The Return of Liquidity Has Eased Industry Fears, but Debt, Fundamentals Still Worrisome
While commercial real estate values have not rebounded in the first six months of the year, the fear that 2010 was a disaster waiting to happen has subsided as liquidity has started flowing back into the market, according to new reports out this past week from PIMCO and PricewaterhouseCoopers.
The pair of reports suggest that, for institutional quality property at least, property values have found a bottom and cap rates have peaked and could even start to subside. Neither of the reports is projecting a worry-free environment, however, in fact both are projecting a long, long road to full recovery.
"While most investors sense that the worst is over in terms of market deterioration, supply greatly outweighs demand across all property sectors keeping overall vacancy rates high and rental rates on a downward trend," said Susan Smith, director, real estate advisory practice, PricewaterhouseCoopers. "Top-tier locations are showing the most signs of life with respect to tenant interest and recovery potential. However, inspiring leasing trends have yet to fully materialize, further contributing to this sense of market flux."
Commercial real estate investors seem frustrated and disappointed at the lack of quality buying opportunities that many expected would have materialized by now, according to the second quarter 2010 findings of PricewaterhouseCoopers' (PwC) Korpacz Real Estate Investor Survey. The report notes that the unknown speed and strength of the economic recovery has many investors anxious, with the uncertainty surrounding the large debt volume coming due in 2011 and 2012 amplifying their angst.
In the quarterly survey, the average overall capitalization rate, a key measure of investors' expectations of property income and value, declined in 17 of the survey's 30 markets over the past three months, an indication that investors perceive less risk in the industry now, particularly for prime properties and better markets, according to the PwC survey.
The 'bottoming' of the industry continues to be recognized by investors' expectations that overall cap rates will either decline or hold steady in most markets over the next six months. Specifically, survey participants forecast overall cap rates to hold steady in 18 of the survey's 30 markets. Furthermore, the survey data revealed that 13 markets could see overall cap rates decline by as much as 100 basis points in this time period.
Surveyed investors cited potential declines in near-term overall cap rates in the Manhattan office market, the national warehouse market and the national apartment market (all three segments down as much as 100 basis points).
For individual office markets included in the survey, average overall cap rates remain lower for central business district (CBD) submarkets than for suburban counterparts, suggesting that investors continue to see less risk and better investment potential in the major CBDs.
"There is a tremendous amount of capital targeting institutional-grade, quality assets," Smith said. "In fact, survey participants cited that strong competition among well-capitalized buyers is helping to elevate sale prices and lower overall cap rates for many prime properties. Furthermore, the low percentage of distressed trades as of late reflects investors' preferences as most buyers are steering clear of 'junk' and focusing only on core assets according to survey participants."
John Murray, commercial real estate portfolio manager and head the PIMCO's CRE/CMBS team, also reported that capital is clearly returning to commercial real estate, helping to stem the value declines in the sector. But, his report stressed that optimism should be tempered because national price indices are misleading when transactions are limited and fail to reflect the significant uncertainty around property valuations.
"Capital has returned to CRE and high levels of bidding activity in certain sectors have made many observers and participants optimistic," Murray wrote in his report. "Transactions have generally been limited and capital flows have been concentrated in trophy properties and in properties where below-market agency financing is available. This has provided a false sense of clarity on the real level of property values. A significant volume of weaker and distressed assets has yet to be liquidated and this foreshadows further pressure on values. Against this backdrop, we caution against the presumptions that a rapid broad-based recovery is underway."
Murray is not as optimistic on the direction of cap rates as PwC survey participants.
"We expect that the spread between cap rates and 10-year Treasuries will remain above its average of 265 basis points seen since 1995, as the litigious deleveraging process leads to a sustained period of risk aversion in the sector," Murray wrote. "If cap rate spreads remain above their average, the market can expect long-term cap rates near or above 8%. In this case, even if properties with floating rate debt can successfully avoid defaults in the short term, rising longer term rates will create a floor for cap rates and limit recoveries."
As the deleveraging cycle unfolds, attractive opportunities are likely to be available to investors with capital, Murray wrote. Although, he warned that capital flows alone should not be a gauge of where attractive investment opportunities lie.
"Many owners in primary markets are perplexed by the extent of non-US capital flowing into their markets. With this in mind, new investors should not expect a continued rapid appreciation in pricing for trophy assets in these markets," Murray wrote. "Conversely, owners of grocery-anchored retail assets in smaller markets express frustration in securing financing today, despite strong tenant profiles and positive demographics. As capital returns to CRE, we expect this yield spread (as reflected by cap rates) between trophy assets and less liquid, quality assets in smaller markets to eventually tighten."
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