Price Gains Will Go Beyond Class A

The traditional commercial real estate recovery pattern can be a powerful tool in planning strategy for 2011 and beyond.  Despite the complexities and unusual severity of the recent downturn, developments in investor psychology and capital flows have been consistent with past cycles to a large degree.

Top-tier assets traditionally recover first and this pattern clearly defined the investment theme for 2010, just as it did in the last major correction cycle in the 1990s. For example, after values bottomed in 1992, it took five years for Class A office buildings to reach pre-recession prices while Class B office buildings took until 2000 and Class C assets until 2004 to accomplish the same.  Values for Class A apartment and office properties have already started their climb, gaining an average of 15% last year with some marquee assets appreciating far more due to intense buyer competition.  In sharp contrast, the median price for Class B apartments and office buildings sold in 2010 dropped by an average of 6%.  Class A prices for retail and industrial showed low single-digit gains, characterizing stabilization.  Investor and lender sentiment toward these sectors is already shifting, particularly for retail, which should support more sales activity and the start of value recovery in 2011.

A review of the data for the past 21 years clearly shows that prices for Class A properties of all four types are more volatile with deeper drops and sharper climbs than Class B and Class C properties.   Institutional and major private investors, which tend to prefer Class A properties in primary markets, have to compete more intensely for these blue chip assets, which leads to higher prices in an up-cycle.  During recessions, these investors tend to retreat to the sidelines first, which results in larger price corrections in the Class A segment.  Institutional and major private investors also lead recoveries by returning to the market first to take advantage of lower prices for quality assets at cyclical bottoms. Class A volatility is further amplified by variations in space demand, with tenants shifting to lower-rent space and less costly units during recessions and to higher-quality space after rents drop and an economic expansion becomes sustainable.

From a capital-flow perspective, as the economy improves, capital tends to shift out of the bond market and other safe vehicles into equities, real estate and capital expenditures.  This pattern is already evident in the stock market.  In real estate, capital has once again moved first to the “safest” sectors and assets.  The improving economic outlook and hard evidence supporting stronger job gains in 2011, modestly better financing availability and low interest rates will spur capital migration. Class B apartments in particular have a compelling attraction as they are less impacted by future construction and a potential increase in home buying in 2012-2013 than their Class A counterparts are. Investor appetite for Class B retail and industrial properties will emerge faster as the overall recovery and capital flow improvement pick up momentum.   The concentration of distressed sales in low-quality properties will keep downward pressure on values for Class C properties, but repositioning and value-add investments with a realistic and grounded turnaround plan will also attract more opportunistic capital. The high risk will be limited until expectations for better economic performance become reality, which puts the timing in the second half of 2011 and into 2012.

As in the past, the current recovery’s progress will be choppy and volatile. In 1994, the Fed’s rapid tightening nearly killed the economic recovery. In 1998, the currency crisis in Russia and Asia hampered capital markets. In the current cycle, de-leveraging, sovereign debt concerns and the Fed’s balancing act between inflation management and recovery support are among numerous challenges that are sure to create bumps in the road. Nevertheless, the long-term performance and compelling yield spread of commercial real estate as an asset class will attract more capital. In fact, 2011 is the ideal time to shape an investment strategy based on likely capital flow patterns, economic fundamentals and traditional commercial real estate recovery trends. (credit h. nadji globe st)

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