Real Estate and the Economic Recovery

In past recessions, real estate development and construction have played an important role in leading an eventual recovery. It doesn’t seem to be happening this time around. Why not?

At the risk of oversimplification, the economics of real estate development can be summed up in two words: product demand. There’s nothing complicated here; it’s straight out of Adam Smith. In real estate, product is classified in two general categories – residential and commercial.

Residential product takes many forms: large, medium, and small single family detached (SFD), and attached product such as duplexes, triplexes, 4-plexes, townhouses, coach and carriage homes, and low-, mid-, and high-rise. Commercial product exists as office, retail, industrial, multifamily, hospitality, or a combination of these known as mixed-use.

New residential construction isn’t financially viable because many areas of the country are glutted with several months of inventory due to:

·        Speculation and easy mortgage money in the first part of this decade that drove homebuilders to oversupply the market,

·        The subsequent plunge in property values resulted in home values dropping below the balances of the mortgages encumbering them, leading to massive defaults and foreclosures,

·        Currently, some 7 million homeowners are more than 90 days behind on their mortgage payments, and this eventually will add even more residential product to the mix.

Many of these residential properties are available for less than their replacement costs. As long as there is a large inventory of properties and pricing remains low, new residential development will remain depressed.

Outside of a few metropolitan areas such as Washington, D.C. and New York City, development of commercial real estate (CRE) likewise remains depressed. This principally is because of three factors.

1.   First, there was an element of oversupply, just as was the case with residential product. Commercial developers, investors, and wannabe developers saw the burgeoning growth of residential and incorrectly assumed all these new rooftops would be occupied and the occupants would need office, retail, industrial, and entertainment facilities.

2.   Second, plentiful and cheap mortgage money made it possible to develop projects for which there is little or no demand and that never should have been built.

3.   Finally, the effects of the recession have caused firms and individuals to reduce the size of their operations or shutter them completely. This has resulted in much greater vacancy rates, lower rent structures, and greater expenditures or allowances for tenant improvements, among other things. These factors have driven income for these properties lower, which, in turn drove their values down.

The debt on many of these commercial properties exceeds the value of the properties. Many of these mortgages already have begun to mature, and will continue to do so over the next few years. Mortgage money for refinancing and new construction is very scarce because lenders have so much distressed debt on their books that their balance sheets are in poor shape.

Consequently, there is very little demand for new development. In good economic times, the development industry employs hundreds of thousands of people, perhaps millions. It’s not just construction and building trade workers. It includes all manner of consultants from an array of disciplines such as architects, planners and designers, market researchers, landscape architects, engineers, surveyors, attorneys, material suppliers, environmental, traffic, and entitlement specialists as well as office staff at all these entities, just to name a few.

Many of these people remain among the unemployed, and their salaries no longer trickle down through the overall economy.

The bottom line is that it will take some time for the inventory in residential and commercial to be absorbed. It will take time for lenders to restore health to their balance sheets. Until these things happen, it would be foolish to expect the real estate development industry to be able to contribute significantly, as in past recessions, to an economic recovery.

Are Cap Rates Telling Us Anything?

Capitalization rates, or cap rates, express the return on invested capital in commercial real estate (CRE) investments. it's derived by dividing the net operating income (NOI) produced by the property by the total capital invested in it. As property values increase, cap rates decrease. In the street patios, this means that the more you pay for a property, the lower the rate of return if NOI remains unchanged.

The ING Clarion recently reported that cap rates indicate CRE currently is undervalued by the standards of the past 10 years. At the height of the recent real estate frenzy, cap rates for some core assets were as low as 2% - even more in some cases. Now, Real Capital Analytics reports them to be in the range of 7.5-7.8%, which is slightly above historic averages for various property types.

It's always dangerous, however, to generalize about real estate. While macroeconomic factors are involved, all real estate is local; thus, the relevance of cap rates is based on local market conditions as well as the unique aspects of a particular property. For example, an office deal went down in Seattle several weeks ago that reflected a cap rate of 5.5%. BUT it was a class A core asset with a creditworthy tenant  occupying 90+% on a lease that runs thru 2024 with another 6% also under lease. In a different situation, with a class C building at 70% occupancy on short-term leases with tenants of questionable creditworthiness, the cap rate could be at 10%+. 


The reality is that the only cap rate that matters is the one generated by the property you're acquiring, and that's largely a matter of the property's characteristics and local market fundamentals.

Loans, Loans, Who's Getting Loans?

As various financial publications have pointed out, there is something on the order of $1.4 trillion in commercial real estate (CRE) loans maturing over the next couple of years. In a strong economy, refinancing would be the order of the day. Values would have increased because rising rents and high occupancy rates would generate greater net operating income.

While there are pockets of relative prosperity, for the broader view the economy is not in good shape. Rental rates have declined and occupancy rates are down. Consequently, the value of many CRE properties has declined, and, in some cases, is less than the amount of the maturing debt. As this debt matures, refinancing in an amount sufficient to satisfy it in full isn't likely. Additionally, the Commercial Mortgage-Backed Securities (CMBS) market is a mere shadow of its former self, and lending institutions seem unwilling to make new loans until they've strengthened their balance sheets.

Still, various pundits note that some properties or portfolios have been refinanced. But, on closer inspection, these situations typically are unique in comparison to the vast number of potential CRE refinancings. These lucky few generally are located in prime areas, are class A trophy structures, and enjoy extremely high rates of occupancy (95%+) by very credit worthy tenants on long-term leases.

The real issue concerns the vast majority of CRE that is not so fortunate as to be in this category. Banks and the FDIC can't afford to pretend and extend indefinitely. Will there be:

• a flood of foreclosures and RTC-like activities?
• a massive amount of loan restructuring?
• fresh capital made available at lower rates of return?
• a development of hybrid solutions not yet seen?

Stay tuned, it's going to get more interesting.

Is History Repeating Itself?

An article by Donald L. Luskin in the Opinions section of last Friday's Wall Street Journal is very sobering. Mr. Luskin is Chief Investment Officer at Trend Macrolytics, LLC.

His article, which also appears on Trend Macrolytics website, demonstrates the eerie similarities between the course of the S&P 500 leading up to the double dip recession in 1938 and the course of the S&P 500 over the past year. The article is well worth reading, but the chart below, which was made by Trend Macrolytics, summarizes the salient points of data in a glance.

If you believe the stock market can presage the future direction of our economy, then this is the kind of information that bears thoughtful scrutiny.

Recovery Underway?

We are regularly assailed by perspectives on the current economy ranging from “we are on the verge of a double dip recession” to “no, recovery is well under way”. I am reminded of an economist who once described the members of his profession as having predicted nine of the last four recessions. So, who does know what is happening with the economy? Apparently, no one does.

Economists and others pontificate daily as they try to interpret the constant flow of data. Their messages swing from bleak to hopeful and back. As someone once said, “perception is reality”. What someone perceives or interprets from a given set of data often becomes their world-view for the moment. Compounding the problem is the fact that the perception often is driven by political or mercenary need for a specific scenario to be “real”. For example, the Obama administration and its supporters in the media and elsewhere need the public to believe that recovery is well under way.

The challenge for truth-seekers is to be able to read through the spin. For example, reports abound that the rate of unemployment, mortgage defaults, vacancies, and rent declines, while still falling, are doing so more slowly. Isn’t this akin to a person hearing from their physician that they’re terminally ill and have but 2 months to live; then seeking a second medical opinion that advises they actually have 4 months to live? Myopically, that’s great news – their remaining life span just doubled. But the big picture remains that they are terminally ill and will die shortly.

The Wall Street Journal may be a conservative, business-oriented publication, but it doesn’t use sensationalism or fear tactics to sell copy. Its reports often are understated and leave it to the individual reader to apply his or her own interpretation. Here are some examples from the WSJ Property Report of July 7:

·        Dividend Capital Total Realty Trust acquired a portfolio of industrial and office properties from iStar Financial for $1.4 billion. This is noteworthy because the scarcity of financing in recent years has made market rate large commercial real estate deals rare. But, before assuming that the credit crunch is over, look at the facts uncovered by the WSJ:

o   The buyer ponied up equity in the amount of 37% of the purchase price (compared to the 5% to 10% of a fews years ago);

o   The iStar is carrying about 8% in mezzanine debt;

o   The loan-to-value ratio on the underlying financing is only 55% (compared to the 80% to 90% of a few years ago);

o   The properties involved enjoy 99% occupancy on leases with very creditworthy tenants averaging 7.6 remaining years (compared to double digit vacancy rates nationally).

Clearly, this is not a typical transaction in the traditional sense, but is it a fluke or a template of deal structures moving forward?

·        Citing data gathered by LPS Analytics, the WSJ also reported that the rate of mortgage delinquencies accelerated in May following 2 months of declines. Is it temporary or a sign of worsening conditions?

·        Citing information gathered by Reis, Inc., the WSJ also reported for retail centers that vacancy ratios continue to increase while rent rtes continue to decline. The rate is slower than over much of the previous 3 years, but is it a temporary respite or a sign of slowly improving conditions?

·        The Journal also reported that spending on new construction was down year-over-year across all categories other than residential, which was up slightly from a year earlier.

These are just a few of the fundamentals that underlie economic activity for real estate development, but they are not cause for celebration. The real question is what do they mean in the context of the larger picture (longer-term)? The only reasonable interpretation is that recovery is not yet “well underway”.

The difficulty this poses for the real estate development industry - whether new development, redevelopment, repositioning, or restructuring, is in the interpretation of short-term data points for strategic application in what essentially is a long-term endeavor.