If anything has been predictable about the 2011
commercial real estate market recovery, it's that it has been unpredictable. For a year that began with much promise following the increased leasing activity, thawing capital flow and widening investor interest that characterized the second half of last year, the momentum in the market seems to have flattened out.
This has been more baffling than discouraging to real estate professionals across the country. Key indicators across a wide number of local markets still hold promise for more vigorous activity. However, according to a survey of readers conducted by CoStar News, landlords, lenders, investors and tenants just aren't making the connections in the marketplace needed to jump start a sustained recovery.
Bryan Cook, a broker with KW Commercial in Knoxville, TN, said commercial bankers, still shell-shocked from the precipitous decline in property values in the recession, are anxious to lend but still very cautious.
Greg Eisenman, an associate in the Retail Service Group at Colliers International in Atlanta, said landlords are seeing lots of activity as tenants fish for deals. The brokers spend a lot of time working through them, only to have the prospective tenant pull the plug once it comes time to make a commitment.
Ronald Fraser, principal/broker of Fraser Real Estate Group in Dallas, said he is seeing continued demand for commercial real estate by investors at the right combination of cap rate and price. But the majority are looking for "deals" and are for the most part unwilling to look at the reality of local market values because of the news they hear and read on the economy.
Stuart Scott, vice president at Daum Commercial Real Estate Services in Camarillo, CA, said that the European debt crisis, stock market correction and continued high unemployment levels have pushed people into a frozen state of indecisiveness, and that the up-again, down-again volatility that occurred in the first half of the year will likely continue in the second half.
These views provide a summary of the comments CoStar Group received from industry professionals that it asked to assess first half CRE market conditions. What follows are the extended comments of others. Their observations, analysis and insights provide depth and color to current market conditions, and are indicative of other comments we received as well.
Where's The Volume? Pricing Is at Pre-Inflation Peaks
John W. Stone, Principal and Managing Director Multifamily, Colliers International, Tampa Bay
I specialize in multifamily, which has been the leading indicator in the industry for the past 18 months. Sales volume has steadily picked up in the Tampa Bay market with a reported $600 million closed so far this year. This is more than double of what it was this time last year ($277 million).
Also cap rates have dropped from a weighted average of 7% to 6.44% even though the overall quality of what has sold has dropped (price per unit has fallen from $74,800 to $62,600).
The thing that is surprising is that the sales volume isn't considerably more!
What is driving my surprise is that most economists and banks are predicting that interest rates must rise and most expect a 100 basis point increase by end of 2012. If market fundamentals hold true, this would suggest that cap rates also must rise thereby resulting in a reduction in market value.
If one believes what the economists and banks are saying, then why aren't more properties being sold now while the pricing is at what appears to be a peak?
While there are as many reasons as there are investors, the most common reason for delaying a sale is to give management time to increase the bottom line. Over the past 18 months average market occupancies have increased from 82% to 92%, concessions have dropped by almost half and rents have nudged up for the first time in several years. This has had a very positive impact on the NOI, but can that type of growth continue?
The question looking forward is -- can management increase NOI by 14.8% in the next 18 months? Why 14.8%? The reason is that 14.8% is the minimum amount you must increase NOI in order to maintain the same sale price if cap rates rise in step with interest rates.
Most managers I have spoken with do not believe they can affect such a large increase in NOI in the forward-looking 18 months. Assuming this observation has any merit, then banks and owners interested in maximizing their sale price should be selling now rather than waiting.
What's Up with Value Add? Fundamentals Can't Support the Risk
John B. Collins, Senior Vice President/Principal, Lee & Associates, Newport Beach, CA
The most surprising trend is the investment community's appetite for "value added" office investments in Orange County since there has been no evidence of rental rate growth and virtually no positive absorption. The lowering of rental rate prices hasn't increased demand.
Moreover, the large supply of underperforming buildings will make it very difficult for these "value added" investors to see rental rate growth because so many buildings are treading water and, for the foreseeable future, they will undercut what value-added investors need to shore up their underperforming assets.
On the industrial front, the most surprising trend has been the staying power of the Orange County industrial ownerships and reluctance to sell. Lease rates have dropped much more than the corresponding sale prices. However, the "old line" individual ownerships are reluctant to re-invest and improve their buildings. While cash-strapped small-cap and mid-cap industrial businesses/tenants who are having a hard time getting loans from lenders are not able, or don't want, to dip into their cash reserves to improve buildings.
I do not anticipate sale prices to drop much, but I also do not expect tremendous appreciation in the near term for building sales. Lease rates will stay depressed for quite some time.
There will be periodic "distress" sales that illustrate that an owner ran out of staying power and sold quickly. There will also be periodic "high" prices illustrating that: a good manufacturing or engineering business really wanted to buy; the building price was relatively small in the businesses overall proforma; the lack of supply provided few options, but that owner wanted to buy and the price was still good relative to peak pricing; and interest rates are great.
I expect "value added" investors to be surprised and disappointed that their investments will not hit the targets that they have proforma'd.
Office and industrial tenants will be able to find tremendous opportunities in well-located and functional buildings. Unfortunately many won't take advantage of this -- causing the good leasing opportunities to last for 18-plus months. The great/good sales deals will still be available, but the supply of quality buildings in good locations is limited.
Buyers should realize that inflation is coming and if you buy a building and secure a great loan, when inflation hits you will be well-positioned for asset appreciation. Buying a bad building at a lower price will most likely not produce a better investment than buying a good building at a slightly higher price.
Fundamentals Somewhat Fragile
Jonathan Larsen, Executive Managing Director, Transwestern, Los Angeles, CA
With regards to the Los Angeles office market, the fundamentals are still somewhat fragile. We are lagging behind other comparable-sized metros in the recovery. I think only Washington DC and San Francisco have shown real sustained progress.
Los Angeles has not exhibited a significant decrease in its office vacancy rate, a significant pattern of increased absorption, rising rental rates or pattern of an increase in leasing activity that New York, San Francisco, Washington D.C. or for that matter Chicago has witnessed in the last few quarters.
With that being said, recent acquisitions in the Los Angeles office market have not been justified by market fundamentals, but are the result of a mixture of overcrowding and attractive relative pricing, relative to other major metros in the limited core-plus and value-add pool we have here.
The speed at which our local investment market has so comfortably gotten back to normal levels (surpassing pre-recessionary highs) in spite of still fragile fundamentals is surprising.
The most relevant trend, though, has been the continuing downsizing and renewal activity as firms look at efficiency and cost savings as well as the ability to move up in quality and location. As this space comes back to the market, it will be interesting to see how this balances out with the demand.
Los Angeles has become a great commercial property investment market for international investors, as far as being a safe place to invest with long term growth versus other alternatives of international grade. I think this trend will continue into the near future six months as excess capital looks for returns and looks to Los Angeles as a bargain alternative to more costly markets or to other second tier overpriced markets that are not global gateways.
This shift in demand, which is already occurring, will continue to flush out assets from all avenues: off market deals, banks, special servicers to a hopefully more normal distribution.
Difficult To Achieve Momentum
Jason Wolf, Senior Vice President - Office, Colliers International, Mount Laurel, NJ
The most surprising trend during the first half was how difficult it has been to achieve any kind of momentum. The first quarter of this year was encouraging, and then activity decelerated sharply during the second quarter.
This was similar to the trends during the second quarter of last year when the stock market volatility impacted business decisions and activity slowed due economic jitters.
South Jersey has been one of the more active investment submarkets. The major REITs -- Liberty Property Trust and Brandywine Realty Trust -- have been selling non-core assets.
In Southern New Jersey and also in the Pennsylvania suburbs, there are a numerous properties in special servicing or that have been taken back by the lenders. As these assets are stabilized, we could see a wave of properties on the market. This may be the actual real estate or the debt on the properties.
There are some large requirements in the market, so we are hoping that activity will be picking up during the third and fourth quarters. We don't anticipate any increase in rents, but if activity increases, some of the landlords may start pulling back incentives on some of the upper-tier buildings.
An Uptick that Flattened Out
Bill Gladstone, Principal, Bill Gladstone Group, Camp Hill, PA
There was an uptick in activity, although prior to the end of the second quarter it did start to flatten out for the larger deals. There still seems to be that surge in smaller deals- sales and leases (aggregate value) under $400,000.
Most surprising is that land development looked like it was going to take off in the first quarter, but it fizzled by the end of the second quarter. In the first half of last year, we had one, maybe two land development plans submitted to municipalities for their approval. This year at the same time we have five. But there is an end in sight - it has started to level off.
Office leasing is still making its comeback - slowly but with stability. Office is the precursor of jobs; more
office space leased, more jobs are being created. This was also true in the flex market and to some degree in the big box warehouse market as proposals actually started turning into deals by the end of the first quarter and beginning of the second quarter.
I don't know that we will see a noticeable difference in anything related to real estate in the second half of 2011. The second half of 2012 is probably more likely to show more than just a small uptick in the market.
Corporations Refocusing On Longer Term RE Needs
Peter D. Reed, Principal, Commercial Florida Realty Services, Boca Raton, FL
Corporations are finally making decisions on their mid- and longer-term real estate needs. We have seen more companies looking out 60+ months rather than the 12 to 24 months that was more the norm the last couple of years. One would hope that these longer-term lease commitments will help satisfy the new loan underwriting conditions.
The fact that decisions are being made on corporate real estate side should help with a more steady flow of business the remaining part of the year and into 2012. Hopefully some of this optimism will spill over to the lending side, but that has yet to be seen in South Florida.
I would hope that we see some properties coming to the market for sale from the loan servicers. There is a tremendous amount of properties in some form of foreclosure and those properties being brought to market and eventually sold, and or recapitalized will help in the overall real estate recovery. However, we will need the help of lending sources to assist in this process and that has yet to seen.
A Banking Policy that Lacks Sense
Michael Buls, Principal, Buls Hodge Consulting, Austin, TX
The national application of a policy (for making) no significant commercial loans is stifling the growth in the areas of the country, like Austin, where good performing loans can be made. This is coupled with the bizarre policy of not refinancing balloon notes on performing real estate, or demanding an unrealistic reduction in principle. It is devastating to the recovery and expansion in cities on the verge of a boom like Austin.
With the Austin market starting at around 20% vacancy at the first of the year, the first two quarters were dominated by large blocks of space being taken down by companies relocating to Texas or expanding their Texas operations.
But the contradiction was that the small leasing market of 5,000 to 20,000 square feet was almost non-existent. As we approached the end of the second quarter, the small market picked up. It appeared to be a trickledown effect as the increased economic activity allowed smaller professionals to increase space, or open new offices.
In some form or fashion, development of significant flex space or existing site plans will take place to fill the gap of dwindling space for large users of 20,000 to 100,000 square feet. Also, with citywide occupancy of Class A apartments at 95% there will be big push to get some apartments built.
Financing Gap Between Institutional vs. Non-Institutional
David B. Duckworth, Vice President, Flagler Real Estate Services LLC / ONCOR International, Boca Raton, FL
The volume of transactions here in South Florida in the first quarter was mostly attributed to institutional grade property sales. But that did not translate into more sales of the smaller non-institutional grade
investment properties.
Financing is non-existent right now for non-institutional investment properties and that is causing the gap between institutional and non-institutional properties to widen significantly. The private investor that has significant cash at their disposal is looking for bank-owned distressed properties.
We are starting to see banks take back more significant assets this year. In the past 18 months, most of the bank-owned inventory comprised of smaller, owner-occupied product or land. I expect to see more foreclosures of Class B and C office buildings or note sales, and as a result values will continue to decline. That trend will continue until the rental market stabilizes and we start to see strong positive absorption.
Debt Markets Still Very Skittish
Juan Vega, Jr., Senior Vice President, Carter, Tampa, FL
For me, the most surprising trend is how little capital is making it to the streets. Private equity has been a challenge as private investors are looking at an investment from every angle before they risk their money.
The debt markets are still very skittish as banks are still deleveraging as well. If someone wants to buy land, the best they can do currently is 50% LTV, on a 2-year term. Banks just do not want land or speculative real estate at this time, as they are still paying back the TARP moneys and increased required reserved figures due to recent changes in the laws.
Ceteris paribus, I expect this market is going to be in a state of 'Groundhog Day' for the next few years. As jobs increase in the Florida market, that is when you will see housing start to turn around, affecting the industries that build the houses.
Cash is Out There, But Sellers Expect Higher Prices
Brian Duncan, Partner/Sales & Marketing, Tyler - Donegan Real Estate, Ijamsville, MD
We recently did one small deal in which both the bank and SBA were quick to lend, fund and close. Granted it was a small deal, 13,200 square feet, and a cold lit shell that needed TI funding as well.
We see a lot of small deals and investment deals, less of the 30,000- to 50,000-square-foot deals. I also know of a $10 million deal where the bank gave a very aggressive rate on a nearly 50% occupied building that allowed it to cash flow. Which is awesome.
There is a definite appetite to purchase among traditional investors with cash. I seldom see strong end-users on the purchase side. The investors will drive sales.
It appears that large institutional buyers have the capital to buy appropriately priced office, retail and industrial facilities. Not really shocking, but until we see the return of the mid-size investor and mid-size buyer the region will have higher than desired vacancies, which will in turn create more opportunities for investors to pick up deals.
Sellers are still having issue with market values and at times are still expecting pre-bust prices.
Signs of Some Recovery, but Not Enough To Drive Occupancy
Ron Murfin, Executive Vice President / Director of Sales, Penn-Florida Cos., Boca Raton, FL
There are signs of some turnaround. But while activity has picked up, net vacancy decrease has not been significant. This is partially due to continued failures by companies weakened by market conditions but that should level off during the second half of the year.
There have been an increasing number of companies entering the market that require some or all of the following: downsized space, reduced occupancy expense, more convenient location, more amenities, concessions in the way of free rent and/or additional tenant improvements.
The most relevant aspect of the increase in activity is shorter lease terms with lower rental rates. Landlords are generally agreeing to the lower rates, but requiring shorter lease terms so that the lower rates will not have an adverse effect on the long term valuation of the building. We expect to see more of these lower rates on smaller spaces however, by year end, the trend will be reversing.
The market will not see new product in the near future and vacancy rates in general are leveling off. The first quarter of 2012 should see a decrease in vacancy rates with stabilized lease rates.
Nothing Beats a Recession Like Shopping in New York
Steve Rappaport, Senior Managing Director, Sinvin Real Estate, New York, NY
My practice area is store leasing and my niche is downtown Manhattan. Within that frame work, my response is simple. Business has been great, trending toward incredible.
That began not just in the first half of this year, but early on in 2010. Why? A weak dollar bolstered tourism, Wall Street recovered, and the famous resiliency of this city. Manhattan's attraction is its vibrancy and creativity, which could not be dampened by any economic slowdown.
New York is a city of immigrants -- a magnetic draw for people from all over the country and the world. This fueled a quick recovery in the neighborhoods where I work. I represent relatively small spaces, on average 1,000 to 2000 square feet.
Leasing rates lowered in the depths of the recession. That attracted, rather than frightened entrepreneurs. First-timer retailers and seasoned small store owners sensed opportunity and began taking space long before the corporate world felt safe to expand.
Now that both are again in the picture, the result is a distinct lack of available space in the primary stretches. For example, on Bleecker, Spring, and Prince streets, there are hardly any vacancies. And even on secondary blocks, is it becoming hard to find a good store.
This problem is especially acute in the food business. There is much less useable space available for this requirement than what is sought. I have literally 20 customers for any decent store. Good for landlord's. Not so good for tenants.
Owner-User Industrial Picking Up
Neil Sawicki, President/Broker, Global Real Estate Advisors Inc., Cleveland, OH
I see the banks getting very aggressive on owner-user industrial facilities and they have loosened up their belts a little on the credit. I have completed four deals within the past week and the banks were very cooperative and worked well with my clients.
We are seeing a lot of small CNC machine operators growing, expanding and merging with others. I also see a lot more companies starting to rebuild inventory on the industrial side. On the retail side we are seeing more new retailers getting into the market on a small scale.
Investment real estate seems to have hit a block with the banks. Banks still have not opened up to financing any type of investment property. We have buyers but no source of funding for investment properties.
I expect to see a slow and gradual increase in the manufacturing - industrial sector. I see the effects of transportation costs, natural disasters in Japan, China and overseas bringing back the manufacturing in the U.S. I also feel the labor costs will rise in the foreign markets making us more competitive in the global market.
One Good Deal Can Make a Difference
Donald N. Noland, Jr., Director New England Research, Cushman & Wakefield of Massachusetts Inc., Boston, MA
During second quarter, Vertex announced plans to build new 1.1 million-square-foot headquarters and laboratory space in the Seaport district, which is just adjacent to the Financial District, the core area of the CBD. This transaction will change the landscape in the Financial District for years to come relative to diversification of tenant base and expected transaction activity to follow. This was one of the largest transactions on record in the Boston CBD and is a relocation to the CBD from Cambridge market. Demand in the Financial District market will improve with this announcement.
I expect to see a continued tightening of available space in the upper floors (greater than floor 16) in the Financial District's class A office towers. In addition, the already recovered Back Bay submarket (6.3% current vacancy) will drive tenant requirements to the Financial District.
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