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Commercial Real Estate in 2010: Weak Fundamentals and Constrained Liquidity

Other Forecasts for the New Year Show Continued Weakness but Some Moderation
January 6, 2010
The outlooks for the New Year have begun coming in and a review of year-end forecasts for 2010 show that many commercial real estate industry watchers remain fearful of weak fundamentals and constrained liquidity. Yet, they also reveal some optimism in some sectors, such as homebuilding and lodging.

We've compiled a few of the outlooks here, organized from more-doom-and-gloom to brightening outlooks, which is how most of them view how 2010 will play out: starting out rough but improving the further along we get.

"The commercial real estate industry is a disaster waiting to happen," said Andy Bogdanoff, founder and chairman of Scottsdale-based Remington Financial Group, a capital services company told a meeting of industry representatives recently. "With U.S. banks in a deep and continuing liquidity crisis and with $1.2 trillion in commercial debt due to mature by 2013, thousands of real estate owners and developers across the country will soon find themselves between a rock and a hard place when their loans mature,"

"Even if bank liquidity weren't an issue, estimates are that two-thirds of the securitized loans and half of the whole loans due to mature between 2010 and 2013 would not qualify for refinancing due to today's more stringent banking standards," Bogdanoff said.

Bogdanoff added that the unprecedented high cost of funds, coupled with a 40% decline in real estate values since 2007, further compound the problem.

"With property values less than the original debt, thousands of owners and developers may have no choice but to sell their properties at a loss or face bankruptcy when their loans mature. If the problem isn't solved soon, the result could be a disaster for the commercial real estate industry and the U.S. economy as a whole."

That view was supported by others who predict a hard slog toward economic recovery in 2010 as businesses weighed down by debt hit rough patches and credit markets shun them. Nearly half (49%) the respondents to the Turnaround Management Association's distressed industries forecast think durable economic improvement is unlikely until at least the second half of 2010. About three out of 10 think the worst is over, but nearly 20% suggest the economy has yet to hit rock bottom.

Three out of four respondents said they think the commercial real estate industry will fare the worst in 2010 as debt matures and lenders remain reluctant to refinance.

"Capital markets, the life blood of real estate, remain stressed," said Anthony S. Graziano, chairman of Integra Realty Resources, Inc. "Deal flow has dwindled to a crawl due to limitations on new financing and requirements for larger equity positions. Refinancing has become difficult as credit markets continue to tighten with strict lending standards, and real estate lending competes with the government's liquidation of local and regional banks. Yet this year's report does contain signs of life in each sector."

"We expect that 2010 will continue to provide mixed signals with regard to the recovering economy and real estate markets," said Jeffrey Rogers, president of Integra. "Values are down 43% from their peak in October 2007, and the Integra Commercial Property Index predicts a further decline of 5% in the next six months. Transactions volumes should recover somewhat from their lows in 2008 and 2009 due to the return of some liquidity in the credit markets. However, volumes will be significantly less than their 2006-2007 highs. Two economic pitfalls to watch will be consumer credit and oil prices. There is significant danger that consumer credit delinquencies and defaults could rise drastically in 2010."

REITs: Improved Liquidity but Weak Fundamentals

Despite improved liquidity profiles and access to the unsecured debt market, weak property operating fundamentals across the U.S. equity REIT sector and the uncertainty as to the exact timing of a full economic recovery remain areas of concern for U.S. equity REITs in 2010, according to Fitch Ratings in its 2010 Outlook report.

In addition to weakening market fundamentals, U.S. equity REITs continue to have above-average leverage in comparison to historical levels. Substantial amounts of follow-on common equity were raised during 2009 across the sector, the proceeds of which were used to repay outstanding indebtedness. However, Fitch remains concerned that future deleveraging actions are less likely in 2010, given the dilutive nature of most follow-on common stock offerings.

Fitch said that the recovering U.S. economy is still subject to economic shocks and expects the pace of expansion will likely be weaker than previous recoveries.

"If liquidity and access to capital remain strong, expect more rating affirmations and fewer downgrades and downward Outlook revisions that characterized 2009," said Steven Marks, managing director and U.S. REIT group head for Fitch. "Conversely, less access to capital and increased use of secured debt will put a strain on liquidity," which Marks added will lead to a more circumspect view of the sector.

  • Despite weakened fundamentals, Fitch maintains a stable outlook for multifamily REITs in 2010 due to limited supply and continued access to low-cost financing from Fannie Mae and Freddie Mac.

  • Health care REITs' stable outlook is largely driven by demographic trends that continue to benefit the health care sector, portfolio diversity and limited supply.

  • Meanwhile, the prospect of further store closures and weak leasing activity will continue to weigh on retail REITs (negative outlook). Overall retail sales in 2010 will be flat to up modestly from 2009 levels, translating to soft consumer demand due to high unemployment levels, continued challenges to consumer credit and ongoing U.S. household deleveraging.

  • Unemployment remains a more pivotal factor in the health of office REITs (negative outlook). While the economic recovery is underway, office REIT fundamentals will not improve until unemployment begins to decline.

  • Above-average leverage and a slow economic recovery, which has reduced overall productivity and the need for space, are the key drivers behind the negative outlook for industrial REITs.

Lodging: Still Bad but Looking Better

The pace of recovery of the U.S. lodging industry has accelerated from previous expectations, according to PKF Hospitality Research in Atlanta. Improving industry data for such key indicators as occupancy, RevPAR and demand suggest that the recovery will arrive a full quarter earlier than the firm expected in September 2009.

"Make no mistake about it, 2010 will continue to be a tough year for U.S. hotel owners and operators," said R. Mark Woodworth, president of PKF Hospitality Research. "We are forecasting that, on average, properties will continue to suffer year-over-year declines in revenue and profits from an already dismal 2009. However, given the deceleration of room rate discounting that we observed during the third quarter of 2009, we believe the severity of the losses incurred in 2009 and 2010 will be less than previously forecast. In addition, year-over-year growth in important measurements, such as occupancy, RevPAR and demand, will be realized a full quarter earlier than we were thinking three months ago."

"While our forecast for ADR movement in the third quarter was a bit pessimistic, we recognize the change in pricing trends and have applied it to our thinking regarding the future. Accordingly, this year's annual ADR forecast has been reduced to a decline of 8.8% and our 2010 ADR forecast is now a minus 1.5%. These compare to declines of 10.4% and 3.1% that we forecast last quarter," Woodworth said.

PKF-HR is also now forecasting lodging demand to post a quarterly year-over-year increase during the first quarter of 2010, thus ending eight consecutive quarters of declines. On an annual basis, PKF-HR is now forecasting lodging demand to rise 1.9% in 2010, up from the 1.6% increase forecast back in September.

Homebuilding: Four-Year Downturn Coming to an End?

With various macroeconomic housing and related statistics bottoming about mid-year 2009 and subsequently moving forward in fits and starts, a four-year downturn has evidently come to an end for U.S. homebuilders, according to Fitch Ratings in its outlook report for the sector.

While Fitch maintains a Negative Outlook for U.S. homebuilding in 2010, the expected conclusion of the national housing credit has positively influenced housing data over the last few months. Pending home sales, existing home sales, single-family housing starts and single-family new home sales have been generally showing improvement after bottoming out earlier this year. The same holds true for new home inventories, home pricing and consumer and builder sentiment.

Nevertheless, Fitch anticipates that the early stages of this expansion may be more muted than the average.

During the first 12-15 months off the bottom, the recovery may appear jaw-toothed as substantial foreclosures now in the pipeline present as distressed sales and as meaningful new foreclosures arise from Alt-A and option ARM resets. High unemployment rates and the probable tightening of certain FHA loan standards (higher minimum credit scores for new borrowers and greater upfront cash requirements) will be notable headwinds early in the upcycle.

"The continuation and expansion of the national housing credit should partially help offset expected seasonal declines during the winter months through the spring of 2010," said Robert Curran, managing director and lead U.S. homebuilding analyst for Fitch. "The federal government's continuing efforts to moderate foreclosures may also show some success in 2010."

"With operational and financial pressures moderating to some extent, most public homebuilders have to operate successfully within this still challenging environment or wither away," said Curran.

Companies have to at least maintain current cost profiles or continue to downsize to the point where they can remain/be profitable (excluding nonrecurring real estate charges). That means possible further moderate cuts in staffing and other overhead, as well as other cost reductions.

Fitch expects the economy to return to positive growth next year, primarily reflecting the impact of the fiscal stimulus package, but also some likely stabilization in housing investment and a weakening inventory overhang.

Download this story and all of the stories in the Watch List Newsletter here. The Adobe pdf version also includes all of this week’s leads of distressed properties and loans of concern, lease cancellations applied for in bankruptcy proceedings, local and national facility closures & layoffs, banks with distressed real estate portfolios and lists of loans approaching their maturity date. Plus the pdf version contains bonus news items not found in these columns or the CoStar Group web news pages.

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