Strengths Outnumber Weaknesses, But CRE Recovery Will be a Grind in 2012

Posted on October 28, 2011

Two more Big Four public accounting firms have issued outlooks for 2012, each noting that improved commercial real estate estate fundamentals are expected to navigate a slow and uneven path to recovery that will be heavily influenced by evolving U.S. and global economic conditions.

Mounting concerns over sovereign debt, the pace of future economic expansion and a weak housing recovery are holding back global commercial real estate recovery, according to Deloitte’s “Real Estate Outlook: Top Ten Issues in 2012” report released this week.

In the U.S., real estate professionals must prepare for “a slowing, grind-it-out economic recovery” marked by sporadic growth and confined mostly to primary 24-hour hubs with global access such as New York, Washington, D.C. and San Francisco and Los Angeles and a handful of energy and technology focused metros, according to the Emerging Trends in Real Estate 2012 survey and forecast released this week by PricewaterhouseCooper (PwC) and the Urban Land Institute (ULI). KPMG came out with a somewhat more bullish survey and outlook earlier this month.

While most commercial markets have at least stabilized, marked improvement in occupancies and rents will be relatively elusive next year, according to PwC. Capital will mostly continue to avoid real estate in most secondary and tertiary cities, despite stepped-up bargain hunting. Only apartments, bolstered by demographic trends and the aftermath of the housing recession, will see increased and sustained demand.

“Commercial real estate continues along a bumpy path to recovery, with strengths outnumbering weaknesses. Foreign investment, absorption and lending have provided a solid foundation for the upward momentum and deal flow we’ve seen over the past 12 months,” said Bob O’Brien, vice chairman and real estate sector leader, Deloitte LLP.

“However, concerns remain. The residential market is challenged and the overall economy faces uncertainty. Until the majority of the challenges are abated, the industry should proceed with caution and a measured optimism.”

According to PwC survey respondents, the hard reality for office landlords is that businesses have learned they can increase profits by using less space. The related drag in consumer spending weakens retail and industrial occupancies and rents.

“Job creation is clearly the critical ingredient for a sustained recovery in commercial real estate and the market participants we surveyed uniformly struggled to identify new employment engines,” said Mitch Roschelle, partner, U.S. real estate advisory practice leader for PwC. “As a result, businesses are focused on squeezing profitability out of productivity gains.”

“In 2012, investors expect pricing to level off in the top markets, and overall ‘buy’ sentiment will subside, selling appetites will increase, and more owners will hold until the economy untracks,” Roschelle said. “This is part of the new normal as investors are coming to grips that they may not be selling for more than they paid.”
Survey participants predict that 2012 will see a rising supply of properties for sale. Due to economic uncertainty, however, interest among buyers may flag.
While investors’ expectations of returns will further recede, well-leased core real estate in top markets will continue to produce solid single-digit returns. Opportunity investors will dial back returns projections to at least the mid-teens, according to PwC respondents.

Key findings of the Deloitte report include the following:

Global CRE: The global economy is benefitting from a partial rebound in manufacturing, increased business spending and higher capital flows, resulting in an increase in CRE transaction volumes for seven consecutive quarters. Foreign investments in the U.S. are helping revive the transaction market. While a favorable assessment of risk versus reward may continue to add momentum to U.S. real estate, emerging markets will remain attractive.

Macroeconomic fundamentals: The U.S. economic recovery appears to be stalling following this year’s U.S. sovereign debt rating downgrade by Standard & Poor’s, the Eurozone crisis and the Japanese earthquake. In 2011, GDP growth will likely be 2.5%, which is lower than the prior estimate of 2.9%. Property fundamentals: Commercial space is being leased or bought at a rate faster than new supply is being completed, reducing vacancies. Construction activity remains at record lows due to tight underwriting conditions and contracted demand. The small improvement in employment is resulting in a better-than-expected uptick in leasing and sales.

Lending: Increased investor demand drove a commercial real estate lending recovery, resulting in higher loan sales and financing options. Lenders’ balance sheets are stronger due to loan modifications and extensions, and fewer write-offs spurred by the “amend and extend” strategy. However, this strategy is gradually losing steam as lenders focus on permanent resolution of troubled loans amid a pick-up in CRE investment activity.

Stalled CMBS: The CMBS market recovery is stalled due to credit market volatility and Standard & Poors’ recent cancellation of ratings of two new issuances. In addition, CMBS spreads have widened considerably in recent months and added to issuer reluctance.

REITs: Investment trusts are well-positioned due to improved fundamentals and market dynamics along with access to capital. However, growth prospects of REITs are now heavily dependent on mergers and acquisitions and rental income due to limited development activity. In the long term, REITs will benefit from global expansion as emerging markets embrace the structure.

Private equity: The private market is still recovering, and property values and economic and market volatility remain concerns.

Distressed deal flow: Driven by REIT acquisition activity and an increase in distressed deals, property transactions continue to recover. Distressed transactions continue to rise due to improved financing conditions and favorable pricing. Distressed inventory fell for the sixth consecutive quarter to its lowest level since the third quarter of 2008. Despite this, with nearly $182.6 billion in troubled assets, transaction opportunities still exist.

Residential market: Housing remains depressed, inhibited by elevated supply, weaker single-family home sales and falling home prices. In order for a recovery to begin, home inventory, including foreclosures, will need to be cleared. For home prices to move upward, supply will have to fall to a market clearing level or to the point at which demand equals supply. Improvement in employment is essential.

Residential mortgage market: While mortgage debt levels continue to drop, new non-agency mortgage securitization issuances remain at record lows. Delinquencies hover at historic highs despite several loan modification efforts by banks and government.

Best investment bets for 2012 cited by PwC respondents include the following:

Blue-chip gateways: The relatively safe harbors all have issues, but assets in 24-hour markets dependably outperform over time because they lie along important global commercial and capital routes.

Job centers: Investors should head to the few cities where employment growth actually occurs, including gateways and those that rely on energy, high-tech and health care-related industries, as well as universities and government offices.

Value-add plays: Look for Class B properties in good infill markets that have been neglected or overlooked over the past five years.

Fixed-rate debt: Owners should lock in long-term fixed-rate financing on assets while they can. Recapitalize troubled equity: More motivated borrowers working with senior lenders will strike favorable deals on mezzanine debt and preferred equity to stabilize. At low interest rates, investors can achieve favorable risk/return spreads.

Distressed debt: Banks and special servicers will continue to dribble out loan pools containing various embedded gems.

Residential land: Cash buyers can claim single-family lots for cents on the dollar.

By Randyll Drummer, Costar Group