This is the second installment of my notes and comments from Institutional Real Estate, Inc.’s Dealmakers Summit (Sept. 14 – 16, 2009). This section regards the state of commercial real estate and the outlook for commercial real estate.
STATE OF REAL ESTATE and OUTLOOK
Most people are well aware that real estate is currently wearing the ‘dunce cap’ in public sentiment. Given how well real estate held up in the last recession (2001-2002), however, real estate has had quite a run (17+ years). The housing market unfortunately, is reinforcing negative sentiment; most of the populous just doesn’t discern a difference.
The downturn is certainly showing up in transaction volume, which, according to several sources, is off somewhere around 90% this year.
It now seems everyone is also aware that commercial real estate fundamentals are on the decline. Most landlords reported making ‘blend and extend’ deals with tenants that have the effect of eroding net operating income. Most landlords are also predicting that fundamentals will continue to erode for at least 24 months, although most report that decision makers are postponing decisions as long as they can, leading many to believe that things could get worse before they get better. This continuing downslide will be caused mostly by job losses and reduced consumer spending (although jobs seem to be the main factor).
The consensus among real estate veterans is that the economy must recover before rent growth resumes. One analyst purported that fundamentals will return six to ten months after GDP growth resumes.
A major topic of discussion at the conference was the fact that there is no market-clearing mechanism (e.g. creation of the RTC after the S&L crisis) as a tool to quickly ‘clear the bench’ and get back to normalized deals. Consensus is that we have to clear the market ourselves and that it will take some time (up to five years) to return to normalization. At the end of the day, the market needs to clear bank inventory of bad debt. It is affecting both the capital markets and leasing markets (given market views that there are large blocks of excess space on the market).
The capital markets will likely recover prior to a rebound in fundamentals. Most investors, however, believe values will drop another 10% before industry can call a bottom. Little to no capital will flow into the market until investors can comfortably call the bottom, even if the bottom turns out to be in the past. A full recovery will be marked by equity players starting to buy vacancy again.
However, even in the absence of a fundamental or capital recovery, inflation may drive capital into real estate quickly. This could subrogate the negative sentiment of fundamental declines. On the other hand, if debt yields go up because of ‘bad credit’ – governments over borrowing and reduced credit profile, then even though this may look and feel like inflation, capital will not go into real estate.
One commenter stated that land would be the first asset class to recover, but yet there is absolutely no market for land right now. That particular speaker works at a large bank in the REO department and further explained that his bank is holding on to land while waiting for recovery. Therefore, you might be able to infer that land may be a leading indicator.
In summary, I’d expected capital markets to rebound in 12 months (give or take) and fundamentals to begin to improve after 24 months. Until then, we remain in a period of deteriorating fundamentals.
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