandi, chief economist, Moody’s Analytics, and Alan Blinder, professor of economics at Princeton University and former vice chairman of the Federal Reserve Board.

The most startling finding is that the labor market would have lost twice as many jobs – another 8½ million – without the stimulus package and the actions taken by the Federal Reserve to ease credit conditions. The unemployment rate would have peaked at 16.5 percent, and the underemployment rate, which includes those who have stopped looking and part-time workers who would prefer a full-time position, would have approached a staggering one-quarter of the labor force. That is unfathomable. Describing the package of measures, the authors assert that “… its effects on real GDP, jobs, and inflation are huge, and probably averted what could have been called Great Depression 2.0.” (Click here for the full study.)

Additional job losses of that magnitude would have hit the office market like a tidal wave. Assuming one-quarter of those jobs were in office-using sectors at 175 square feet per employee, losses of that magnitude would have pushed the vacancy rate from the current 18.0 percent (tied for the all-time high) to above 22 percent.

But did the government’s actions really save the day? Economics is not like a chemistry experiment where you can test alternative policies while holding everything else constant. The truth is that we will never know for sure what would have happened had the government done nothing.

NPR’s Planet Money had an interesting conversation on the efficacy of Keynesianism with Mark Zandi and Tyler Cowen, an economics professor at George Mason University, who took the opposite view. Professor Cowen asked, “… what happens when you pull the stimulus away? If you simply slide back to where you were, all you've done is postpone that process of adjustment. So I view it as a short-term fix that had some stabilizing properties but didn't really turn the economy around." Click here for the full story and access to the NPR podcast.

Was it worth it? Again, we will never know for sure. But given what it felt like after “Lehman Brothers weekend” in September 2008 and through the spring of 2009, I think the “stabilizing properties” mentioned by Professor Cowen were worth it even if you’re not ready to buy into the study by Zandi and Blinder. The risk of a Great Depression-like scenario where a spiral of falling confidence and trust takes the global financial system down to the roots was too big of a risk.

Last week I spoke to a Grubb & Ellis-sponsored conference of financial advisors who sell or are interested in the company’s non-traded REIT products – a pro-free-enterprise and limited-government group, I would say. I asked the 70+/- attendees whether they thought the government did the right thing. Much to my surprise, the vast majority raised their hands indicating that, yes, the government’s actions at the time were necessary.

This says nothing about whether we need additional stimulus. My hope is that the economy will muddle through without it.

Improved Corporate Earnings Prove Bad for Commercial Real Estate

noreply@blogger.com (John Gentry) — Tue, 03 Aug 2010 15:00:00 +0000

Quarterly corporate earnings are great, the Dow has clawed its way above 10,500, and gas is relatively cheap, so how could this be bad for commercial real estate (CRE)? It’s bad because none of these events have contributed to job growth or physical plant expansions.

CRE basically provides a roof over people, products and equipment. Because overall consumption has dropped precipitously in the last two years, our need for roofs is significantly lower than it was a few years ago.

While corporate America has been masterful in its ability to resize and adjust to consumption levels, what the economy needs is top-line revenue growth from corporate America. Harley Davidson Corporation reported a $71 million profit in the second quarter of 2010, while nearly simultaneously, they reported they will layoff an additional 1,500 employees by year-end. Although this appears to be incongruous, it has become a common practice among publicly traded companies. Profits attract investors which, in turn, drive stock prices higher. Unfortunately, higher stock prices don’t necessarily lead to job growth or facility expansion. Even more concerning is that corporate America has realized, through resizing, how top-heavy they had become.

Is Today’s Consumption Environment the New Normal?

Corporations have resized based on their forecasts for consumption in the coming months and years. So, too, has the consumer resized to adjust to lower income levels, fear of unemployment and a new psychology of frugality and resourcefulness. It’s no longer in vogue to “keep up with the Joneses.” Consumers are beginning to enjoy having cash on hand and not being beholden to credit card companies and banks. A new ideology of humbleness and fiscal responsibility seems to be taking hold among many consumers. Let’s face it—if a Mercedes didn’t make you appear successful, far fewer would be sold.

Will These Trends Last?

Some contend that our economy has been artificially manufactured for the past 20 years, with both the dot.com bubble and the securitizing bubble (packaging homes, CRE, student loans, automobiles, etc.) being mega-profit scams created by Wall Street and approved by the federal government. If, in fact, no new scams are created for a while, a new economy of less consumption and more resourcefulness may persist for the next several years, or at least until Wall Street can design a new debt-driven economic engine that can fuel more consumption.

So, What Does the Future Hold for CRE?

Several macro dynamic changes could adversely impact the recovery of CRE in the coming years. Among these dynamic changes are consumer consumption declines, the internet and changing corporate physical infrastructure.

We’ve already determined that high unemployment through corporate contraction adversely impacts CRE. If we agree that CRE is largely a means to keep people, products and equipment dry, will we need more physical structures if we chose to shop via the internet rather than at the mall? With WI-FI, PDAs and laptops, we now work virtually anywhere; does that mean we’ll need more hard-wall offices? Open office environments (which are preferred by the millennial generation) can save companies 20-30% on the amount of office space needed to serve the same number of employees—will that increase CRE needs? How about bank branches—will we need more or less of those in the future? Our habits are changing the CRE market.

It’s interesting to observe all of the ideological and cultural changes that are occurring in our society. We must ask ourselves, “What will drive the need for more CRE when so many new initiatives seem to reduce the need for more physical plants?” Too often, we tend to rely on historic data to forecast the future when, in fact, much larger macro dynamic shifts are taking place. Nassim Taleb, author of The Black Swan, would contend that eventually, these dynamics will become quite obvious, but only after they have already occurred.

Investing in CRE – Midyear 2010 Update

noreply@blogger.com (John Gentry) — Tue, 29 Jun 2010 14:18:00 +0000

During the first six months of 2010, we’ve seen national sales volume for office and multifamily properties increase modestly while retail and industrial property sales have declined. Overall, commercial property sales are up about 56% from a year ago. While a 56% jump may seem extraordinary, it’s really not, considering the abysmally low volume of transactions during 2009.

Some industry experts contend that commercial real estate sales are poised to soar in the next year—investors believe that prices have bottomed out and consider CRE a good hedge against inflation. There are certainly legitimate arguments for buying sooner rather than later. If cheap long-term financing can be secured, you could justify purchasing a well-located property with high occupancy that may be discounted 20 -30% over peak 2007 levels. Many such sales are occurring in primary markets, including Washington, Los Angeles and Boston. However, sales in tertiary markets such as ours (Richmond, VA) remain benign, with transactional volume only slightly better than last year.

Moody’s Commercial Property Price Index reported that CRE prices have increased by 1.7% in the last month, which leads to the growing consensus prices have bottomed. There is a dichotomy to the transactions included in the report. On one hand, you have hugely discounted distressed transactions, while other transactions represent the best of the best in primary markets where properties are trading at 2006 cap levels. This disparity suggests two distinct investor profiles currently in the CRE market. There is the discount buyer who will only purchase severely depressed assets and the trophy seeker who will only invest in high-profile assets in primary markets. The trophy seeker is likely to be an over-capitalized REIT or private equity fund that is feeling pressure to spend someone else’s money. The discount buyer is typically more patient and not the least bit concerned about insulting a seller.

Fundamental Still Weak

While clearly the CRE investment market has strengthened in the first half of 2010, I don’t expect the market to surge in the next six months. The primary reasons I think transactional volume will remain sluggish are:

Vacancy Levels – National vacancy levels in all asset classes, except apartments, have risen in 2010. Current national vacancy levels are at 7.5% in retail, 17.9% in office, 10.9% in industrial and 8% in apartments.
Credit Challenges – While the CMBS market has surfaced, it has a much different structure now, and the volume of these package loans remains low, at just over $1 billion issued year-to-date. (Many experts predicted that between $15 and $20 billion of new CMBS issuance in 2010.) During 2009, $2.2 billion of CMBS was issued, mainly through TALF, and 2007, $237 billion was issued. In addition to the lower-than-expected CMBS issues, bank lending remains cautious and selective. Currently, 140 banks are scheduled for FDIC takeover. So far this year, 86 banks have gone into FDIC receivership. With 775 banks currently on the FDIC problem list, I would not expect robust lending any time soon.
Loan Defaults – While the rate of CRE labeled as “in default” is lessening, these distressed assets continue to accumulate and are now estimated to be valued at $239 billion. At the end of 2009, $165 billion of CRE properties were in default or foreclosure.
Unemployment – CRE is inextricably linked to employment and the amount of space companies need. With unemployment seemingly stuck at 9 - 10% for the foreseeable future, it is going to take quite some time to fill the exorbitant amount of vacant space that has accumulated over the last several years. Until unemployment shows a sustainable decline, expect investors to remain cautious, particularly in those asset classes with the highest vacancies, such as office and industrial.
Government Reform – The federal government has taken the position that anything related to business or banking needs to be reformed. As laws are passed, it takes some time for lawyers, bankers and accountants to sort through the legislation. With so much of this reform being opaque, don’t expect underwriting or capital requirements to loosen any time soon. In fact, Senator Judd Gregg said that the banking reform bill will “crush credit” to small businesses in 2011.
Taxes – With substantial tax increases on businesses and individuals coming in 2011, it’s hard to believe that economic growth will surge. Without increases in business expansion and consumer spending, there is no need for more office, retail and industrial space. Higher taxes will likely have an adverse effect on CRE, not to mention that owners may become more reluctant to sell when calculating their new capital gains tax payout.

While ostensibly the volume of CRE investment sales will be higher in 2010, the volume will be nowhere near the peak levels experienced from 2005 through 2008. With so much uncertainty on the horizon, expect investors to remain cautious and opportunistic for the next six to twelve months. While CRE prices in primary markets may have stabilized, there is much speculation that foreclosed property transactions could bring on more price destruction, and no one really knows how much the banks “pretend and extend” practices have delayed the inevitable.

There Must be a Better Solution

noreply@blogger.com (John Gentry) — Tue, 25 May 2010 18:05:00 +0000

It would appear that the Federal Reserve’s only real potential cure for the financial crisis is to continue to inflate the crisis away. Many Americans bought into this panacea because Paulson, Bernake and Geitner convinced the world that the only solution to financial meltdown was immediate shock-therapy crisis management, a Melton Friedman approach to saving an economy. Dr. Friedman has an abysmal record of managing financial crises, as evidenced by the economies of Brazil, Argentina and Poland, to name a few. Read The Shock Doctrine by Naomi Klein to learn more.

Given the excessive debt in Europe, particularly in Greece, there is growing concern that more EU countries may be on the brink of financial meltdown. One must ask whether it’s possible that California, New York, Ohio and Rhode Island may be the U.S. versions of Greece. Is it possible that after Congress audits the Federal Reserve (which in the past they have only been able to do every five years) we will realize our debt-to-GDP is far higher than the 90% reported by the Federal Reserve? I wonder if the Federal Reserve includes Social Security and Medicare entitlements in their debt-to-GDP equation. Let’s hope so, because if not, that 90% is grossly understated.

Because of the lack of transparency by the Federal Reserve and Treasury, U.S. citizens are growing skeptical that the financial crisis can be resolved by borrowing and inflating our way out. The following excerpt, from Jesse’s Café Américain blog entitled “Here is Why the Fed Cannot Simply Continue to Inflate Its Way Out of Every Financial Crisis that It Creates.” I think this gives us a good perspective on why we can’t manage this financial crisis through inflation

“The return on each new dollar of US debt is plummeting to new lows according to figures from the Federal Reserve…The ability to expand debt is contingent on the ability to service debt. If the cost of the debt rises over the net income of the country’s capital investment, or even gets close to it, the currency issuing entity is trapped in a debt spiral to default without a radical reform.

In other words, if each new dollar of debt costs ten percent in interest, largely paid to external entities, and it generates less than ten cents in domestic product, it is a difficult task to grow your way out of that debt without a default or dramatic restructuring.

So we are not quite there yet. But we are getting rather close on a historic basis. Without the implicit subsidy of the dollar as the world’s reserve currency it would be much closer.

As it is now, [the above] chart indicates that stagflation at least, rather than a hyperinflation, is in the cards for the US. But the trend is not promising, and the lack of meaningful reform is devastating.

The economy is out of balance, heavily weighted to a service sector, especially the financial sector, which creates no new wealth, but merely transforms and transfers it. With stagnation in the median wage, and an historic imbalance in income distribution skewed to the top few percent, with the banks levying de facto taxation and inefficiency on the economy as a function of that income transfer, there should be little wonder that the growth of real GDP is sluggish in relation to new debt.

Along with the ‘efficient marked hypothesis,’ trickle-down economics is also a fallacy. This is why the stimulus program being conducted by the Federal Reserve, in an egregious expansion of its authority to conduct monetary policy, in subsidies and transfer payments to Wall Street is not working to stimulate the real economy. It merely inflates the bonuses of the few, and extends the unsustainable.”

In layman’s terms, the idea that an economy can prosper by trading equities and suing one another is a fallacious premise. The service sector exists because necessary tangible goods and products are produced by a population within a certain geographic economy. It is without dispute that when the service sector of an economy grows larger than the manufacturing and production sectors, that economy is predestined to degradation. Currently, the U.S. service sector accounts for 80 percent of all jobs in the U.S., including financial services, health care and retail.

Scientists, engineers, physicists and the like are the elixir to position the U.S. for future prosperity. It is these minds that will create, innovate and design tangible products that bring meaningful value to our economy.

I believe we have all come to realize that a financial derivative, a product of the financial services sector, has no meaningful or sustainable value.

Mixed Messages

noreply@blogger.com (John Gentry) — Tue, 06 Apr 2010 13:35:00 +0000

Many economists suggest that commercial real estate will continue to be a drag on the economy for the next several years. According to Real Capital Analytics, the current volume of commercial real estate that has fallen into default, foreclosure or bankruptcy has risen to $208 billion, up from $165 billion at the end of December 2009. Although the increase in distressed property is said to be moderating, billions of dollars in additional loans will mature over the course of the next several years, which stands to have a significant effect on the banking industry. Elizabeth Warren, head of the TARP Oversight Committee, reports that almost 3,000 regional and community banks are significantly overextended on loans to primary asset ratios, and it is likely that hundreds of banks will fail in 2010. Much of this overextension results from troubled commercial real estate loans.

While the statistics and forecast remain somewhat bleak, certain geographic areas are fairing extremely well. Additionally, REIT stocks have rallied impressively over the last two quarters.

Investors looking to purchase Class A real estate in downtown Washington, Boston, San Francisco or other primary markets can expect to pay premium prices. Pricing in these markets is near 2006 levels with CAP rates in the 6–6½% range. Owners of properties for sale in these areas, particularly premium office buildings, receive multiple offers, and it is not uncommon for the prices to be bid-up before contracts are secured.

Equally as popular is the REIT sector. REITs are attracting investors in droves as the All REIT Index posted a total return of 11% for the first quarter 2010. Investors are enamored with the above-average dividend yields afforded in the REIT sector, despite weak fundamentals in the commercial real estate sector including:

· Anemic corporate hiring (needed to fill vacant space)

· Continued downward pressure on lease rates

· High vacancy rates

· uncertainty in valuation of assets

Especially popular are healthcare and hospitality REITs. It is not clear whether investors are riding the REIT trade or are in it for the long haul. Some investors are convinced that the worst is behind us, while others contend that financing challenges, high unemployment, and benign economic growth will contribute to continued underperformance of commercial properties.

At this point, the tables could turn either way. There are legitimate arguments to support better REIT performance or conversely, underperformance. Favoring the REIT sector has been the REITs’ ability to recapitalize during 2009. By in large the sector, which hit rock bottom in March of 2009, has been able to restructure debt, dispose of assets, issue new stock offerings, and as a result, in many cases, overachieve in respect to recapitalization. With all of this fresh money, many REITs have turned opportunistic by bidding on properties for sale in an effort to beef up portfolios.

While the jury is still out on the sustainability of REIT stocks and the yields thereof, it is important to remember, particularly in real estate, to ride the horse that has access to the money. The REITs have proven that lenders and investors are willing to pony up.

Show Me the Money

noreply@blogger.com (John Gentry) — Tue, 02 Mar 2010 15:40:00 +0000

One tough year

2009 was a tough year to borrow money for commercial real estate. Commercial banks were scrambling to get their books in order. Life insurance companies received higher profits in alternative investments such as corporate bonds, thus making real estate loans an unattractive option. The CMBS (conduit) market was virtually shut down, with a paltry $1.4 billion in loans issued, compared to $239 billion in conduit loans issued in 2007. The only vibrant sources of funds were those issued through the assistance of Fannie Mae and Freddie Mac. These agencies buy mortgages on the secondary market and support funding for homeowners, apartment complexes and multi-family projects.

State of the Capital Markets

The total amount of commercial real estate debt in the U.S. currently stands at $3.5 trillion. Of this $3.5 trillion of debt, $1.5 trillion matures by the end of 2013. Currently, almost $200 billion in loans are in default, which represents about 6% of the total debt market. More concerning, an additional $200 billion in CRE loans are 30-days or more delinquent on payments, meaning that more default is inevitable in 2010. Many industry experts contend the default rates will exceed 12% in the coming years. Based on current debt default and delinquency, 12% appears to be a pretty safe bet.

Who is in the game and who is not?

While there appears to be some loosening of credit among the larger commercial banks, many smaller regional and community banks are struggling to get the green light from the FDIC and the Fed to lend. According to Elizabeth Warren, head of the TALF Oversight Committee, some 3,000 regional and community banks are significantly overextended on existing loans relative to primary reserves. Until these loans and reserves are brought back into balance, many of the smaller banks have been advised to curtail lending for commercial real estate. These banks comprise approximately 40% of the total number of banks charted in the U.S.

Historically, life insurance companies have been a primary source of large commercial real estate loans. It has been reported that commercial real estate lending is back in favor for many of the life companies. The bond rally from which these companies profited in 2009 has slowed, and they are now turning their attention to CRE lending. Borrowing money from a life insurance company has traditionally been an excellent source of funding. In most cases, the money comes without recourse, the maturity terms can be up to 10 years, and rates are typically quite competitive. Like all current sources of funding, underwriting by the life companies will likely be onerous, meaning that many properties will not qualify for the new standards. Loan-to-value terms will also remain low at 65 – 70% of appraised value.

Of the $3.5 trillion commercial real estate debt market, $800 billion is attributed to the CMBS (conduit) market. While most pundits contend that the CMBS market will revive, it will surface in a very different form, and it will not happen quickly. Much of the $1.4 billion issued in 2009 was done so through the Term Asset-Backed Securities Loan Facility (TALF), a program which is due to expire in June. As the CMBS market is restructured, certainly, the originators and servicers of this debt will have to have more “skin in the game.” No longer will bond holders be stuck holding the bag when the market goes south. Industry experts expect that $14 – 20 billion of conduit loans will be issued in 2010.

For those seeking funds for multi-family assets, the flood gates remain open at Fannie Mae and Freddie Mac. The government has issued these agencies a blank check, and they are spending it expeditiously. While the agencies are predominantly government-owned, they have quickly learned to operate in full governmental fashion by losing $16.8 billion in the fourth quarter of 2009 and a total of $25 billion for the year. Regardless of their performance, these companies have funds readily available, although there has been some tightening of underwriting standards. The money from these agencies remains nonrecourse, 80% LTV, 10 year maturities, 30 year amortization, and rates of 6% or better.

How will the money flow in 2010?

While 2009 was an extremely challenging year for the capital markets, 2010 should bring some relief. Ostensibly, the commercial real estate market has further to fall in regard to default and foreclosure, but lenders will start to find more comfort in bargain real estate values, which should ease their risk adversity. All of the primary funding sources appear to be open for business and the money should flow at a stronger pace relative to the trickle pace of 2009.

New Records in the Office Market

noreply@blogger.com (John Gentry) — Tue, 02 Feb 2010 16:18:00 +0000

This past year was a difficult one for commercial real estate in Richmond, Virginia. Our office market set several new statistical records, ones that we hope will never be matched again. Richmond’s overall office vacancy rate increased in 2009, from 13.6% in 2008 to 17% in December 2009. Total absorption during the year achieved a historic low, (503,000) square feet. Net absorption in 2008 was 113,500 square feet, and 2007 had set a seven-year high for net absorption at just over 750,000 square feet.

Office Building Sales: Office building sales hit rock bottom in 2009. No office building sales in excess of $5 million were reported, and very few sales were reported at under $5 million, most of those were condominium sales and buildings with values below $1 million. The volume of sales in 2008 was $133.5 million, a 65% decline over peak sales levels in 2007. In Richmond, 2009 was the worst year for office building sales on record.

We expect the volume of sales to pick up moderately in 2010, as more distressed and foreclosed properties are marketed. Recently, one of the former Circuit City headquarters buildings was listed for sale at $40.00 per square foot. Lexington Property Trust purchased the building over 10 years ago in a sale/leaseback transaction for $130.00 per square foot.

National Perspective: Financing for commercial office buildings will remain tight in 2010, as banks remain cautious with their underwriting, and deteriorating real estate values make appraising properties a greater challenge. The once vibrant CMBS market issued only $1.4 billion in securitized debt during 2009, most of which was done in conjunction with the government sponsored TALF program. The CMBS market issued over $237 billion in debt during 2007.

It is reported that commercial office building values nationally have dropped 43% on average since the peak values of 2007. With over $1.5 trillion in debt coming due through 2012, more defaults and foreclosures are expected in the coming years. As of January 1, 2010, $165 billion of commercial real estate nationally (all asset classes) was in foreclosure or bankruptcy, while another 6% of commercial real estate assets are delinquent on mortgage payments by 30 days or more.

Many lenders continue to implement “pretend and extend” policies with their borrowers. Lenders are doing virtually anything legally possible to avert foreclosure, to include: reducing monthly payments, adjusting loan terms, and in some cases, even forgiving debt. These types of policies cannot go on forever, and unless the economy revives soon, more properties will fall victim to foreclosure.

Final Word: The coming year is sure to be another challenging one for the Richmond, VA, office market. Until we see significant signs of improvement in employment, lending practices and sustainable corporate profits, expansion of the office environment will be slow. Without employees to occupy space, an office building is an expensive liability that will deteriorate over time if allowed to sit idle.

This report solely reflects my views and opinions of the current and future state of the office market in the Richmond metropolitan area.

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An Extraordinary Year

noreply@blogger.com (John Gentry) — Tue, 05 Jan 2010 22:30:00 +0000

The year 2009 has been extraordinary with sky-rocketing government debt, record-level deficits, corporate bankruptcies, bailouts, stimulus and most puzzling of all, an unprecedented recovery in the Dow Jones Industrial Average. Since March 2009 the Dow has increased by 59%. On March 9, 2009, the Dow stood at 6,547, while on December 31, 2009, it closed at 10,428. I have read numerous articles recently pertaining to the economic outlook for 2010. The general consensus among most of the pundits is that the first quarter will show robust GDP at 3–4%, modest job growth, rebuilding of inventories and some monetary tightening from the Federal Reserve. These prognostications suggest that the recession is now a bad memory, and the economy is well on the road to recovery. While we all want to believe the economy is back on track, could it be that these rosy forecasts provide a false sense of security. Some contrarian economists forecast a very different outlook for 2010. Even most of the bearish economists believe that while the first quarter will offer positive signs in many economic areas, they also say that the positive momentum is not sustainable.

For the past decade, and arguably longer, the economy has been running at full throttle because the Federal Reserve, Congress and the Treasury have been, in my opinion, irresponsibly relaxed on many fronts such as lending practices, securities regulation, interest rates and banking regulations. Because of these relaxed policies, the economy became artificially prosperous, and in late 2007 the prosperity ended. We all know the results of the “end of prosperity,” and to a large extent many of us are still feeling the economic pain.

Ostensibly, most economic indicators suggest improvement, which means the near-term outlook is positive. The question that must be asked is whether the improvement is a result of the government creating yet another artificial economy, one that has been rejuvenated by excessive government spending, crisis management, stimulus, and historically-low interest rates. Is there a price to be paid for such a government-sponsored economy? No one really knows. Only as time passes will the answer become apparent. We must understand that our policymakers are pioneers. They are truly explorers sailing in unchartered waters. These astute financiers and economists are hoping that the books they studied at their Ivy League schools and the professors that taught them will guide them on the right path. Obama, Franke, Geithner, Summers and Bernanke combined do not have enough experience to guarantee that we are on the right path because they have never experienced the enormity of the last two years. Let’s face it—they never even saw it coming.

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Refinancing today may be a better option than refinancing in the coming years?

noreply@blogger.com (John Gentry) — Tue, 24 Nov 2009 15:45:00 +0000

I recently had an interesting conversation with a client who owns a substantial portfolio of office and industrial properties. Contrary to popular belief and what I had thought, the client mentioned that he was glad that he has notes due and additional loans expiring in the coming months. He shared with me that he had recently renegotiated several of his loans with more favorable terms and, in some cases, he had even been forgiven debt, by simply placing the loan with another lender. My client was more concerned about loans he had coming due four and five years out, as he thinks interest rates may be far higher than today and the underwriting will remain onerous.

Given that not all lenders these days are this cooperative, I found this owner’s perspective both enlightening and concerning. After pondering the discussion, I investigated the likelihood of higher interest rates in 2010 and beyond. The general consensus among pundits is that interest rates will rise in the next 12 months and they may likely continue to rise in 2011 and beyond. How much interest rates rise depends largely on the amount of damage that has been inflicted on the dollar, government indebtedness and the overall economy in general.

To put events in better perspective, consider the year 1980. In 1980 the inflation rate soared to 13.5%, the monetary base was approximately $200 billion, the national debt was over $900 billion and the U.S. federal deficit approached $100 billion. The country was in a serious recession and the prime rate was a staggering 21%.

Conversely, 2009 has almost come to an end and the inflation rate is -1.3% (by the way, that’s deflation), the monetary base has escalated to $1.8 trillion, the national debt is a staggering $12 trillion (excluding $43 trillion in Social Security and Medicare debt) and the U.S. federal deficit is approaching $1.8 trillion. The country has been in a serious recession for nearly two years and the prime rate is currently 3.2%.

The disparity between these two recessions is paradoxical. How could the current staggering increases in debt and deficits lead to deflation? The answer is relatively simple. When consumers and businesses stop spending, there is no pricing power. With unemployment at 10.2%, spending will continue to be sluggish, and deflation will likely persist. Similarly, with vacancy rates for commercial real estate at 17% nationally, owners have no pricing power, and as a result, rental rates, as well as property values, fall. The ability to spend and borrow freely, without government intervention, is the elixir for economic recovery.

So what’s all the worry about?

When the economy and unemployment begin to improve, inflation will likely increase, at which time we’ll likely see higher interest rates. The Federal Reserve and Treasury have collectively managed to increase the monetary base, federal debt and federal deficits to unprecedented levels. As a result, the dollar has fallen significantly against most major currencies around the world. China is the exception because of its inherent need to tie their currency to the dollar in order to keep their exports flowing.

In the words of Paul Volcker, Federal Reserve Chairman in 1980, “excessive growth in money supply is the root cause of inflation—too much money chasing too few goods.” Hence, too much printed money debases the currency which further contributes to inflation. Volcker was not very popular when he elected to raise interest rates abruptly as inflation began to soar in 1980 and the prime rate reached 21%. Popular or not, Volcker’s plan worked, and inflation gradually tapered off. By 1983, inflation had fallen to 3.2% which is considered a healthy range for inflation. Many economists believe the Fed and the Treasury have created a 1980’s scenario which will likely start to play out towards the end of 2010 and into 2011. A lot will depend on unemployment and the government’s ability to stimulate job growth. So far, that plan has not worked very well, and it’s likely more stimulus money will be needed. More stimulus money means more government debt; rest assured, Congress will spend whatever it takes to create jobs, even if it means economic destruction. Ben Bernanke contends he has the monetary policy under control and will begin tightening that policy at the appropriate time to avoid inflation and thus mitigating the need to raise interest rates excessively. My guess is that he didn’t expect double digit unemployment to continue through 2010, which is likely. The Kiplinger Letter reports that it will take 125,000 new jobs per month to hold unemployment steady at 10.2%. This accounts for young people entering the job market as well as immigrants.

You have seen the numbers and you know the history. Are you willing to bet that refinancing today may be a better option than refinancing in the coming years?

Clearly we remain in a very unpredictable and highly volatile economic environment, and we can only hope that our current Fed and Treasury officials can navigate these unchartered waters. If not, higher interest rates will be the inevitable panacea.

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Inflation or Deflation?

noreply@blogger.com (John Gentry) — Tue, 27 Oct 2009 15:10:00 +0000

Currently, economists are debating an important topic—whether the U.S. will experience inflation or

deflation in the coming years. Some economists believe that government borrowing, coupled with the

printing of money, will soon lead to rising inflation. Other economists contend that consumers have

abruptly reverted to being savers rather than borrowers and spenders. They believe that the increased

savings combined with high unemployment and a slow, jobless economic recovery, will all contribute to

significantly reduced consumer spending and thus, deflation. Both forecasts are legitimate, but it’s

probably too early to make an unequivocal judgment as to whether we will experience inflation or

deflation in the coming years.

I suggest that with the possible exception of energy costs and health care, the U.S. is already in a

moderate deflationary state, as there appears to be little pricing power for most of the items consumers

need to survive‐‐food, shelter and clothing. Candidly, a dollar today still pretty much buys what a dollar

bought two or three years ago, unless you are shopping in Europe. Technically, deflation occurs when

the annual inflation rate falls below zero, where negative inflation occurs. The current U.S. inflation rate

is ‐1.3%. Statistically, that means that the U.S. is experiencing deflation. Interestingly enough, the

annualized 2008 inflation rate for the U.S. was 3.8%, the highest rate since the 1990 rate of 5.4%. The

inflation rate in 1980 was 13.5%, and the highest rate ever recorded—18%‐‐occurred in 1918. If you

take a look at the historical inflation rate charts (www.usinflationcalculator.com), it is interesting to

notice how capricious the rate has been during certain periods. In 1932, annual inflation was ‐9.9% and

by 1934, it was 3.1%. By 1938, the rate had turned negative again, down to ‐2.1%. While the economy

will always fluctuate as the Federal Reserve tweaks interest rates and adjusts the monetary policy, it is

clear that the economy is at its best when the inflation rate is running between 2% and 3.5%.

While economists are divided in their opinions on what leads to inflation and deflation, one premise on

which they all seem to agree is that by increasing the money supply too rapidly, which devalues the

currency, inflation will ultimately occur. Very simply, debasing the currency means it will take more of

our dollars to buy the same amount of goods and services. If you have any doubts as to whether the

U.S. money supply is growing prodigiously, take a look at the chart at the top of the post.

The monetary base has increased from approximately $800 billion in 2005 to a current level of almost

$1.8 trillion. From 1919 to 1971, the monetary base was relatively flat, never exceeding $100 billion,

followed by a gradual increase through 2005. It is important to note that in 1971, the gold standard was

rescinded, which many believe has contributed to this accretive money supply.

In recent weeks, concern has grown over the possibility that the value of the dollar may be in free fall,

and monetary tightening by the Federal Reserve will be required in order to stabilize the trend. While

the Fed claims to be implementing policies that will lead to gradual monetary tightening, the question

becomes, “Is it too little, too late?” We must be mindful that debasing the currency is one of the surest

signs that inflation is on the horizon.

While economists continue to debate whether we will experience inflation or deflation in the coming

years, much like their attempts to predict a recession, we will likely be well into an inflationary or

deflationary cycle before the final “call” is made.

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The “New” Commercial Real Estate Bailout Plan

noreply@blogger.com (John Gentry) — Tue, 29 Sep 2009 20:51:00 +0000

When we think of real estate investment trusts (REITs), we think of publicly traded companies that purchase commercial real estate in the form of apartments, office, industrial and retail properties. Recently, there has been a rash of public offerings from companies, backed by large investment firms, in an effort to form REITs that purchase commercial mortgages rather than hard assets. These newly formed REITs expect to be able to purchase billions of dollars in distressed mortgages, particularly those loans tied to commercial mortgage backed securities (CMBS).

With no real mechanism for refinancing $900 billion in CMBS loans and with defaults reaching just over 3% in July, this market is hungry for a “bailout” program. Mortgage REITs might be one elixir to help the commercial real estate market recover faster than many pundits have predicted. Given the prodigious amount of money these new mortgage purchasers have raised, several billion dollars in the last six months, many investors are betting that these guys are seasoned debt negotiators and experts in calculating the value of deteriorating real estate in an array of geographic locations. With the massive purchasing power these newly formed REITs will have, they will certainly be able to take advantage of the term asset backed security loan facility (TALF), assuming it remains available and they don’t mind having the government as a partner. TALF could provide these REITs with government leverage of six to one, in which case their $1 billion in equity will become $6 billion in purchasing power.

Buying CMBS loans will not be a lay-down for the mortgage REITs. At Harrison & Bates Investment Realty Advisors, it has been our experience, in selling properties tied to CMBS bond packages, that negotiating with bond holders and special servicers is no easy proposition. Bond holders who have paid premiums to receive yields in keeping with the AAA rated bonds are reluctant to sell property loans at a discount. And the special servicers, in trying to avoid foreclosures, are able to modify loans more selectively, which means fewer loans will become distressed. I suspect it is easier for a servicer to modify one loan at a time rather than a package of 100 loans that may be at various levels of distress or in no distress at all.

The competition vying for these securitized loan packages has increased and now includes hedge funds, mutual funds and private equity. It seems that the “big money” sees a tremendous opportunity to fatten coffers with distressed commercial real estate, rather it be through the purchase of hard assets or mortgages. Buying a loan at the right price can pay substantial dividends, even if the property falls victim to foreclosure. In a market where property values are falling and interest rates are likely to rise, picking the right loan price can be a daunting task.

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Wake Up Call

noreply@blogger.com (John Gentry) — Tue, 08 Sep 2009 15:56:00 +0000

As of September 1, 2009, the United States government has borrowed $11,745,808,640,024. This 14-digit number represents almost 12 trillion dollars. This number is also commonly referred to as “The National Debt.” Public debt - money borrowed from state governments, corporations, individuals, and foreign countries - is part of the national debt. Another component of national debt is internal government debt, money the government borrows from federal agencies such as the Social Security Administration. To put these mounting IOU’s in perspective, the national debt was approximately $5.7 trillion in 1999; the debt load is scheduled to escalate to $20 trillion by 2019.

Many economists believe the U.S. government grossly understates the national debt, as the almost $12 trillion figure ignores other government liabilities such as civilian and military benefits and entitlement programs which includes Social Security and Medicare. The government has committed to these obligations but currently has no funds to cover them in full. If we add these government obligations to the national debt, the debt load increases to $56 trillion, of which Social Security and Medicare make up almost $43 trillion.

These numbers are truly astounding! According to The Heritage Foundation, every U.S. citizen now owes $184,000 towards debt incurred by the U.S. government. The annual interest payments alone on $12 trillion are $253 billion, scheduled to increase to $650 billion in 2019. In addition, the U.S. owes $3.5 trillion of our national debt to foreign governments, among them China, which controls almost $1 trillion of U.S. debt.

As the national debt mounts, so, too, does the “Federal Deficit”. A federal deficit occurs when a government spends more money than it collects given an established annual budget. The U.S. government collects money from several sources including individual income taxes, payroll taxes, corporate taxes, and excise taxes. Individual income taxes represent approximately 45% of all government revenue. Currently, the U.S. federal deficit is $1.8 trillion. The deficit at the end of fiscal year 2008 was $407 billion, and in 2007, $163 billion.

At some point, something’s got to give! With government debt and deficits mounting, literally out of control, how will our government ever be able to bring them back into balance? The current administration contends that tax increases, stimulus programs, and other government initiatives will generate sufficient revenue to bring the debt load under control. However, they offer no specific date as to when this will occur. Compounding the problem is the precipitous drop in federal revenue, which is scheduled to be 18% less than the original 2008 forecast and expected to be even lower in 2009.

The numbers have simply become so large, and with interest payments, they now escalate seemingly out of control. We are clearly in unchartered waters. While the current administration, Congress, and the Federal Reserve try desperately to stabilize a crippled financial system, a much bigger problem, simply known to all as “debt,” grows like a cancer for which there is no known cure.

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Where are the Investment Sales?

noreply@blogger.com (John Gentry) — Tue, 04 Aug 2009 13:34:00 +0000

According to Bob Bach, Chief Economist at Grubb & Ellis, investment sales nationally for all disciplines of commercial properties are down 78% year over year and 92% from July of 2007. Peak sales for investment property occurred in 2007 with over $425 billion in transactions. To date in 2009, transaction volume has been paltry at less than $18 billion exchanged.

Apartment properties continue to maintain the lead as the most traded commercial investment. As I reported a few months ago, apartment demand is expected to grow in the coming years, and investor financing remains available from Fannie and Freddie. Nationally, capitalization rates for apartments have increased modestly to 7%. In some markets during 2006 and 2007, cap rates had fallen below 6%.

Unlike multi-family sales, sales volume for office, industrial and retail product remains precipitously low, with little prospect of increased volume through 2009. These product types have grown out of favor because of high unemployment rates and historically low loan-to-value requirements. Loan underwriting is as stringent as it has been in nearly 20 years, going back to the Resolution Trust days of the early 90s. According to a recent survey of office lenders by HBIRA, consensus is loan to value of 60-65%, interest rate range of 7-7.5%, and 20-year amortization schedule with a five-year call. To qualify for financing, any office property under consideration will need to be well-leased with credit tenants (90% leased or more), have three and five year minimum term balances, and be well-located in a strong economic market.

In July, HBIRA conducted a cap rate survey of over 1,000 investors that included REITs, individuals, institutions, and opportunity funds. Our goal was to determine cap rate expectations for single-tenant office buildings with an A-rated credit tenant, a 10-year lease balance, and a Richmond, Virginia address. The survey results were:

7% - 8% Capitalization Rate	9% - 10% Capitalization Rate	11% - 12% Capitalization Rate	13%+ Capitalization Rate
5%	47%	35%	5%

Nationally, according to Real Capital Analytics, the average cap rate for 2009 office sales hovers around 7.75% on very light sales volume of $5.7 billion.

The value gap continues to be cavernous between buyers and sellers. Cap rate expectations alone have driven values for office and retail properties down 20-30%. Vacancy rates for these product types continue to rise, increasing the downward pressure on property values.

As the economy revives from recession, and unemployment begins to trend downward, investors and lenders will grow increasingly bullish on office and retail products. However, this bullish attitude will likely not matriculate for another three or four quarters, as unemployment is expected to rise, although at a slower pace. Forecasts for unemployment now peak at 10-13%.

Investors generally agree that they see a great deal of distress on the horizon. With over $1 trillion in commercial real estate loans maturing in the next three years, investors are optimistic about the buying opportunities ahead. The CMBS market in particular has forced a new dynamic in how lending institutions and bond holders will deal with distressed properties. To date, the pipeline for distressed properties is at a trickle as the special servicers try to determine how best to extricate the most challenged properties from securitized debt.

A letter to Trim Geithner and Ben Bernanke, signed by 41 members of Congress, stated, “Unless the TALF program is extended beyond its current expiration date of December 31, 2009, the commercial real estate market will simply not have sufficient liquidity to deal with this looming debt challenge.”

Because there is no secondary financing market to support CMBS, it’s quite disconcerting to think that we might have to rely on TALF to clean up the CMBS mess.

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Is it Time to Start Buying Commercial Real Estate?

noreply@blogger.com (John Gentry) — Tue, 07 Jul 2009 16:31:00 +0000

A wise commercial real estate investor once told me, “It is better to be late and right than early and wrong.” Picking the right time to get in the game can be tricky; picking the right product type can be equally as tricky.

Recently, apartment properties have been the most popular product choice available on our site, www.hbira.com. Each week, the site receives over 20,000 hits on the various multi-family investments listed. Apartments are an attractive alternative for investors because those with substantial equity on hand can find financing sources, as Fannie Mae and Freddie Mac are still in the business of purchasing these loans. In addition, investors speculate that the contraction in consumer wealth will cause more people to lease apartments as opposed to purchasing homes. Furthermore, the stigma of leasing an apartment has faded as consumers lose confidence in home values and realize that a home can no longer be used as a cash register.

Sales volume for commercial products such as office, retail, and industrial properties has slowed precipitously. Most savvy investors with substantial cash on hand are pacing the sideline in anticipation of a value meltdown in these property types, comparable to the S&L crisis of the early 1990’s.

According to Jeff Greene, a billionaire and arguably one of the most successful real estate investors in America, the outlook for office and retail real estate is bleak.[1] In an interview with Greene on CNBC’s “Squawk Box”, Greene said, “I’m very pessimistic about the economy. We’re in a difficult time.” According to Greene, commercial real estate deals have yet to reach truly distressed levels. “There is still a huge disconnect between what sellers are asking for properties and what buyers are willing to pay. There are no deals yet,” he said, adding that it is likely that by the time deals come along, everyone will be “so beat up they won’t want to buy.” As for real estate investment trusts, Greene thinks they are a “slow-speed train wreck.” Greene expects REITs will be hit by a “triple-whammy” that includes tenants renewing leases at highly reduced rents, higher financing costs and equity dilution. The backdrop for Greene’s outlook is the opinion that the U.S. could suffer a five-to-seven year period of slow growth. “We just had this huge, huge ten-year party,” Greene said. “I think that basically what Americans did was not live off their income; they lived off their assets…now we’re cleaning up this mess, and I think the consumer is shell-shocked.” Greene expects it will be a long time before Americans are willing to jump back in and get leveraged again. As of May 14, 2009, he speculated that the real troubles for the commercial real estate market have yet to materialize.

Mr. Greene’s words are worth considering, as he is the man who bet against sub-prime mortgages to hedge his real estate portfolio and ultimately hit the mother load.

According to most industry experts, there is somewhere in the neighborhood of $300 billion in CMBS loans coming due between early 2010 through 2013. Of this $300 billion, an estimated third will not be refinancable. In addition, there is over $1 billion in commercial real estate loans financed by banks that did not participate in CMBS.

The potential for a commercial real estate crisis reviling that of the S&L crisis is a growing concern, which many believe is inevitable. Interestingly, the banks seem to be playing down the issue, which suggests that they have it under control. For now, most banks choose to partner with the troubled borrowers rather than foreclosing on them as they did in the early 1990’s. I suspect, given the comeback that the large banks have made in the last three months, the last thing they would want is to alarm the public of more trouble ahead.

Most industry experts agree that commercial real estate will remain “out of favor” until there are signs of job growth and a stabilized lending environment.

Over the last year, commercial real estate values in most product types have fallen by 15 to 20 percent nationwide. It is forecasted that commercial real estate could decline another 15 to 20 percent by mid-year 2011.

If you believe interest rates will rise in the next 24 months, and the employment rate will exceed 10 percent during that same period, then you may want to remain on the commercial real estate investment sideline.

For those that believe overall economic conditions are improving, the time to invest may be upon us. If you choose to get in the game now, it will likely be determined within the next 24 months whether you were early and right or early and wrong.

[1] Excerpt provided by Christina Cheddar Berk, News Editor, CNBC’s Squawk Box. For the complete interview, go to www.squawkbox.com.

Federal Reserve: Guardian of Monetary Supply or Cash Register?

noreply@blogger.com (John Gentry) — Tue, 02 Jun 2009 14:17:00 +0000

With the yield on 10-year treasury bonds rising to 3.61% last week, could it be that the Fed has run out of options?

The Federal Reserve desperately needs interest rates to remain low as housing recovers and the commercial real estate market begins to deteriorate. If interest rates tied to treasury bonds rise, a precipitous end to mortgage lending and refinancing may follow. Some experts purport that residential mortgage rates above 5% will initiate further declines in home values. Mortgage rates of 4% to 4.5% have been the panacea to bring us closer to the bottom of housing, while higher rates will surely be noxious for economic recovery.

The Fed typically buys and sells short-term treasury bills to set the overnight Federal funds rate. Buying long-term treasuries has only occurred twice during the Fed’s existence. They purchased long-term treasuries in 1952 and in small amounts during the 1960’s. When the primary purchasers of treasury bonds demand a yield that is not palatable with current market conditions, the Fed becomes the buyer of last resort. The Fed pays for its purchases of long-term treasury bonds by creating new money. This new money eventually circulates into the economy, debasing the value of the dollar. In addition, with more money chasing the same amount of goods and services, prices will inevitably go up.

The Federal funds rate is virtually zero, treasury yields are rising, and mortgage rates may likely rise as well. This appears to be a very tenuous predicament. The only arrow left in the quiver is the Fed’s ability to buy more long-term treasuries and accept a lower yield, thus keeping rates artificially low. The Fed has already purchased over $600 billion in treasury bonds and mortgage backed securities. Many economists believe the Fed needs to buy up to another $1 trillion dollars in treasury bonds to sustain the low interest rate mortgage environment that is critical to ending the recession.

To avoid inflation, the Federal Reserve will need to raise interest rates as the economy revives. This is an enormous challenge and the central bank does not have a very good track record for timing an increase in interest rates with the end of a recession. As you will recall, it took the Fed a year to recognize we were in a recession.

According to former St. Louis Federal Reserve president, William Poole, by loading up the balance sheet with an unprecedented amount of long-term treasury and mortgage securities, the Fed is hindering its ability to adapt to rapidly changing conditions. Poole stated, “I believe this is an unfortunate and dangerous policy the Fed is getting into”.

I suspect the Fed has no other choice but to purchase vast amounts of securities. However, the paradox is that the Fed would serve as a cash register to keep the economy out of depression while it is supposed to be the guardian of our nation’s monetary supply. Their role is to make sure that the money supply is adequate to encourage growth without causing inflation.

I, like Mr. Poole, am very concerned about the Fed’s ability to be a responsible guardian of the nation’s monetary supply, particularly if it requires timing the end of a recession.

How Much Commercial Real Estate Do We Really Need?

noreply@blogger.com (John Gentry) — Tue, 21 Apr 2009 13:21:00 +0000

Ostensibly, corporate America, over the last year, has, by necessity, experienced a major contraction in terms of head count and physical plant. Unemployment for non-farm employees rose to 13.2 million people at the end of March 2009. The overall unemployment rate rose to 8.5% in the first quarter 2009. This rapid decline in employment has caused consumers spending habits to shift precipitously, and saving money has become the new mantra. Many economists believe if per capita consumption continues to deteriorate, so too will the need for office and retail square footage.

What does the new consumer spending trend mean for the future of commercial real estate? As it relates to office buildings, even before the shift from consumption to savings, corporate America and small businesses were looking for ways to increase the efficiency of their physical plants. Open plans with modular furniture configurations had already become acceptable, due in part to Generation Y’s preferences for these configurations over traditional “hard wall” offices. Gen Y employees prefer computing power over privacy. Furthermore, every generation has become more comfortable with working out and about the office, rather than strictly in an office. Hoteling, telecommuting and home shoring are all effective ways of working as opposed to the traditional clocking in at the office from nine to five. In fact, nine to five is considered by many employees and employers to be archaic. Technology has turned non-traditional work hours and methods into the norm.

Studies show that by utilizing open plan work environments, where people flow in and out of the office, employers can save up to 30% in occupancy costs. They can substantially lower leasing costs because of reduced square footage needs and fewer “hard walls”. Vast improvements in sound attenuation also make these environments far more palatable, even for the Boomer generation.

With the U.S. vacancy rate for office space now exceeding 15%, with over 25 million square feet dumped on the market in the first quarter of 2009 alone, it will take years to absorb this over- supply of space. Making matters worse for the office market is the desire for open plan environments. In some respects, you can consider this the “perfect storm” for the office market. With the glut of space likely exceeding the vacancy percentages of the early 90’s and the shrinking need per square foot per employee (120 s.f. down to 64 s.f.), office building values will likely deteriorate in the coming years. Many experts predict that values will fall 20% to 30% overall and remain flat for the next decade.

The retail sector is also experiencing a contraction in the need for physical plant. Again, technology plays a large role in this contraction. Internet retail sales increased 16.6% in 2008 to $204 billion dollars, which was about the same rate of growth as in 2007. The largest percentage gainers for online growth included apparel (17%), computers (15%), and automobiles (15%). E-tailing has quite a way to go before it rivals retailing, as e-tailing still accounts for less than 5% of the overall retail market in the U.S. However, ease, acceptance, and convenience all increase e-tailings momentum, thus reducing the need for mall and shopping center square footage. It is unlikely that e-tailing will eliminate the need for physical plant in retailing, but clearly, the number of same-store retailers will decrease within certain geographic boundaries. E-tailing, as a manner of purchasing retail goods, along with America’s compunction to save, will surely contribute to further contraction in the retail sector.

While vacancy in the retail sector has not accumulated to the degree of the office sector, vacancies in U.S. malls and shopping centers has risen to the highest levels in more than 10 years. Overall, vacancy rates in retail are fast approaching 10%, with over 8.6 million square feet of retail space going dark in 2008. High-end retailers such as fashion and jewelry stores have been hit the hardest, while expensive dining and specialty retailers have experienced a considerable decline in volume.

While the well-positioned neighborhood shopping center will always serve the need of consumer convenience, supercenters and mega retailers will likely suffer in a contracting economy. Discount retail centers and big box retailers offering competitive prices will fair the best, particularly as consumers become more price conscious.

We have all bought books online, but were you aware that you can now also download books from Amazon.com for $5.00? Books can be downloaded on a device called a “Kindle”. The device is about the size of a thin magazine, the font and lighting can be changed on the device to suit the reader’s preference. My point in mentioning this device is to demonstrate how through new and simple technology the need for physical plant to warehouse books, paper, printing and binding, packaging, and shipping are all substantially reduced. At some point in the near future, library books will likely be downloaded, thus again reducing the need for physical space, transportation, and energy. If you still question whether a device such as the Kindle could really be a problem for commercial real estate, consider the changing state of the video distribution business, i.e., Hollywood Video and Blockbuster. Will bookstores and libraries become a product of the past?

While the need for physical space will never be eliminated, some requirements are diminishing which will impact the value of commercial real estate. Some office buildings will become functionally obsolete, and increasingly, retail centers will become geographically obsolete. Development of office and retail properties will also diminish as vacancies grow and alternative uses for existing properties evolve.

While the outlook for the retail and office sector is rather bleak, at least for the next several years, new and innovative real estate products will be designed and constructed. The new age of real estate will be functionally efficient and energy efficient. Over the course of the next decade, we will observe a paradigm shift in this product we call real estate and the way we use it.

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How much value has your office or retail property lost in the last year?

noreply@blogger.com (John Gentry) — Mon, 16 Mar 2009 18:07:00 +0000

In order to determine the value of a commercial property there are three basic factors that must be addressed first. These factors include the rent the property will dictate, the appropriate capitalization/yield value of the property, and the actual or implied vacancy of the property.

For the sake of this discussion, let’s assume that rents have decreased by 5 to 10% over the last year, which is the case in most markets around the country, government driven sectors being the exception.

The summer of 2007 marked the high-water mark for property values as related to capitalization rate (“cap rate”) compression. Premium properties in my area, Richmond, Virginia, traded at cap rates between 6.5 and 7.5%. These were the absolute lowest rates I have experienced in my 22 years in the brokerage business. Conversely, today most premium properties are trading in the 8.5 to 9.5% range, with some sub-premium properties trading at 10% plus caps. Admittedly, there have been very few investment transactions this year, but I believe it is safe to assume expectation yields on NOI have increased by nearly 200 basis points or 20% in the last year.

The third basic value consideration, vacancy rate, is also adversely affecting most office and retail properties. At the peak of the sales cycle, underwriters and appraisers generally allocated no more than a 5% vacancy factor and sometimes no vacancy factor. Today, the implied vacancy is 10%, regardless of the property’s actual vacancy. That means even if your office building is 100% occupied, you will only get credit for 90% occupancy. I recommend that you not argue this point with your appraiser or lender, as vacancy rates today, in most geographic areas, are higher than 10%.

Taking these basic value principles into consideration, most office and retail properties have lost 15 to 20% of their value, relative to peak values in 2007.

Other ways your office or retail property may be losing value

Basic value principles aside, there are more devils in the details that could adversely impact the value of your property. Such details include: the term lengths of existing leases, capital reserves, the age of the property, geographic obsolescence, functional obsolescence, and GREEN.

Let’s start with lease term length and market rates. If your existing leases are 24 months or less, plan on receiving a 50% probability of renewal score. If your lease rates have escalated above current market rates, plan on them being discounted back to market.

How old is your property? If it’s more than 10 years old and has an original roof and HVAC equipment, plan on a line item expense of 50 cents to one dollar per square foot to cover the future cost of those items.

Now more than ever, buyers scrutinize the geographic and functional obsolescence of the properties they are buying. Investors want properties that are well-located in the path of progress. They want properties that are contemporary, with appealing amenities and floor plate and bay sizes that serve the needs of a broad base of tenants.

Lastly, beware of the need to be GREEN. There is a growing initiative, particularly with federal and state governments, to require green. This green initiative is framed much like the requirements for the American Disabilities Act (ADA). The requirement will likely increase the renovation costs for existing properties, with little to no return on the bottom line.

When will values return to peak 2007 levels?

If I knew the answer to this question, I would probably not be writing this Blog, but I’ll take a shot at it.

Ostensibly, rental rates and vacancy rates must show significant signs of improvement before property values will rise. Given the amount of securitized commercial debt forecasted to mature in 2010 and 2011, it is hard expect any increase in values for the next two years, and more likely we will see further deflationary pressure on values.

While we don’t know the potential impact of government spending in the next three years, assuming inflation is likely and commodity prices will rise, the cost to operate a commercial property could increase significantly.

And while interest rates remain low today, at some point they will rise, particularly if inflation becomes a problem. Therefore, it is probably safe to assume that mortgage rates will be higher three years from now.

Considering all these micro- and macro-economic assumptions, I believe retail and office properties will not return to 2007 peak values for at least five years, and most likely it will be longer that. If my forecast is correct, the opportunity to purchase value priced commercial real estate may be as good as it was in the mid 1990s.

To check out what’s for sale, go to www.HBIRA.com.

Will There Be a Tsunami of Troubled Commercial Real Estate in 2009?

noreply@blogger.com (John Gentry) — Thu, 05 Feb 2009 14:43:00 +0000

During 2007, the commercial mortgage backed securities market (CMBS) issued $180 billion in loans. In 2008, the CMBS market issued a fraction of that amount, just over $12 billion. The total allocation of CMBS loans is approximately $4.4 trillion, a third of the $12 trillion market for securitized residential debt. The question I ponder is, "What happens now that the secondary market (CMBS) has dried up and banks no longer have a vehicle to move massive amounts of, sometimes marginal, loans off their books?" I believe the answer is: "Lending will be done the old-fashioned way."

Real Capital Analytics reports that the value of the commercial real estate now listed on their Troubled Asset Radar tops $106 billion and the number of those properties is rising rapidly. Of this $106 billion, $81 billion appears to be in serious distress due to maturing loans, failed development, tenant bankruptcy, and under-performing/over-valued assets. Another service, Foresight Analytics, reports that an estimated $400 billion of commercial loans (all types) will come due in 2009, of which $19 billion is CMBS debt. It is difficult to extrapolate how much CMBS debt is toxic because for now, the vast majority of the loans are current and performing fine. The challenge facing borrowers of this debt is refinancing a loan that may become due over the next several years. Because the CMBS market has shrunk precipitously, far fewer lender choices are available to those requiring primary financing or refinancing of existing debt. Today’s lenders have a much different approach to lending money, particularly in terms of underwriting assets, debt pricing, equity requirements, and borrower wherewithal. The underwriting standards imposed on borrowers during 2009 will surely lead to asset devaluation. Re-pricing, resulting from tighter lending practices, will likely cause a 10% to 15% reduction in overall commercial real estate asset value. A more concerning problem looming on the horizon is the devaluation that occurs due to foreclosure. It is still too early to forecast another RTC debacle, but there are signs that a similar occurrence is plausible.

Reflecting back on this recession, decession, repression, or depression (take your pick), the pundits have, in virtually every category, understated the severity of the crisis. Additionally, it is forecast that every category of the commercial real estate is expected to experience a rise in vacancy during 2009, with the office and retail sectors generating the highest levels.

If the Ivy Leaguers of the former Wall Street banks are unable to derive another esoteric lending vehicle, i.e., the derivative, and vacancies continue to rise because of a contracting corporate America, foreclosure will become inevitable. An environment of prolific foreclosure will lead to massive asset re-pricing with the same 20% to 50% discounts experienced in 1991.

Again, it’s too early to call a systemic meltdown in the commercial real estate market; however, evidence of why a meltdown will not occur is equally as hard to identify.

Commercial Real Estate Collapse?

noreply@blogger.com (John Gentry) — Thu, 11 Dec 2008 22:02:00 +0000

The pundits, whoever they are, contend that there will be a catastrophic collapse in the commercial real estate market sometime between January 2009 and December 2012. This so-called meltdown will occur because billions of dollars of securitized commercial mortgage debt will be called, defaulted on, and otherwise evaporate during that period. The basic cause of the debt destruction is due to over-leverage in the commercial markets and unsustainably low interest rates. Arguably, the worst time to purchase investment real estate is when capitalization rates are at all-time lows and interest rates are at historic lows. I concede that many of the gamblers, particularly those that missed the property flip, will lose the pot in the coming months. However, it is difficult to speculate whether this collapse will be as precipitous as the commercial real estate depression of the early 1990’s.

CB Richard Ellis, the 800 pound gorilla, prematurely announced that they had secured an exclusive contract with the FDIC to dispose of the billions of dollars of commercial real estate that is forecasted to be foreclosed on in the coming months and years. While we now know the CBRE contract with the FDIC is not exclusive, it is apparent that the FDIC expects there to be a sizable crisis in the commercial real estate industry. I can only surmise that CBRE and one of the remaining commercial/investment banks, possibly Goldman Sachs, are lining up commitments for the “Distressed Commercial Real Estate Fund” not unlike the Goldman fund established in 1991. Such a fund was established in 1991 to expeditiously dispose of hundreds of millions of distressed real estate properties, at supposedly no cost to the taxpayer, while filling the coffers of Goldman. A coup such as this could be an easy solution for the FDIC, but this type of solution will likely cause major value destruction for commercial real estate properties. Who can blame the respective brokerage houses; this is the American way of finance and profit. It is the new age of making “big money” fast; you move it around rather than create something meaningful with it. That’s what the investment banks did best but, in the fall of 2008, there was nowhere else to move the money.

I have no evidence to substantiate a coup between CBRE and Goldman Sachs, yet it does seem a bit obvious. Both Goldman and CBRE need cash fast to offset fee deficits and satisfy looming debt obligations. A commercial real estate collapse may be the last opportunity to cash in “big” for quite a while.

There will be foreclosure and distress in the commercial real estate market in the coming months and years; however, there is a far more “macro issue” that real estate owners and developers will need to address in the coming decade. Stay tuned as I will portend the next commercial real estate meltdown which is just around the corner.