Susan Smith is a director in the PricewaterhouseCoopers real estate sector services group and editor-in-chief of the firm's Korpacz Real Estate Investor Survey, which anticipates a stabilization of
capital and the rate of vacancy in 2010 for commercial real estate. However, delinquencies are still spiking, and more banks could be closing
under the weight of these loans. For this episode of In This Corner
, Susan reminds us that where there are problems, there are always opportunities.
HW: What's the biggest ailment plaguing the commercial real estate market?
Susan Smith: One of the biggest problems for commercial real estate is the still-fragile underlying US economy, especially the US employment situation. The performance of the commercial real estate industry lags behind what happens in the economy by several months. So a slow-moving economic recovery will continue to be a drag on the underlying fundamentals of the industry. Although employment statistics show that job losses as a whole are tapering off, it is important to remember that nearly 8.4m jobs have been lost since the start of the recession in December 2007. It is a huge number to regain. And it will take several months to do so, which is difficult for many investors and property owners to fathom. Without consistent job growth, each sector of the commercial real estate industry suffers. Without job creation and job growth, demand for housing, goods and services, and office space will remain muted. Jobs create tenant demand for office space. Jobs make people search for housing and seek out goods and services. It has a real domino effect on the industry.
HW: Commercial real estate is the biggest impending crisis that everyone knows about. But what would you like to see lenders and their regulators do about it?
SS: This is always a good topic of discussion with survey investors. For the most part, the viewpoint among them is that the current problems in the commercial real estate industry tied to the financial crisis are ones for the buyers, sellers, owners, and lenders to work through. While investors recognize that more oversight is needed, particularly with respect to the securitization market, they do not believe that government intervention is the complete answer. During the expansion of the cycle, the commercial real estate industry became extremely overheated due to the vast amount of cheap debt and equity available. Many deals were fostered with the expectation that value increases and appreciation would just continue. Many buyers and lenders used aggressive underwriting assumptions in order to simply justify the placing of debt and equity into the market. It was a false sense of reality. Due to the recession and financial crisis, property values are down significantly (as much as 40% in certain instances) and underwriting is once again very conservative and more equity is needed to secure debt. The industry is back to the "old way of investing" when buyers really focused on the asset. I think the de-leveraging of the industry was a big wake-up call to owners and lenders.
HW: Why does commercial real estate troughs and peaks always lag behind the residential side?
SS: It's all due to the economy. The residential side typically feels economic shifts more quickly because it is more closely tied to the US economy. The US consumer, which represents 70% of the US GDP (gross domestic product), will immediately reduce spending and its demand for housing when job losses or the fear of job loss occurs. In good times, the reverse happens: job security and income growth generally spur housing demand.
Eventually, what happens in residential will trickle through to the businesses and companies in the commercial real estate industry that support consumers, such as retail merchants and warehouse owners who ship and store goods. Interestingly, investors are already starting to see some glimmers of hope in the residential sector. Many of them project that the apartment sector will continue to lead the recovery as value losses have been almost fully recognized, and some multifamily assets are actually showing slight value increases.
HW: So, what opportunities are out there?
SS: Some of the best opportunities right now are for tenants, especially those looking to either relocate to a better address or renew current leases. Rental rates are down across all property types and all geographies. At the same time vacancy rates are up and many landlords are offering concessions, so it's a great time to be a tenant. For investors, there are some opportunities to acquire decent, quality assets at below-peak pricing due to stress on the part of both owners and lenders. But such opportunities are fewer in number compared to the vast number of offerings presented to investors during the peak of the cycle nearly three years ago in mid-2007. Consequently, when quality assets are placed up for sale now, they receive numerous bids and pricing is tough.
Our recent survey finds that while 2010 is expected to be a slow year for sales activity by historical comparison, there could be marked improvement from 2009, as banks and other lenders appear more willing to lend. One thing is for certain: there is a tremendous amount of capital on the sidelines looking to be placed into commercial real estate, and it is still a great time to buy.
HW: Where are some of the better markets for investors?
SS: Defining or labeling one market better than another is very difficult. Just as markets are very different, investors' strategies are very different. Right now, however, stability and reliability are most appealing to investors. As a result, most investors will continue to target the global-gateway, 24-hour markets that are located along the coasts of the United States—Manhattan, San Francisco, Los Angeles, Miami, etc.
One of the most talked about markets in terms of stability and long-term appeal continues to be Washington DC, as well as the metro areas around it, such as the close-in suburbs of northern Virginia and suburban Maryland. The underlying economies of these areas are diversified, yet have a large government sector, which offers stability during downturns.
Another highly regarded market is San Francisco. The office market there is showing slight signs of stability, and some investors sense a bottom is emerging. Nevertheless, fundamentals favor tenants. In fact, it is a great time to be a tenant in San Francisco. Tenants looking to lease space are finding plentiful options and much lower rental rates than during the peak of the cycle.