Mortgage bankers acknowledge that the commercial real estate sector has stabilized, property valuations have recovered, and liquidity has returned to the sector. But they are also mindful about lessons learned from the last real estate cycle and express caution about the future.
Speaking at the opening session of the Mortgage Bankers Association’s Commercial Real Estate Finance/Multifamily Housing Convention & Expo, panelists expressed optimism, but suggested there remain significant weaknesses in the sector: Fundamentals are still soft and are slow to recover in certain sectors, cap rates may have fallen too much, the process of real estate deleveraging has reached only its mid-point, and substantial “pain” may still lie ahead as the commercial real estate sector rights itself.
“The good news is that we are now in the upward phase of the real estate cycle,” says the panel moderator, Michael Berman, 2011 MBA chairman, and president and CEO of CWCapital. Berman points out it was only 18 months ago that there was “zero” lending in the sector.
Patrick Halter, CEO of Principal Real Estate Investors, says there is “definitely” a recovery in commercial real estate valuations. For the first time in the past two years, there have been vacancy declines in all major property types except retail. “There will likely be additional room for pricing power in 2011,” says Halter, noting that supply is currently inadequate even to counter asset obsolescence. Nevertheless, although there is “pricing recovery,” Halter has not seen much “space recovery.” And there is still not a lot of landlord pricing power in all sectors except for multifamily, which saw strong performance in 2010.
Diana Reid, executive vice president of PNC Real Estate/Midland Loan Services, says the apartment sector is “very strong” but that the office sector remains weak. That sector is typically the last to emerge from a recession; it is highly sensitive to job growth; and companies are needing less space and still disposing of space. “There are some real challenges in office,” she says. Retail, on other hand, may have gone through its most difficult period in the past few years.
With regard to capital availability, “We do not have liquidity crunch. We have a transactions crunch,” says Jack M. Cohen, CEO of Cohen Financial. Cohen says he is not worried about a lack of capital. “There are plenty of participants. We are missing transactions.” Halter agrees that there is a “significant” amount of liquidity, although it is still not as much as some industry participants would like.
Berman says that debt financing terms today are “markedly” different from those of the past, with 60 to 65 percent leverage, compared to the 80 to 85 percent leverage that was standard before the financial crisis. “Lending will remain conservative at least for the near term.”
Equity is also returning to the market. “A lot of equity is deployed to go,” says Halter. REITs are in growth mode and pension funds are considering real estate investing again. “There is a lot of equity that wants to participate in U.S. real estate again.”
Indications that fundamentals may be stabilizing need to be tempered with the notion that much of the problems of commercial real estate still needs to be worked out.
E.J. Burke, executive vice president, group head, of KeyBank Real Estate Capital, observes the confidence levels of tenants are rising. However, there is a “ways to go” before the deleveraging process that is needed in the industry is completed, although the situation will not be “catastrophic.” The next two to three years will continue to see more CMBS loan maturities and many of the loans will be difficult to refinance. Additionally, a certain amount of loans refinanced in 2010 were merely extended for another five years, adding to the amount that will be maturing in the years, notes Burke.
There is still “a lot of pain and suffering” that will occur in the near term, agrees Halter. Higher quality products will find ways to recapitalize, as equity is also returning to the market. Core properties that are in special servicing will be foreclosed upon as banks feel more comfortable selling in the present market.
Likewise, there is some concern about possible overheating in the markets. Reid says she has generally not observed that current revenue growth is likely to support current cap rates. Cap rates, she says will likely “edge up” in the next few years. Timothy Gallagher, managing director at Morgan Stanley, agrees that cap rates may rise, maybe by one to three percent, in the next four to five years. It is difficult to see lower cap rates given rising interest rates, he says.
Cohen says he is concerned that the industry may continue to make the mistake of making valuations on the basis of “scarcity” and the returns of Treasury rather than on the basis of “risk.” With higher risk, prices should be higher, but “that is not happening.”
In response to a question from Berman regarding lessons learned, Gallagher cites the need to stay in core markets versus tertiary markets, and in product types in which the company has expertise, rather than venturing into financing, say, casinos. “Do we know the market in the middle of Nebraska? We probably don’t. Should we be lending there?” Gallageher says.
Berman asks whether CMBS will be 2.0 or 1.1 or 0.9. He is of the opinion that CMBS is not “fundamentally mis-structured,” but the loans were. The CMBS system, he says, is not broken, though it could be improved. And Burke says what he is concerned about is the financial legislative and regulatory changes that are, or will be, taking place. (credit k. foong, cre)