Industry Fears Financial Instability, Lack of Financing Will Drive Values Way Down
by Mark Heschmeyer Wall Street's wild swings and the turmoil in the credit markets are confounding the commercial real estate industry.
Three fourths of the way through last year, there was no telling from quarter to quarter what the commercial real estate markets looked like. That shifted in the fourth quarter to uncertainty from month to month. Early this year, it shifted to week to week and this month, it became day to day. Who knows what tomorrow brings.
The Dow Jones Industrial Average has trended down since October from record heights of more than 14,000 to less than 12,000, but has experienced dizzying daily up-and-down swings of 200 to 400 points or more.
Each burst of exuberance is followed by the news of some stunning collapse. This week it was the thorough and rapid depletion of liquidity of Bear, Stearns & Co. Inc., a leading global investment banking, securities trading and brokerage firm. The firm lost more than 90% of its value in three days and agreed to be sold to JPMorgan Chase & Co. at 'value-meal' prices with bailout support coming from the Federal Reserve Bank.
Meltdown?
E. William Stone, chief investment strategist at PNC Bank, likened the fear in the markets to the fear in the late 1970s of a nuclear reactor meltdown.
"With the seemingly endless stream of negative news from the economy, credit markets, and financial institutions, there has been talk in some circles of a meltdown of the U.S. financial system," Stone wrote in a post this week. "In complex systems, like a nuclear reactor or an economic system, risk analysis is inherently difficult. The U.S. economy is suffering from serious financial stress as a result of a combination of complex and financially engineered products and inadequate risk analysis. How serious the damage will be to the U.S. financial system in addition to the U.S. and world economies has yet to be determined."
But Stone said the federal government seems aggressively intent on providing enough liquidity to the banking system to avoid a financial meltdown and is optimistic that it will eventually regain control of the markets.
However, the collective reaction of the commercial real estate industry to this volatility and instability and need for federal buttresses to support it is fear and dread.
"History has taught us that when the federal government begins to enter the financial markets in order to try and fend off material negative news, the economy and consumer confidence responds by consolidating its positions and retracting," said Donald A. Shapiro, president and CEO of Foresite Realty Partners in Rosemont, IL. "The confidence level falls further and the business approach tends to be very conservative in an almost bunker mentality waiting for the storm to pass. The Fed's attempts to lower interest rates, while welcomed by the economy, will be too late and not have the desired effects."
"Either this is the end of the world, or it isn't. Just last week, the stock market soared 400 points before sinking back into the blackness. The market rise demonstrates investor fear at missing the recovery; its fall demonstrates a sign the recovery is not yet here," said Edward L. Miller, managing director and principal of Colliers Arnold Commercial Real Estate Services in Tampa, FL.
"The herd mentality of the capital markets has spilled over into the commercial real estate market even though the fundamentals of the industry are solid," said John Battle, principal Lee & Associates - LA North/Ventura Inc. in Sherman Oaks, CA. "However, with that being said, the availability of capital and the terms associated with it have changed dramatically since Aug. 2. The primary result is a considerable drop in deal flow."
The drop in deal flow is adding to the perplexity in the commercial real estate markets. Unlike stock and bond values that can be determined instantaneously upon trading execution throughout the day, real estate values can only be determined through an accumulation of deals over time. Without enough volume, there is not enough information for investors to make decisions on whether to hold on or bail out or buy up.
"Buyers have clearly retreated to the sidelines as the capital markets have deteriorated. The commercial real estate market is the proverbial baby that that has been thrown out with the bath water as fundamentals, by and large, are very strong," said Tom Hanacek, senior advisor of Sperry Van Ness in Portland, OR. "If the capital markets can be straightened out, I would look for a sharp snap back in the commercial real estate market. However, the longer it takes for this to happen, the greater chance that the recession will worsen and fundamentals will start deteriorating."
Are Values Falling?
Current conditions have been likened to the Zen question, "if a tree falls in the forest and no one is there, does it make a sound?" Trying to answer the question proves impossible because it cannot be solved rationally. With commercial real estate, the question is, "if a seller doesn't want to sell (or buyer doesn't want to buy) and there is no deal, then is there a price decline?" Trying to answer that question right now is equally mystifying.
Some market observers are seeing declines and others are seeing continued strength. First let's hear first from a couple of bears.
"We have further to go in the downside of commercial real estate. It never got as overheated as residential, and there are underlying fundamentals to its value, in contrast to where the single-family market raced, however, there is no question that the relative availability and price of capital drove values in commercial as well," said Michael Green, principal of Virtu Investments in Carlsbad, CA. "With the recent pullback, we have and will continue to see a decline in values. It is close to 10% today already and has at least that far to travel again before this is over."
"Prevailing wisdom is that it will be less in those stronger, core assets and locations, and more in B and C assets in the tertiary markets, as a correlation to access to capital," Green continued. "However, there will be large players with core assets that made inappropriate leverage decisions (Macklowe) akin to Bear Stearns and Carlyle [Capital Corp.] in the financial sector that will get caught and forced to re-price which will have a sobering affect on all our values for the next few years. Real estate has returned to its roots, cash flow, long-term appreciation and tax benefits. The fun of trading it like stocks has come to an end."
Carlyle Capital defaulted on $16.6 billion of debt and has determined that it is insolvent and that investors will not likely to get any proceeds after its operations wind up.
Jason K. Check, an acquisitions specialist with TPG Residential in San Juan Capistrano, CA, said that 20% negative value adjustment is a conservative estimate.
"Although few sellers are willing to admit the truth that exists today, if any of these same groups are out in the market attempting to acquire deals, they understand that lenders have fundamentally adjusted their underwriting practices. No longer will lenders agree with proforma income expectations," Check said. "Any deal getting done today, and for the foreseeable future, will be on balance sheet and be based on conservative [debt service coverage ratio] DSCR of from 1.2 to 1.25 and in-place [net operating income] NOI. All speculation aside and assuming a 75% [loan-to-value ratio] LTV, this mathematically equates to a 20% - 25% correction in value or additional equity required to get a deal done."
Even that estimate incorporates an assumption that market fundamentals are not adversely affected by our current economic malaise, Check said.
"If you build in a decrease in commercial real estate occupancy levels, thereby lowering in-place NOI, valuations for certain commercial real estate assets may adjust well beyond 20% to 25% from there market peaks," Check said. "It took nearly a decade to construct the complex financing mechanisms that enabled new entrants in our industry to obtain 95%+ leverage and outbid more conservative groups focused on market fundamentals. It will take several years for the industry veterans to re-establish their footing in a new market."
Bull Market or Baloney
Steve Alter, CEO and founder of Real Capital Markets in Carlsbad, CA, said: "We see a tremendous amount of the daily volume which has to some degree leveled but it's our opinion that there are still enough buyers out there that can also close all cash that they can still make a market even when the markets might be slower than they have leading up to the past 6 to 9 months. These all cash buyers such as the pension funds and the foreign buyers have recently allocated larger amounts that is ear marked specific for the larger real estate transactions right here in the U.S. as well as other cities around the globe. What we're seeing maybe is more of a run from the traditional stock and bond investments and into the hard assets such as precious metals and even real estate."
"Today the real estate market is truly a global market place and there is no better example of this than the real estate market in Manhattan," said Elliot Bogod, managing director of A&I Broadway Realty in New York. "There are several key fundamentals driving this marketplace today. Manhattan has always been seen as an attractive place for foreign buyers to own real estate as a means of diversifying their global asset holdings. A key factor driving the recent surge in demand has been the relationship of the U.S. dollar to foreign currencies. This month, the U.S. dollar surpassed the $1.50 per Euro mark for the first time in history and the U.S. dollar is also at a low relative to many other currencies including the Canadian dollar for the first time in history. Many foreign buyers, including Asians, Canadians, and especially Europeans, who previously did not invest in the U.S. real estate market are now considering real estate purchases in Manhattan."
Industry observers in other markets, too, notably Florida and Las Vegas, echoed Bogod's sentiment.
"While deals are unwinding and not getting done across the country, here in Las Vegas, multi-billion dollar deals are closing left and right," said Eddie Haddad, president of Great Bridge 1031 in Las Vegas. "Building after building is going up at the 12 million-square-foot World Market Center, the largest Furniture Mart in the world. Goldman Sachs just completed its purchase of the Stratosphere Hotel and Casino. Dubai is getting involved in not only Project City Center with MGM, but is developing the second and greatest Project City Center North, at the corner of Sahara and Las Vegas Blvd. We are expecting 50,00 hotel rooms to open in the next two years, creating 125,000 jobs. With families, this is an additional 250,000 residents moving to Las Vegas. We won't have enough housing in the next two years."
However, the markets are giving clearly warning signals, said Marc Thompson, a member of the Counselors of Real Estate for 10 years and senior vice president of Bank of the West in Walnut Creek, CA, where he manages lending operations for health care properties.
Thompson reiterated remarks he made at a recent Counselors of Real Estate seminar.
"It is my contention that the combination of a high demand for investment real estate and favorable lending market conditions for investors created a significant credit bubble," Thompson said. "As a result, a higher risk for deflation of income-property collateral values now exists for income property investors and owners of income-property collateralized debt, including commercial banks."
Thompson holds to the theory that the most optimistic investors stand to lose the most.
"The most optimistic investors, such as hedge funds (Bear Stearns) and investment banks (Merrill Lynch), were first to get hit with losses in the [residential mortgage-backed] securities market," Thompson said. "It is apparent that the [commercial mortgaged-backed securities] CMBS market is at the tipping point where actual losses may begin to occur. The warning signs follow the same line of logic as observed in the MBS market collapse."
The numbers of loans of concern in CMBS deals are growing and defaults are likely to rise, if for no other reason than they are at historical lows.
Also, Thompson said commercial bank lending dropped to $9.2 billion in third quarter of last year from $37 billion in the second quarter because of the aversion to risk.
"The ultimate irony here," Thompson said, "is that the U.S. consumer now needs readily available capital more easily than ever, but they're going to have the most difficult time getting it."
Substitute the word consumer in that quote with commercial real estate investor and it is pretty much the same story.
It's a Catch 22. At a time when liquidity is needed to refinance and or complete deals, it is not easily available. No matter how willing the federal government is to provide liquidity, traditional lenders are reluctant to invest in risk or in products in which values cannot be determined. And until there is more liquidity, it will be hard to determine what damage the financial storm is taking on property and investors. And until the damage can be assessed, fewer deals will be getting done.
Additional Comments
We've heard from a lot of readers regarding this topic and here share additional pertinent ideas and insights.
In Denial
It became quite obvious to me a few weeks ago that many people were still not aware of how serious the problems were and how much it is affecting not only the residential real estate market but all sectors. I had comments from people who I thought were knowledgeable about the current real estate situation say "well the commercial market is not affected" I was quite surprised. Maybe it just takes a little longer to see the cause and effect of how one sector affects the other. It is obvious now that Bear Stearns was in denial that many of us were also in denial.
My market is the South Florida market. I have seen a slowdown in the industrial leasing of space since October 2007. I have noticed many more spaces available from the 5,000 sq. ft. up. I have seen more commercial properties available on the market "For Sale" which include industrial buildings, not only the condo warehouse buildings which started to become more plentiful in the last 12 months. I have seen many development sites offered "For Sale" for multi-use buildings and this is trickling into all the markets. I have seen more vacancies in retail space. The office vacancies had started showing up and more companies were allowing employees to work for home offices.
Marianne Winfield
Broker
Brickell Bay Realty Group
Fort Lauderdale, FL
Just Beginning
The Wall Street financial crisis is a leading indicator and is just beginning. CRE is a lagging indicator and has hardly begun. The house of cards our economy built around lax regulation, mindless credit, reckless spending, and overseas deficits is now crashing. The slide in CRE values will unwind slowly and endure for three to four years.
Steve Collins
Environmental Liability Transfer
St. Louis, MO
Keynesian Schmeynesian
Our economy is headed and has been headed downward for well over a year. It had been fueled with speculation, a wartime mentality and an administration and Congress that could not leave politics aside and let the market place fall or rise to it's on level. We could end this current malaise within it's own time by leaving it alone. There is really nothing that is going to 'save our economy' but patience.
Those whom unwisely speculated on the economy are bound to fail, the question is only when and by how much?
As our economy continues to fail, our ability to meet our obligations fail, our employment base fails, hence our ability to produce goods and service fails. The value of our currency is tied to our ability to produce these goods and service. (Economics 101) Hence the vicious circle continues to cycle.
Harvey M. Jacobson, MBA
CEO
Keller Williams Realty MarketPlace - Commercial Division
Henderson, NV
Grassroot Problems
I broker apartment properties and have done so for 30+ years mainly in the Atlanta area. Most of the properties I deal in are "B" and "C" grade properties in low to low-middle income areas. I have always said that if one wants to know what is happening in the economy at the "grass roots" level, talk to managers of apartment properties to see the level of the "Economic" Occupancy in properties they manage. In lower socio-economic areas collecting the rent is always a challenge, but I believe it is more of a challenge in these economic times based on the many operating statements I analyze. Additionally, the ability to reduce concessions and therefore effectively raise rents is a real challenge. Therefore, the value of many of the "B" and "C" apartment properties is at the least not going up that much and at the worst is some cases is being reduced compared to a few years ago.
Roy Wright
Senior Vice President - Brokerage Services
Love Properties Inc.
Atlanta, Ga.
Only Themselves To Blame
I work in the employment industry. As I go to job fairs, areas of high layoffs, etc, I see far more employers that are trying to hire the laid off workers than the number of workers available. I see many people changing industries looking to find more stability. I am guessing that we have a stable but yet unsure customer confidence level that is being swayed by the latest media influence. Wall street is in trouble because they are much more of the cause of this meltdown than anyone else, but let's see what happens.
When I look at the real estate bubble. I see a bunch of greedy people that made very unwise buying decisions. They went from good business sense, to greedy get rich quick style decision-making. Yes, I see the economy suffering greatly from a relatively small number of people that made very poor decisions. I see that they need to take a hit to learn a lesson, and if we bail them out they will just do it again. To me the indicators are directly related to whether they learned their lessons or not. As we climb back out of this set back, will they just shift to a new industry to be the "savior" of their stupidity or will they choose to take their time but make wise choices. If they take their lumps and invest in long-term investments, then I'm not worried at all about the economy. If the environment hasn't changed, then it will only get worse.
Eric Stauffer
Employment Connections Inc.
Spencer, IA
Stick to the Basics
Sellers who want to sell can present an opportunity, however discipline and hard work are required. This is a time to stick to the underwriting basics and do your homework: you need to pay careful attention to tenant quality, construction, location, etc.
Terri A. Gumula
Vice President, Commercial Acquisitions
Real Estate Capital Partners
New York, NY
Spending Drop Points To Worsening Conditions
It's going to get BAD! Mortgage Equity Withdrawal (MEW) will continue to drop and as a result, consumer spending will fall and continue to fall. The U.S. needs to continue to grow its exports and manufacturing. The only wrench to the machine here is if our buyers of imports also fall into recession.
Vacancy rates are a key indicator and they are increasing. Consumer spending drives business growth and consumer spending is dropping at an increasing pace. It's imp[possible to grow business if consumption falters. In addition, most of the business growth in Southern California was real estate related, and included Realtors, title companies, and mortgage companies. This industry is now faltering and creating huge commercial vacancies. In addition, as we enter this recession, other companies will fail and create more vacancies.
Louis A. Atwell
Deputy Director of Public Works
City of Downey
Downey, CA
More and More Difficult
I think that there will be a significant reduction in commercial land values over the next couple of years. Not as bad as the residential meltdown, but still significant, and there will be a flight to quality. Poorly located commercial land won't sell without large price reductions. Leasing activity is way down, so it's getting more and more difficult to line up anchors, which in turn makes it difficult to do a development deal.
Jason Weber
Director of Acquisition
Cole Companies
Phoenix, AZ
Apartments Counter Cyclical
Speaking from a broker's perspective who specializes in B and C class multifamily in the Dallas/Fort Worth area, operations in that arena are at a historical high and should continue to climb. This type of product moves counter to the residential market and to the economy as a whole. When the economy is depressed or moving in that direction people look to save money by leasing a less expensive unit. They also "double up" by taking on a roommate when they may not have considered that option in the past (important to have a good unit mix). D/FW currently leads the nation in multifamily teardowns and it is not economically feasible to build C-class product. Therefore, I would recommend a commercial real estate investor diversify their portfolio with an asset class that currently cash flows, benefits from a sluggish economy at a price where they could warehouse the land for future development.
Todd Franks
Senior Vice President
The Cantrell Company
Dallas, TX
Solvency Crisis
There is not really a liquidity crisis but there is instead a solvency crisis. The vast amounts of risk that have been conveniently parked off-balance sheet needed some off balance sheet capital reserves to go with them! The average consumer needs to go back to having a positive savings rate (this produces a depression in the short term but also provides traditional benefits for individuals and the nation in the longer term). The current administration seems to want consumers to go back to spending far more than they earn - however too many years of negative savings have done damage that is not easily or quickly unwound.
James Bond
Major Properties
Los Angeles, CA
Election Bump Up To Come
As a real estate Broker and investor for many years, I have seen these adjustments in the market come and go. Few have matched the government directed collapse of the '80s for size and devastation to the national economy. I believe the future holds tremendous opportunity for growth because of the elections and the excitement surrounding a new leadership. Historically, politicians have been among the most active and influential investors in real estate. They are currently still buying and investing and will most likely continue until the economy cannot absorb the foolish bailouts that our government continues to do. They liberally use the people's money and benefit by that use until the people rise up to stop that misuse.
Larry V. Locke
McAllister & Associates
Austin, TX
Do it Yesterday
As far as I can tell, it's not a question of whether we're in a recession, it's a matter of how much worse it's going to get. Those who waited to buy and shored up cash are going to see some great deals in the next six months. When it comes to locking in financing, you need to do it yesterday unless you run the bank yourself. I don't see much that investors can do who are already in the market. Those who were patient will obviously fare a lot better. A good deal is a good deal in a good or a bad market. It's just a matter of whether or not the banks are going to be using the cash that the Fed gave them to shore up their positions and start lending. We're at a freeze if they just bury it in their yards.
John J. Tilley
Director of Real Estate
Jacmar Builders
Alhambra, CA
Never Before Unexplored Territory
One of the lowest default rate securitization pools on the planet, the CMBS has literally been wiped off the planet, the majority of portfolio institutions are cutting back lending allocations, and we will likely see a great number of banks fail once the commercial side starts to default. It just gets harder to get deals done today. The effort it takes to complete a deal is much higher than it needs to be.
Suffice it to say that we just saw the worst jobless report in five years, the majority was not housing related (and that is just starting to slide, retail jobs will go next)...we have the lowest home equity ratio since they started tracking it in 1945...the highest default rate ever...highest ratio household debt to income ever...and the list goes on. Not to mention that we've got the U.S. dollar at record lows...record high energy costs...and skyrocketing health care and food costs.
The scariest thing afoot isn't the historical parallels though, it's the host of major negative factors in play that we've NEVER seen before. What seems to get lost in the endless conversations on the subject is that we have never before seen such a "hollow run up" in the R.E. market, and that therefore historical parallel analysis is of limited value.
Christian Lawrence
Vice President
George Smith Partners
Los Angeles, CA
Unexplored Territory
The end is unknown, but in our view the fundamentals of the commercial real estate market have not changed significantly. Tenants need space to function and from which to operate their business. High quality locations are still in demand, and despite the market, many commercial businesses are looking to expand.
At Situs we have been focused on technology and process improvement initiatives along with highly trained outsourcing as solutions to manage costs and information flow. Many of our customers are using the downtime to get a handle on the current performance of their CRE portfolios, determining if the reserves are sufficient against potential impairment and raising additional capital for new investment ventures.
Ralph Howard
CEO
The Situs Cos.
Robbins, NC --------- 
About CoStar Group, Inc.
CoStar Group, Inc. (NASDAQ: CSGP) is the leading provider of information services to commercial real estate professionals in the United States and the United Kingdom. CoStar's suite of services offers customers access via the Internet to the most comprehensive database of commercial real estate information on 66 major U.S. markets and the United Kingdom. Based in Bethesda, MD, the Company has approximately 1,000 employees throughout the United States and the United Kingdom, including the largest professional research organization in the industry. Article used by permission. Copyright 2008 CoStar Group.
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