Are We Stuck In a Moment In Time When We Expect the Worse? “Yes, but…” Say Investors
By Mark Heschmeyer
September 26, 2012
Despite improving job numbers, rising CRE and housing prices, declining vacancies and stabilizing rental rates, not to mention a new round of fed stimulus that will pump $40 billion a month into the mortgage markets, the prevailing sentiment in the commercial real estate industry still seems to be one of doom and gloom. And importantly that outlook is affecting which deals are getting done and which ones are not.
“We have noticed the trend as well and concur that a negative, or rather extremely conservative, mindset is prevalent with the investors in the market,” said Steve Timmel, senior vice president of Colliers International in Cincinnati. “Many investors are analyzing assets based on the ‘what-could-go-wrong’ view versus spending time focusing on ‘what-could-go-right’ and this has had an impact on pricing and deal velocity.”
“We appear to be in an extended period of uncertainty that is creating a tremendous amount of gridlock,” added Ron Riley, Timmel’s counterpart with Colliers in Memphis, TN. “As the economy grinds along, it will take really positive news to start moving it forward again in a sustained fashion.”
For now, at least, the mindset of investors seems to be one of caution while the economy staggers to its feet, ignoring the positive signs of returning growth and instead expecting another knockdown punch.
“Are we stuck in a moment in time when we expect the worse,” asks Randall Chrisman, principal of The Chrisman Co. in Carrolton, TX.
His answer is: “Yes, but…”
“People tend to lean toward pessimism over optimism. Nevertheless, just because you are paranoid, doesn’t mean they aren’t out to get you,” he said. “There is a lot of money sitting on the sideline rather than investing in capital and expansion. It is a hunker-down mentality based on a very scary economic world.”
“No one wants to be the first guy to make a bad deal and investors are very sensitive to overheated markets,” Timmel of Colliers said. “Investors are in pursuit of yield, and with the exception of a few, are risk adverse until the overall economic picture gains more clarity.”
Ruijue Peng, chief research officer for CoStar Group, says this mindset is not necessarily unexpected — or a bad thing.
“Studies have shown that real estate practitioners tend to be among the most ‘myopic’ bunch, which is one of the reasons for the long and wide real estate cycles,” Peng said. “Because of the current mindset, we can assure ourselves that the market won’t get overheated any time soon. If the majority is optimistic, then it is often too late to get good deals.”
Adam J. Hardej, Jr., president and chief appraiser for BAAR Realty Advisors in Palm Beach Gardens, FL, said he thinks “the markets can be best described throughout the country as discerning and unforgiving. (But) if a buyer gets a whiff of distress or any issues associated with a property, then the sharks start circling and looking for a discount off what are already historically low commercial real estate values.”
“This is a boom period for commercial real estate appraisers with the mass of peak market financings/loans done with 5- to 7-year balloons on them – all coming due now – is keeping us commercial real estate analysts very busy,” Hardej said.
We asked other CRE professionals across the country what they see as the current mindset in the industry; what is driving it; and how is it affecting the dealmaking environment. Their answers follow.
Lack of Confidence Not Surprising Given Severity of Downturn
Confidence is the lifeblood of commercial real estate development. Developers are constantly gaging both the prevailing mood and the trajectory of the next mood swing.
This recession was severe and sudden. 8.8 million people lost their jobs. Over four years later, half of the people who lost jobs still have not found a new one. And many people are working part time or working at a job that does not engage their highest potential. By the technical definition, the recession ended 38 months ago but it does not feel that way if you are one of the people that are not fully employed or if you own a home that is still worth less than it was seven to 10 years ago.
More than any other factor, this was a recession that was triggered by financial excesses. Most of our major banks were on the brink of bankruptcy or regulatory shut down four years ago. Government intervention prevented a financial meltdown. The banks survived but they are going to be more conservative for some time to come.
So, if the average person is cautious or frustrated by the job market and the primary source of money for business expansion is at least somewhat more cautious than they were, it is no shock that we are seeing a slow recovery.
That is a reading of current sentiment. But one huge key to success in commercial real estate is reading the trend and the timing of changes in sentiment. Smart money has already been buying quality commercial real estate for investment. When you consider what you can earn from a bond today (almost nothing), it makes a lot of sense for investors to put some money in an investment that earns a tax sheltered 7.5% with the possibility that the underlying asset will appreciate over a 10 to 15 year lease term.
Larry Callahan, President & CEO, Pattillo Industrial Real Estate, Stone Mountain, GA
Inflation May Be Next Sword To Swallow
If more distress is coming it will be the result of low interest rate mortgages coming due into a market where interest rates are significantly higher. Combine that with expenses spiraling out of control and income not keeping up with the costs of running a building and we could have the perfect meltdown.
Adelaide Polsinelli, Senior Director, Eastern Consolidated, New York, NY
Deal Impact: Driving Up Core Prices; Driving Down Repositioning Prices
The impact of the negative mindset is having a two-fold effect. It’s driving pricing to historic highs on the top assets in core markets, and it’s driving down the pricing, or decreasing the buyer pool for assets that have a leasing story and need some repositioning. Generally the market continues to be a “have and have not” market. If you have a core asset you have numerous buyers to pick from, and if you don’t, you “have not” or the pricing is so low you don’t want to consider the pricing.
The equity that is in cash and un-invested is immense and all waiting for some positive news on the economy and the resolution of some of these issues. This equity is only venturing out for the no-brainer offerings or core assets in the market.
Meanwhile, the debt that is available for these core offerings is as good, or better, than it ever has been with the CMBS market poised for a massive rebound in 2013. Rates for high quality commercial assets are in the low to mid 4% range and Class A multifamily is even lower. Investors are certain that we are in line for inflationary impact of the continued fed manipulation and are locking in these low rates as they anticipate significant rate jumps in the next few years.
Jeff Johnston, Brokerage Senior Vice President, Colliers International, Cincinnati, OH
Tenants Avoiding Long-Term Commitments
What I’m seeing are two factors. One the government contractors are really being cautious; contracts are slowing down, and there is a real desire by tenants to avoid the risk of long-term commitments. This is combined with a general push by them to downsize and control costs.
Second, the threat of sequestration and the fall elections, with the uncertainty on tax policy, spending, etc., and the general tightening of state and local government expenditures reinforces the negative concerns, especially in this sector. This is partially being offset by increased activity in the high tech sector where I have seen increased activity among the startups , as well as in the service sectors both office and retail.
Frank W. Dillow, Long & Foster Realtors – Commercial Division, Vienna, VA
We Create Our Environment
We will create this environment with our mindset. There are business owners out there who are very positive with the coming years. I’ve noticed that these folks are typically utilizing the social and cloud business model.
The distress may be coming from all property types. However I think the industrial spaces are having a better chance to catch the wave of returning manufacture to the U.S.
Tom Mong, Appraiser, Market Value Advisors, Los Angeles, CA
In What World?
I recently sold an apartment building for $3.1 million. Two years ago. I and my partners bought it for $2.065 million. In those two years, I took revenue from $17,000 per month to $53,000 per month thereby justifying to the appraiser and the buyer’s lender the increase in valuations.
Now as we search for another property to acquire, we are running into sellers listing their properties at “pro forma” revenues, and I sit there and go: “Here we go again.” Didn’t anyone learn from the last time we did this?”
We put in an offer on a building a few weeks ago that fell out of escrow at $3.8 million; the place was listed at $4.25 million. The NOI provided by the seller’s agent showed a negative NOI for 2011 and only $32,000 for the first half of 2012. Our offer was all cash at $2.6 million and we’ll take it as is. The seller didn’t respond to our offer and the seller’s agent said we were $1 million off.
Really? In what world is that seller going to get past an appraiser or lender for even close to what they want for it. The only way would be all cash and it would take an utter idiot to do that.
CRE prices have increased but I believe the days of getting a quick 50%-100% appreciation are over. I think things will flatten out a little and I believe velocity will slow drastically going forward because the “pro-forma” monster is rearing its ugly head again, and I hope lenders won’t buy into it. If they do, then the fan is going to really get hit hard down the road.
Neil Evans, Partner, 3211 Pinchot Properties, Phoenix, AZ
At the Mercy of Events
With external factors such as Europe and China looming, unfortunately we are at the mercy of (their) fiscal and monetary policies. The question is, will they come in for a soft landing guided by these policies or will they crash and burn?
Closer to home with the election looming, continuing deleveraging and the need to restructure, we are faced with our own daunting tasks. Regardless of the outcome of the election, uncertainty will be eliminated for the better or worse but the silver lining is we will all have a better sense of the overall direction that the country will take.
It appears there has a been a paradigm shift with both individuals and corporate America with both doing more with less and being a bit more cautious. When our GDP is comprised of 2/3rd consumer spending and you have a lack of faithfulness in corporate America to “protect” its workforce and at the first sign of additional slowdown to slash payroll, you have a serious recipe for disaster.
Ron Riley, senior vice president | office division asset services, Colliers International Memphis, TN
Fed’s Money Machine
Many CRE prices are presently back at the “bubble” levels of five years ago. How? Today’s lower income is capitalized at lower bubbly capitalization rates. Notice that effect is limited to “investment grade” big buck assets as Wall Street money is struggling to escape the Fed’s 0% interest rate hole. The dichotomy between Wall Street and Main Street isn’t any more sustainable than trillion dollar deficits.
The present capitalization rates are likely to regress to the long-term average around 9%. Because of the evaporation of much of the present liquidity, volume will also fall.
Eventually the big question is whether the next year will see much or any real economic growth. Or will the economy simply see more liquidity pumped in by Fed printing money to buy T-bills, thus supporting the deficit? That’s where, conceivably, November makes a difference. There are going to be some tough choices in the next year in DC.
Charles B. Warren, Principal, Urban Real Property, Pleasant Hill, CA
In Search of Income Security
Your questions are about perceptions. But transactions fuel new real estate development — folks renting apartments, buying stuff, businesses renting offices. The bottom 80% of our income distribution is still in hard times and unemployment is stuck at elevated levels. Until that 80% sees income security and liquidity, we’re not going to see a robust transaction environment from those folks.
Steve Price, Partner, Terra Property Analytics, Seattle, WA
Political Discord
I actually think if the market is left to itself, we will certainly continue to see improvement, but the bigger question doesn’t have much to do with supply-demand, it has to do with the unwillingness to cooperate on the part of our politicians. It is difficult for small or large businesses to go on a hiring spree, when they don’t know what additional taxes, regulations, and demands are coming down the pike. These businesses are socking away dollars for the ‘What If’, which means less dollars being used in the economy. Until we get America back to work our buyer pool remains extremely limited, and no matter what the CAP rates there will continue to be significant areas that show little, if any, improvement.
Carol Gwin, Principal, Carol Gwin Realty | Commercial Group, Oakley, CA
An increasing federal deficit, combined with society’s increasing governmental “dependence” will spell a very long road to economic recovery. More of the same seems in order until some group of politicians is willing to make the tough decisions that will reduce long-term spending by government, decrease disincentives to business expansion and ultimately allow the small- medium-sized businesses in this country to pull us up by the bootstraps out of the fiscal mud — business growth and expansion is the only way out of this quagmire.
David L. Skidmore, RG Kennedy & Associates, Commercial Real Estate Services, Columbus, OH
Reference: Mark Heschmeyer (CoStar Group, Inc.), “MAJOR DILEMMA: Economically We’re in Recovery; Mentally We’re Stuck in Recession.” (September 26th/2012). <http://www.costar.com/News/Article/MAJOR-DILEMMA-Economically-Were-in-Recovery;-Mentally-Were-Stuck-in-Recession/141847>
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