Marcus & Millichap's Hessam Nadji: How This Recession Differs From the Last One

Hessam Nadji, chief of research for Marcus and Millichap, says job losses, the amount of troubled inventory that comes onto the market, and when companies will shed their fear of the economy are wild cards in the CRE market recovery.

Hessam Nadji, the managing director of research services for Marcus & Millichap Real Estate Investment Services, has been a leading go-to figure for divining the state of commercial real estate marketss since the mid-1990s.

Nadji joined Marcus & Millichap in 1996 as vice president of research and was promoted to managing director in April 2000. Formerly, Nadji was the national director of research and information services for Grubb & Ellis Co., where he was responsible for managing the company’s national research group, including real estate and economic analysis for all major real estate sectors. He now oversees Marcus & Millichap’s research division, including economic and real estate information tracking, analysis and the production of the group’s various publications.

With first-quarter metrics and analysis in the books, CoStar Advisor called on Nadji for his take on the state of the economy, his outlook for property prices and investment opportunities, the role of cap rates and any other important trends he sees going forward.

CoStar Advisor: What's the good news, if any? Will there be an economic recovery this year, or in 2010?

Hessam Nadji: We think job losses and the recession will end in 2009. We’re expecting that job losses will bottom by the third quarter, perhaps into the fourth quarter. For 2010, if you look historically, we’ve had plenty of instances where sharp declines and severe and sudden recessions have been followed by years of growth spike and better-than-average growth -- especially the first year after a recession. But this time around, we still have a significant amount of consumer debt to unwind and we’re still dealing with a lot of headwinds in housing and corporate debt. I don’t think 2010 will bring an economic spike. We’ll see positive job growth of 1% to 1.25% and positive 2 ½% to 3% GDP growth, much of it coming from simply seeing the housing market bottom. However, I don’t think housing will bottom this year. We’ve seen the bottom of the sales cycle, but pricing has not yet bottomed. We don’t anticipate that until late ‘09 or the first part of 2010.

Advisor: What does that mean for commercial real estate?

Nadji: Our industry as a whole lags the general economy by six to nine months, and the office and retail sectors lag more, while apartments and industrial are more responsive to the economy. We expect a quicker positive effect from the economic bottoming, and at least showing moderate expansion, in the apartment and industrial market. If GDP is moderately positive, hotel demand will also be somewhat positive. But office and retail will lag because of the hit we’re taking in financial and professional services on the demand side -- and the amount of sublease space coming to market.

Retail is going through such a significant restructuring of tenant mix, with tenant lineups changing due to bankruptcies and consolidations, that it probably will take longer to recover -- probably until 2011 or ’12. You have to remember that retail, unlike the other product types, did have a fair amount of overbuilding prior to the recession. The others have more of a demand problem to resolve in this recession, versus retail, which has both a demand and oversupply problem to resolve. By 2011-12, the economy should be on a different growth path -- the worries will be about inflation and how the Fed needs to remove the stimulus that it’s already pumped into the system.

Advisor: What’s the most important thing we don’t yet know about the short- to medium-term outlook for commercial real estate?

Nadji There are three vital things. We need to know how long job losses will stay at these extreme levels. In most recessions, we saw job losses of 150,000 to 225,000 jobs a month. In the first part of 2008, they were below those averages. Right now, we’ve been at 600,000 to 700,000 losses per month since November; we’re now in an extended period of extreme job losses. The expectation was that the escalation of job losses was a ripple effect of what happened in the commercial paper market freeze-up and interbank lending freeze-up last September and October. You would expect that to have tapered off by now. But it hasn’t and I think we’re in for it for at least another couple months. Most indicators say job losses will remain high for at least another couple months. That’s a big wild card - how long will it take companies to move off this level of extreme fear?

We also need to know how much distressed inventory is going to appear and move through the market. I believe a lot of buyers with lots of cash are sitting on the sidelines looking for signs of an economic bottoming and waiting to see the scale of distressed property sales. Over the next six months, we’re going to get a better reading on the market because both financial institutions and owners of properties are still having stress and they’re going to have to decide what to do with those assets. I think there will be more motivation to sell at more realistic prices than there was a year ago.

Advisor: Is there any evidence that recent office trades in New York or other transactions in different markets has helped set a benchmark for prices?

Nadji: We’re starting to see some trades. There’s the beginning of enough of a pricing reset to show some transactions clearing the market, including some larger properties and quality assets. So far, distressed inventory has been limited to lower-quality properties in secondary and tertiary markets. That’s beginning to change as we see more core quality properties coming to market. But those are far less distressed. The price correction that’s necessary to get the market moving again is starting to happen. It will take another six months to really establish new pricing in the marketplace and for buyers to feel pretty comfortable that we’re getting close to the bottom.

One or two high-profile deals are not going to refine the market. Its going to take a little more volume, and a sampling of different asset sales in different places starting to trade, for it to become more of a widespread conviction that it’s time to get back in.

Advisor: Are cap rates still a good or accurate barometer for where prices are and where they’re heading?

Nadji: That’s a very good question. A lot of our clients don’t really look at the cap rate the same way that they used to. That’s not to say that no one thinks about cap rates anymore -- they certainly use it as a metric -- but you have to look at return on cash, number one, and using the new underwriting parameters to clear this market for financing, which requires more equity up front and much more realistic rent growth projections and occupancy projections. That would lead you to look at the return on investment for years year one through three in terms of cash flow, which is right now far more important than just a cap rate, which you can come up with in so many different ways.

Right now, investors are asking, ‘What’s my risk tolerance? I’m having to put up more equity and be more conservative about rent growth and occupancy, with the potential that over the next 18 months, I’m actually going to see further decline in property prices?’ Then you have to gauge what the upside is, because when the market comes back, we’re going to get above-average rent growth, just as we’re having a severe rent decline now. We’re going to move from severe rent declines in 2009 and 2010 to 2% - 3% rent growth in 2011-2012, especially for apartments.

Advisor: Have we turned a corner on the outlook for financing and in the capital markets?

Nadji: Not yet. Over the last three months, financial markets have actually gotten tighter. The banks are still dealing with their own liquidity issues even though there are promising signs, and profits were impressive in the first quarter on the operations side.

Advisor: What impact will the Term Asset-Backed Securities Loan Facility (TALF) program have on the commercial real estate debt market? Will TALF make much of a difference in terms of reassuring investors?

Nadji It won’t be immediate, but it’s a step in the right direction because it starts to move some assets off balance sheets. A $1 trillion target is a good start. It’s not going to fix the market for financing but it’s a step. We need to see a series of things that will allow banks and other financial institutions to get back into lending, and that’s not a quick fix. I think it will take the better part of this year for banks and financing to start to move toward normalization.

Advisor: What’s the toughest question you’ve received lately at an industry meeting?

Nadji: The key question is from buyers. Should they wait to see more distressed inventory come to market at cheaper prices? Or should they make an investment now? For a lot of the investors that we interact with around the country, we’re advising them that the handling of commercial real estate is probably going to be very different than the 1991-93 cycle.

Back then, banks and S&Ls that went bust held the loans. The government took over those institutions, the loans were on their balance sheet, it was very clear where those assets were in terms of financing and performance. That enabled the RTC [Resolution Trust Corp.] to become a very effective institutional clearinghouse and move a lot of inventory out into the marketplace. This time around, though, the loan structures -- because of the securitization of a large chunk of the distressed assets -- is far more complicated because they’re not owned individually or on the balance sheet of any one lender. They are in pools that brought in investors from all over the world.

The master servicers have a lot of restrictions on how they can treat properties during distress, which leads to a lack of an immediate foreclosure and an indecisive way of moving the assets out. Plus, the financial institutions right now are not at a place where they can tolerate more losses or write-downs.

Rather, the forces are working to minimize foreclosures, and therefore this notion of an RTC 2.0 that will bring quality assets to market at huge discounts may not materialize the same way. Meanwhile, because of what’s going on with economy and financing, there are quality assets on the market now that are trading at far more reasonable prices than at any time in the last 15 years. There’s more need to sell properties, therefore pricing has become more reasonable.

If you’re a buyer with a particular market or product type, and have a value creation strategy, I think there are a lot of choices in the market even as we speak. It’s a great time to buy in some priority markets with quality assets and for a long-term hold. And on a value-added basis or higher-risk, higher-return basis, there are plenty of those transactions available as well.