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CRE Outlook Choppy, Uneven for Cities, Property Types and Firms

No "V" Here, Industry Expected to be in for a Long Slow Recovery Characterized by Extreme Caution
August 11, 2010
The near-term outlook for the commercial real estate market may be clouded over concerns that stronger job creation is needed to support the nascent economic growth, the impact from possible deflation and the winding down of government stimulus, but its prospects remain somewhat bullish over the longer term. However, most expect the economy to recover in an uneven fashion, characterized by wide variations among markets, property types and firms, according to a new crop of CRE outlooks issued this summer.

The good news remains the fact that an accelerating inflow of capital to the commercial real estate market continues to come from a wide variety of sources, including institutions, foreign investors, private equity and REITs, according to Prudential Real Investors in its latest U.S. Quarterly Market Perspective. Investors are attracted by the sector's improved outlook, signs that prices have bottomed and that the foreclosure crisis will not be as widespread as previously feared, as well as by prospects for more-attractive returns relative to other investment options.

Still, the outlook varies by segment, Prudential said. Growth in the near term appears to be strongest in the apartment and hotel sectors because their relatively short lease terms enable them to react relatively quickly to economic growth. Meanwhile, the industrial, retail and suburban office sectors are likely to rebound much more slowly because they are more dependent upon the direction of job growth. Some 600,000 jobs have been created this year, still a fraction of the millions of jobs lost during the recession. As a result, the pace of growth has to pick up greatly before real estate fundamentals can improve significantly.

Value and Maturity Gaps in Office Markets
CoStar Group's most recent base case forecast indicates that, for its index of 54 office markets tracked by Property Portfolio Research, office property values are expected to rebound by about 25% approximately five years after their late-2011 trough, said Tiandan Wu, debt analyst for CoStar. However, this will leave them at 77% of peak values. Only 11 of the markets are expected to regain their previous peak by the end of the decade. The rest will likely experience a much more drawn-out recovery.

With values down from peak levels for an extended period, there will likely be plenty of borrowers who will have trouble rolling over their loans. The "maturity gap" represents the difference between future available refinance proceeds and balloon balances. Consider a sample of loans that originated at the peak and will mature in 2019, with 70% loan to value and a 30-year amortization period. Based on the forecast's change of values from 2007 to 2019 and the estimated maturity gap, the 54 markets fall into three categories.

Markets in Category 1, such as Boston, Chicago, Houston, enjoy the strongest value bounceback. With an average value that settles at a new peak higher than the 2007 level, they are most likely to get the green light when it comes to refinancing.

Markets in Category 2, such as Baltimore, Cleveland, hav eoffice property values that are not expected to reach their 2007 peaks, but they come within shouting distance of them, and since growth is relatively strong, they enter the safety zone as well.

Markets in Category 3, such as Detroit, Miami, Hartford, Philadelphia and San Diego are expected to continue to see a wide gap between values at origination (2007) and maturity (2019), which translates into a maturity gap that is hard to work out.

Executive Sentiment Still Cautious
Unstable market fundamentals and uncertainty over government policy are among the significant concerns voiced by senior real estate executives about the economy's tepid performance and the commercial real estate sector's outlook for recovery, according to The Real Estate Roundtable's Third Quarter 2010 Sentiment Index.

"Uncertainty reigns. Whether it is job creation, unstable capital markets or a volatile mix of current policy and the upcoming mid-term elections -- investors and businesses are skittish, causing the commercial real estate outlook to be flat," said Jeffrey DeBoer, Real Estate Roundtable president and CEO. "The good news is that last quarter's view that commercial real estate markets have stopped falling has been confirmed this quarter and values for high quality assets show strength. But the overall sentiment is that the industry is in for a long slow recovery characterized by extreme caution,"

Although a total of 62% of the survey participants reported real estate market conditions today as "somewhat better" than a year ago (down from 65% in the second quarter), only 19% said conditions are "much better" (up from 17% last quarter).

Looking forward, 59% of respondents predicted conditions one year from now will be "somewhat better" (down from 60% in the second quarter), whereas only 20% expect conditions one year from now to be "much better" (down from 28% last quarter).

For real estate asset values, respondents reported some improvement in expectations, yet emphasized the gap between valuations for Class A assets and all others. According to one survey respondent, "The market remains very murky. The few quality assets that do come to market tend to attract rabid bidding, but there's still general illiquidity."

The respondents also reported that the instability of capital markets remains a significant cause of unease, although conditions have improved marginally since the previous quarter. One executive noted, "Our concern is that the pending loan maturities in the next three years continue to outpace the capacity of lenders to provide sufficient refinance capital. Assuming that the recent 'extend and pretend' practices cannot continue indefinitely, does this suggest that we are in for another round of value decreases in the commercial real estate sector?"

CRE Will Drive Municipal Credits
While most U.S. municipalities will feel no more than a marginal ripple effect of the commercial real estate downturn, some municipal issuers will be left more vulnerable to performance pressure, according to Fitch Ratings in a new report.

Despite improving indicators, commercial real estate fundamentals are still weak and are expected to remain so for the short to intermediate term, which has direct revenue inlays for numerous municipalities.

"Municipal bonds most at risk include special assessment and tax increment bonds, along with hotel tax and sales tax secured bonds," said Eric Friedland, a Fitch managing director. "Cosmopolitan and diverse metropolitan global gateways appear to be the most resilient, while bubble/bust and rust belt metro areas are the most vulnerable."

This is reassuring news for general obligation and tax supported bonds in global gateways with a high amount of multifamily and retail properties such as New York, San Francisco and Seattle. Conversely, tax increment and special assessment bonds in bubble/bust and rust belt locales with high hotel and warehouse property concentrations are of substantial concern, namely Phoenix, Las Vegas, Detroit and Cleveland.

Among economies with CRE concentrations, Fitch is most concerned about those concentrated in hotels, followed by office, retail, and warehouse, with multifamily the most stable.

Ranked from most to least risky, bonds at most risk from a CRE downturn are those secured by special assessments and tax increments, followed by hotel taxes, sales and other broad-based taxes, and finally general obligations.

Fitch considers the most cosmopolitan and diverse metropolitan areas (global gateways) most resilient, with regional hubs less resilient, and resort/retirement, bubble/bust, and rust belt metropolitan areas the most vulnerable.

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