Opportunity Funds Waiting for a Bottom

One of the overriding capital markets trends of the past few months has been the large number of real estate opportunity funds amassing war chests to go after distressed properties and debt. According to Preqin, real estate private equity funds raised $30.2 billion in the 3rd quarter with much of this focused on opportunistic acquisitions and distressed real estate debt. A few days ago, Blackstone CEO Tony James reported that his firm is sitting on $13 billion of capital while waiting for real estate valuations to bottom out. While no specific market has caught his eye, he does believe that the US market will be the first to bottom out and begin the long climb back up.

To date, there have only been ripples of activity in the distressed debt market. For example Lehman brothers, the poster child of distressed sellers, sold $4.2 billion of mezzanine debt at discounts as steep as 35% in the second quarter. Apparently that discount should have been steeper, and we’re starting to see some debt trading at less than fifty cents on the dollar. Overall, however, the market has been eerily quiet so far. Some suggest that this is because the high-leverage, interest-only CMBS loans made in the past few years have not yet come due and forced borrowers to refinance under today’s stricter underwriting standards. When they do mature, starting in 2009 and accelerating through 2012, when five year loans originated in 2007 mature, the cash that is now on the sidelines should be more than happy to come to the rescue as long as it can earn a 20%+ return. The question on the minds of the funds raising cash in today’s market is not if they will be able to buy distressed assets and debt, but when and at what prices. The answer is one on which fortunes will be made and lost in the next decade.

Llenrock Group

Multifamily Fundamentals in Question

Multifamily is the sector of commercial real estate most directly tied to the broader housing market that has been at the root of America's financial market slump. While the different subgroups of multifamily are being affected differently by today's market, it's generally safe to say that funding multifamily development and acquisition has gotten more difficult, and the trends that had been expected to drive up rents and occupancies have so far failed to show up in many markets. However, compared to other commercial real estate sectors, multifamily has held its own with major owners such as Camden Property Trust and AIMCO reporting flat or slightly positive 3Q08 results.

According to the National Multi Housing Council's latest survey, multifamily industry insiders feel the market is at historic lows in terms of investment volume and availability of capital. With unemployment rising and the national economy in general decline expect fundamentals like occupancy and rents to start declining as well, especially in areas hit hard by job losses. Hopefully some of the 'vulture capital' waiting on the sidelines will soon become active and start transactions flowing again, but for now with buyers and sellers at a stand-still, it's important to remember that medium and long-term trends still bode well for multifamily rental properties.

In the medium term, continued turmoil in the for-sale housing market, projected to last from 6 to 24 more months, will keep renters renting and return some former homeowners to the rental market due to foreclosure. This should keep occupancies relatively healthy although these are not the type of renters who can support big rent growth. Additionally, lenders should return to multifamily before they look at other sectors because of government backing through Fannie & Freddie and the commodity nature of rental housing - consumers will stop shopping, dining out, and traveling before they stop renting a place to live.

In the long term, demand for rental housing should be very strong thanks to general demographic trends toward a younger, more mobile, more urban population. Arthur C. Nelson from the University of Utah predicts that between now and 2020, 72% of new housing stock should be built as rental units in order to maintain relative supply-demand balance. Hopefully we can keep these long term trends in mind as we wait for the good deals to make their way to market.

Llenrock Group

Damage to Hotel Fundamentals Contained?

Hotel investors have been waiting for the proverbial 'other shoe' to drop on the fundamentals of the U.S. lodging sector for some time now, and with the release of Smith Travel Research's latest forecast it seems that 'other shoe' is hitting the ground hard. For the month of September STR reports industry-wide RevPAR (Revenue Per Available Room) is down 2-4% year-over-year, with the lower end of the market being hit hardest as consumers feel the economic pinch. STR is projecting a meager RevPAR increase of 0.4% for all of 2008, which would be even worse if not for stronger performance early in the year. Going forward, STR projects RevPAR will decline by 2.5% in 2009 driven by declining occupancy rates that will continue through 2010 before bottoming out at 58.7%.

Until the economic upheaval of the past two months went global, international tourism was helping to prop-up hotel fundamentals in many markets. The weak dollar was attracting European, Asian, and Middle Eastern visitors to New York, L.A., Vegas, Chicago, San Francisco, and Miami. But now the dollar is strengthening, making visiting the U.S. more expensive, and even wealthy tourists are being hit by declining worldwide stock markets and rampant uncertainty. International tourist magnet New York City is seeing a decline in bookings going forward and is preparing for a weak holiday tourist season. This despite the fact that many analysts had predicted New York would act as a 'value alternative' to a European vacation for many U.S. travelers.

On the bright side, overbuilding appears to be contained and the tight credit markets should keep new supply in check for the foreseeable future. Few new hotel development projects are coming out of the ground right now and deliveries of new rooms should slow to a crawl as we get into 2009. There could be another six to twelve months of very tight financing for hotel construction, keeping construction starts to a minimum in all but the economy sector, and allowing us to come of out of the current downturn with a relatively healthy supply-demand balance, leading to a faster recovery. Only select markets with unique growth stories will see significant new development over the next year, but developers with deep pockets should find plenty of opportunities for bargain purchases, repositionings, and bailouts of weaker operators.

Llenrock Group

Retail Fundamentals Shaky at Best

The fundamentals in the retail real estate sector eventually boil down to American's propensity to consume. If people are buying, stores will open, vacancy will decrease, rents will rise, developers will build and the world will keep on spinning. If, for any reason, people stop spending this process goes into reverse and can unravel quickly. This reversal can be especially painful when retailers have spent the past decade expanding at breakneck pace and now have to pull-back double-speed to maintain profitability - see Starbucks' recent experience for a prime example.

September's retail sales numbers show only 1% growth year over year, the worst performance since September 2001, mostly attributable to the economy-wide slow-down and financial crisis. This growth hides the fact that while most retailers struggle mightily a few are actually benefiting from the economic hard times. Apparel and luxury goods retailers are being hit hardest with sales at Neiman Marcus, Sak's, and Nordstroms down 15.8%, 10.9%, and 9.6% respectively. The bright spots are warehouse stores and discounters where consumers can stock up on essentials at bargain prices. BJ's and Costco saw sales increase by 10.4% and 7% respectively showing that consumers were still spending in September, they just shifted from the mall to the power-center.

It is yet to be seen how falling gas prices, government bailout packages, and a roller-coaster stock market will affect consumer spending patterns through the crucial holiday season, but it is safe to say that while uncertainty reigns the safest bets are in core markets that haven't taken major hits in terms of housing price declines and job losses.

Retail developers that we've spoken to seem to think conditions are still good for non-luxury retailers selling essential products at good prices. Many also think that the 'near-luxury' retailers will attract those customers who want to be prudent but don't want to go all the way down the scale to shop at the discounters and warehouse store. Another area of optimism has been urban markets in dense, central-city locations, although if financial sector job cuts increase, these CBD markets could lose many of the high-earning consumers that make them so attractive.

One bright spot in the retail sector is that, largely due to high construction costs and the credit crunch of the past year, overbuilding has been contained. Many lenders and equity sources have dropped out of the retail game altogether, and those that remain are keeping LTV's low and raising the cap-rates at which they value properties. In today's environment stricter underwriting should continue to keep speculative building in check and keep all but the strongest projects on the sidelines until the consumers come back.

Llenrock Group

Remember When Fundamentals Were Strong?

For most of the past summer the mantra of the commercial real estate industry was that while the residential market was being battered and capital was harder than ever to come by, the fundamentals of commercial real estate were still strong. This attitude naturally led to the conclusion that as long as fundamentals were strong commercial real estate pricing didn't have to drop by much.

Well so long summer. It has become obvious over the first few weeks of autumn that the fundamentals of commercial real estate are weak and getting weaker and consequently pricing will have to adjust accordingly. The one bright spot for those of us on the transactional side of the business is that falling prices may lead to a slight uptick in transaction volume.

Over the next few days we'll take a quick look at the current state of the fundamentals across various property sectors, starting with retail tomorrow, perhaps the sector with the weakest outlook from today's vantage point. We'll also try to highlight the bright spots in each sector, to give you an idea of the type of deals that can still get done even in today's market.

Llenrock Group