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Bifurcation in the Commercial Real Estate as Demand Outstrips Supply, For Now

Written by Peter L. Mosca on Wednesday, 31 March 2010 7:00 pm

[Note: To follow is an excerpt of a radio show interview conducted by Peter L. Mosca, host of Income Property Investment Talk dot com, with Dr. Sam Chandan, Global Chief Economist and Executive Vice President of Real Capital Analytics (RCA) and adjunct professor of real estate at the Wharton School of the University of Pennsylvania. To listen to the show archive or download an MP3, go to]

Mosca: The services of Real Capital Analytics are based on your proprietary database of commercial property transactions. The integrity of your data is unparalleled. I know your company goes to great lengths to make sure that your data is timely, accurate, and completely objective. That said, what is your interpretation of that data as it relates to current trends in the economy that are most relevant to commercial real estate?

Chandan One of the things we see very clearly right now and it's quite consistent with previous cycles both for the economy and for the real estate market. What's happening with rents, what's happening with vacancy rates, what's happening with net operating income both of those measures of real estate market activity are lagging the trends that we see in the broader economy. for people outside of the real estate sector, this can sometimes come as a bit of a surprise. What we have is a critical juncture in the economy where all indications are that conditions are improving. Even in the labor market, although we have not had a meaningful decline in the unemployment rate, although we are not creating a large number of new jobs that are bringing people back to work, the number of jobs that we've lost over the last couple of months has been a small fraction of the types of job losses and the magnitude of job losses that we are experiencing early in 2009. That being said, when we look at some of the trends in the real estate market specifically what our data shows on the investment side of the market, capital trends in terms of mortgage performance as well, it's very clear that as we move forward into 2010 we face a continuing set of challenges in commercial real estate whether we are talking about apartment buildings, what we will refer to as multifamily properties, retail, office, hotels, industrial, or development sites.

Mosca: I read a quote from Dan Fasulo at Real Capital, "Well if Sam Zell is getting into the market, that might say something to a lot of people." What do you think?

Chandan: For every individual investor, depending on the nature of their capital source, depending on their cost of capital, and depending on the time horizon for their investment they are going to have to make an independent decision about the right timing for the market. One critical differentiator is that all investors need to be very careful of the fundamentals for the real properties, for the office buildings, the apartment buildings, because it can lag the economy in a very significant way. Even if you are able to identify a very good investment opportunity for yourself and the price seems right, the market seems right, the capital is available, you have to have a strong operational capacity. Again, assuming you are in a property or investing in a property or taking exposure to an asset where there will be some degree of exposure to the market over the next couple of years, each and every one of us are going to have to contend with the fact that it is a difficult environment in which to maintain occupancy, in which to manage the relationship with the tenant. There are going to be continuing strains on cash flow.

Mosca: What is the CPPI and what is it telling us right now?

Chandan: Moody's Commercial Property Price Index, the CPPI, is an index that is fed by Real Capital's transaction data There was a slight up check in prices for properties and this does come as a bit of a surprise again for some people who do also see that if levels of distress, delinquency, defaults on commercial mortgages continue to rise how is it sometimes seems counterintuitive that we might actually see a slight price increase. There is a lot of capital sitting on the sidelines. There are a large number of investors both domestic and foreign that have raised pools of equity and over the last year have waited very patiently but all things considered are growing increasingly frustrated at a lack of opportunity to really invest that capital. What we do see is that for the potential targets for those investors they may want to buy well performing office assets or apartment's assets in very liquid metropolitan areas, the 24 hour cities on the two coasts of the country. The number of investment opportunities that are available to them, the number of properties that are unoffered that meet the profile, and the characteristics of the type of asset they would like to introduce to their portfolio, those opportunities are still very small in number and so when some of these assets are becoming available in the market, we surprisingly see that there is actually a fairly robust bidding for these assets and that's supporting some degree of improvement in pricing.

Mosca: What does that say about the market?

Chandan: We have bifurcation in the market. By that I mean that again we have bidding and interest in those very good quality assets, assets that are performing on a fundamentals basis because occupancy in particular is so highly valued right now. The next couple of years are going to be particularly challenging for commercial real estate fundamentals. It will be a while before we see vacancy rates coming down and rents increasing again. So, where you do have solid tenants in place, where you don't have significant exposures to the market as a result of impending lease rollovers, that occupancy where it is stable, good quality credit tenants that is very highly valued and those properties are seeing very healthy bidding. On the other side of the market, we may have assets that perhaps are in metropolitan areas where the economy is weaker, where the recession has taken a greater toll or where some characteristic of the asset leaves the investors to believe that it will fundamentally underperform not only over the course of the next couple of years but it will very difficult to get that asset really to the point where it was in 2006 and 2007 at the peak of the market. Those assets are available for sale in larger numbers but what I think we have to recognize is that those characteristics of the property, the fact that occupancy is so valued but these properties may have high vacancy rates are resulting in fairly weak bidding for those assets.

Mosca: Does an investor have to manage their cap rate and cash flow expectations in this particular marketplace? Could they expect or should they expect the numbers to be the same as they were before maybe in the early 2000s?

Chandan: We need to be very careful about how we look at an individual property's cash flow, its tenant role, and when it will have exposures to market when thinking about how that asset will perform. For the foreseeable future, we need to be not only realistic about how property level cash flow will change but we need to in many cases be very prudent about anticipating where there could be downward pressures on cash flow. In as much as this has been a very unusual cycle in the economy, certainly there is a great deal of debate in economic circles around the nature of the recovery, the extent of the recovery that we'll have. I think for listeners, it's critical to remember that commercial property fundamentals depend critically upon jobs. We've lost an unusually large number of jobs over the course of the cycle. We are still in an uncharted area in terms of our thinking about what the new sources of jobs will be. Where will those new jobs come from? What will be the time frame over which we replace all of the lost jobs from the last two years? It's only until we can see very clearly that new jobs are being created, ultimately resulting in new demand for office space, driving payroll and wage growth, supporting retail space and ultimately industrial warehouse distribution. Young people critically need to find their way back into the labor market in larger numbers so that they can be demanding apartments. All of those things need to happen. We do at the individual property in metropolitan area levels need to think about how is that going to impact my expectations for the property level cash flow. One thing I should add there is that the cycle can be fairly protracted. You mentioned the early 2000s. We reached a peak, for example, if we just look at the office sector for a moment in property fundamentals in 2000. Then we had a recession that began in early 2001, at least technically the National Bureau of Economic Research tells us that it ended in November of that year. How long was it before we started to see a meaningful improvement in property fundamentals after the end of that last recession? What we actually saw was that vacancy rates for office properties at the national level continued to trend up for another two years after the recession ended. It wasn't until the 4th quarter of 2003 and the 1st quarter of 2004 that we saw we reached a peak in vacancy rates and over this entire period rents are still falling. After that, it was about another two years before vacancy rates had come down enough that we started to see some meaningful improvement in asking and effective rents. This is a four to five year cycle over which fundamentals were declining before they began to then improve again and that requires an unusual degree of patience when we are thinking about taking investments in positions in the commercial real estate market.

Mosca: We have had guests on Income Property Investment Talk dot com who spoke about international investors and their desire for U.S., assets. What are your thoughts?

Chandan: When you look at a survey done here by the Association of Foreign Investors in Real Estate, they work with and they survey active investors on the global stage and they inquire about which markets those investors might target. What are the markets where they see the greatest potential for asset price appreciation? The results of the most recent survey from earlier this year complement data that we've collected at Real Capital that shows that foreign investors remain very interested in the US market. For all of the challenges we faced over the course of the last couple of years, in spite of the fact that in the minds of many of these investors, the root of many of the challenges that we've faced in the global economic environment over the last couple of years have had their roots right here in New York and other parts of the United States in part because we have relatively higher cap rates here. They do perceive that the US and some very specific markets in the US that this is really the target market for them at this particular juncture. This is something that the Real Estate Round table in Washington has also taken an interest in when you look at their current policy agenda and they are working with legislators and policy makers. One of the items on the list is a potential relaxing of FIRPTA, the Foreign Investment Real Property Tax Act, which assesses a tax against gains that are realized by foreign investors into US real assets and REIT stocks. That is something where there are certainly constituencies in the market who feel that there are a large number of foreign investors both on the debt and equity side who have an interest in coming to the United States, being active within the US market, and we should remove some of these disincentives. My particular view is that we can relax FIRPTA. It's not necessarily going to result in a sudden uptake or a sudden flood of new capital to the United States. I think changes will occur fairly gradually and in part that's because foreign investors are already very interested in taking exposures in the US market. One thing there that we do have to be realistic about, I think you mentioned it already is that there are only a finite number of cities within the United States that really do enjoy the full extent of the benefit from investment flows into the US. There are the major coastal cities both on the East Coast and West Coast but for the vast majority of individual metropolitan areas foreign capital inflows are not necessarily a significant factor.

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