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Commercial Real Estate Market to Hit Bottom Next Year, Urban Land Institute

Written by Peter L. Mosca on Tuesday, 06 January 2009 6:00 pm

No matter the market, capitalizing on industry knowledge has always been a major ingredient to overall business success. For builders looking to better understand the real estate market, they should take note of a new report by the Urban Land Institute. According to the "Emerging Trends in Real Estate® 2009" report, released by the Urban Land Institute (ULI) and PricewaterhouseCoopers LLP, real estate industry experts expect financial and real estate markets in the United States to bottom in 2009 and then flounder for much of 2010, with ongoing drops in property values, more foreclosures and delinquencies, and a limping economy that will continue to crimp property cash flows,

"Commercial real estate faces its worst year since the wrenching 1991-1992 industry depression," conclude industry experts interviewed for the report, which projects losses of 15 percent to 20 percent in real estate values from the mid-2007 peak. "Only when property financing gets restructured will pricing recorrect so we can find the floor; and this transition could wipe out companies and people," said one respondent interviewed for the report.

In general, interviewees believe that financial institutions will continue to be pressured into moving bad loans off balance sheets, using auctions to speed up the process. Investors will be discouraged until the "bloodletting' is over, states the report. When that occurs, cash and low-leverage buyers will be "king;" surviving banks will impose strict lending guidelines; commercial mortgage-backed securities will revive, but in a more regulated form; and opportunity funds will need new investment models.

"The industry is facing multiple disconnects," said ULI Senior Resident Fellow for Real Estate Finance Stephen Blank. "Many property owners are drowning in debt, lenders are not lending, and for many (industry professionals), property income flows are declining. There is an unprecedented avoidance of risk. Only when financing gets restructured will pricing reconcile, giving the industry a point from which to start digging out of this hole."

"The cyclical real estate markets always comes back, and they will this time too, but not anytime soon," said Tim Conlon, partner and U.S. real estate sector leader for PricewaterhouseCoopers. "Commercial real estate was the last to leave the party, will feel the pain in 2009, and may be the last to recover. In the meantime, smart investors are going to hunker down and manage through these tough times. We expect to see patient, disciplined, long-term investors rewarded, and return to a back to basics approach to property management, underwriting and deal structure."

Distress in the housing market is benefiting the apartment market, which the report lists as the number-one "buy." Moderate-income apartments in core urban markets near mass transit offer the best buy, a trend that carried over from the previous year.

The report acknowledges that commercial markets will recover more quickly than most housing markets, and homebuilders may have to sell land tracts for "cents on the dollar" or face foreclosure on their holdings, adding to the already high rate of mortgage defaults and foreclosures.

One silver lining: Interviewees agreed that eventually, savvy investors will be able to cash in on the inevitable recovery, which some see occurring as early as 2010. "Money will be made on riding markets back to recovery and releasing properties, not on…financing structures," finds the report.

Before a rebound, Emerging Trends says the following needs to happen:

  • Private real estate markets need to correct - lenders must force distressed owners to become motivated sellers.

  • Debt capital needs to flow - lenders will need to learn to deal in a more stringent regulatory landscape. The commercial mortgage-backed securities (CMBS) market must "reformulate." ? Regulators need to restore confidence in the securities market. The government will insert itself into overseeing mortgage securitization markets. Systemic overhaul promises more measured debt flow.

  • The economy needs to improve. Falling demand for space won't affect real estate markets severely until 2009.

The Report also offered these tips for what to do in 2009:

  • Recap distressed borrowers - invest in maturity defaults, construction loans/bridge loans, or take mezzanine positions and equity stakes in properties.

  • Focus on global pathway markets - 24-hour coastal cities.

  • Staff up asset managers, leasing pros and workout specialists. Separate good assets from bad.

  • Retrench on development and reorient to mixed-use and infill. Higher-density residential with retail will gain favor in next round of building. ? Go green - cutting energy expenses is likely to be a priority.

  • Buy or hold multi-family; hold office; hold hotels; buy residential building lots, but be prepared to hold.

  • Purchase distressed condos in urban areas near transit.

Lastly, the Report listed a number of markets to watch in 2009. Here's a look at the Report's Top 5 Markets:

  • Seattle boasts its "corporate giants," but the market braces for rising downtown office vacancies; now at 10 percent. Tepid job growth will flatten rental rates. Housing demand drops and prices will slip, but stay above national averages. Interviewees rate the market a strong "buy" for apartments, and the "number-one buy" among industrials is the Puget Sound ports.

  • San Francisco offers a Pacific gateway and a high quality of life with a well-diversified economy. The city ranks first for development and homebuilding, and is a leading "buy" city for apartments and office. Even though housing prices are expected to decline, foreclosures should remain in check, the report notes.

  • Washington is the "ultimate hold market when the economy struggles." Downtown office vacancies should remain below 10 percent, and apartments lease "no matter what." The above-average employment outlook offers promise for the retail sector, the report says. Still, office vacancies continue to soar in northern Virginia, and further declines in condominium and home prices can be expected.

  • New York takes a beating with the Wall Street "implosion" creating job losses and office vacancies. Hotels should continue to draw tourists with the weak dollar. Retail frenzy ends, but the wealthy keep Madison Avenue boutiques alive. With the condo/coop market at a "crest," developers "should worry about flagging buyer demand," the report notes.

  • Los Angeles downtown benefits from condo/apartment projects. "It's almost impossible to lose money on apartment investments if you have a five- or 10-year investment horizon," notes one respondent. Hotels benefit from global pathway location. One downside -- homebuilders in San Bernardino and Riverside continue to grapple with the housing collapse.

Rounding out the top ten markets to watch:

  • Houston. Stays relatively strong as long as energy stays hot. It makes the top ten for the first time since 1995. Office vacancies drop to 10 percent, "a good buy opportunity," but apartments soften. Cheap land results in cheap housing, and prices have not gone up dramatically.

  • Boston. Job outlook is more favorable than most cities, with office space "tight" in the Financial District and the Back Bay area. New "harborside hotels threaten older product."

  • Denver. The state capital has a major federal government presence, which should buffer job losses. Steady population growth and broadening diversification of the industry keeps the housing market stable. Mass transit should pay future dividends.

  • Dallas. Compares favorably to other "hot-growth" markets. Although office vacancies downtown are 20 percent or higher, apartments do well and developers keep building single-family homes.

  • Chicago. Apartments do well, but condos weaken as speculators leave the market. Office vacancies are in the low teens, and O'Hare International Airport keeps industrial space in the "global pathway."

While most of the findings in the ULI Report were unfavorable, there were 'silver linings' mentioned. For builders looking to seek competitive advantages, possessing the best knowledge available about the industry should help the process lead to greater success.

[Note: Now in its 30th year, Emerging Trends is a highly regarded annual industry outlook for the real estate and land use industry and includes interviews and survey responses from more than 600 leading real estate experts, including investors, developers, property company representatives, lenders, brokers and consultants.]

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