Real Estate and the Credit Crunch Update 2008

The Current Affairs of the Real Estate & Capital Markets

by Rob E. Lee

All trees aspire to grow to the sky; likewise during a boom market the human spirit cannot believe that there will be an ultimate bust. As last year drew to a close the investment environment transitioned from cautious optimism to a heightened level of realization that there was a global credit crisis brewing in the financial markets.

Today, the commercial real estate market has entered a period of declining values, or as any would say "correcting values" in an effort to adjust the risk basis. Many properties are overleveraged or encountering financial difficulty. The collapse of the housing market coupled with fuel and food price inflation are putting tremendous strain on the American consumer, the ultimate driver of our economy.

Hidden behind the creative genius and financially engineered products that drove much of the aggressive view that the economy could do no wrong during the last decade, Wall Street and Main Street have been oversold, especially with respect to securitized single-family residential debt products, or subprime loans. In fact, the housing market was overleveraged more than anyone realized, or even suspected, relative to the fundamental values of the underlying residential assets.

According to Jack Cohen, CEO of Cohen Financial, a leading commercial real estate investment bank, a massive real estate resetting and de-leveraging is occurring during this first quarter of 2008. Some say it is due directly to sub-prime and single family housing troubles. Mr. Cohen says this is not entirely true. The commercial and residential markets are not linked but for three items: 1) space demand is linked by the health of the economy; 2) lending is linked through the capital markets; and, 3) bond pricing is linked through the investor base (supporting the capital markets). Otherwise, no other links exist. Commercial and residential issues are not at all intertwined. "None of the flaws in the sub-prime business model are remotely present in the commercial real estate lending business. To the contrary, the strengths of the commercial real estate lending business model were not present in the sub-prime business model," stated Cohen.

As the residential market's weakness increased in 2007, the commercial real estate market reached its pinnacle to date, with mega multi-billion portfolio deals such as the Blackstone Group and Equity Office Properties (EOP) Trust transaction. When the cracks in the foundation of the credit markets appeared as a result of the subprime mortgage market meltdown, the commercial real estate market took notice and quickly inventoried its own aggressive dealings and pricing during the past five years. Risk aversion quaked throughout the world's credit markets, resulting in the Federal Reserve pumping liquidity into the financial markets and dropping the federal funds rate. The world and domestic commercial real estate investors prepared for new terrain.

The Federal Reserve created the perfect environment and many lenders detached risk from reward in a market where more money was made securitizing the loans rather than holding them. Demand for securitized loans forced lenders to sacrifice underwriting standards and reengineer loan products such as interest-only loans and low or no debt-service coverage requirements. Financing at all levels of the capital stack created more asset demand. Cap-rate compression happened quickly, falling from 11% in 1995 on average to 6.29% in June 2007. Without leverage, investors would demand a higher return.

In the wider marketplace, the subprime debacle has ensnared some of the biggest institutions on Wall Street. Write-downs at Merrill Lynch totaled $22 billion by mid-January, and Citigroup wrote off $20 billion. Citigroup Chairman Charles Prince and Merrill Lynch CEO Stan O'Neal resigned. Even mortgage financiers Freddie Mac and Fannie Mae, stalwarts of the secondary mortgage market, face potential write-downs of $16 billion for the fourth quarter of 2007 because of flawed subprime loans and other investments.

The threat of recession is also taking a toll on the market, further shaking the confidence of bond buyers and sellers. The Federal Reserve's startling, 75 basis point cut in interest rates on Jan. 22 - the largest reduction in more than two decades - quieted turbulent stock markets momentarily, but raised new questions.

"While it's meant to stabilize things, that to me are going to make people more nervous," says Kim Diamond, managing director at Standard & Poor's, since it signals the Fed's deep concern over the economy. "A 75 basis point cut off-cycle is pretty extreme."

Despite a slowdown in 2007's growth rate, the U.S. economy remains resilient beyond most expectations - but that is what keeps market nerves on edge while providing a much-needed stable market influence. Fortunately the global economy is on solid footing and is expected to grow at a faster pace, helping the U.S. weather this slow domestic economic picture.

For borrowers, the call to action is to proceed cautiously and creatively, rather than sit on the sidelines. Forget about an attempt to convince a lender to be "aggressive" or "creative" when financing your next real estate deal. Banks have gone back to basics - solid fundamentals, and nothing less will do.

Although inflation pressures probably will continue in 2008, the Federal Reserve has shown its willingness to accommodate the markets by lowering interest rates and injecting liquidity into the economy to help avoid a recession. Unemployment remains low, but with the continuing housing slump and high energy prices, consumer spending and job growth may slow. Strong employment will favor commercial real estate, keeping vacancies low and providing the necessary support for investment earnings. However, geographic differences in commercial investment markets will play a pivotal role, as some U.S. regions have seen variations in their local economies.

Unstable financial market realities favor commercial real estate. As the financial markets become riskier and less attractive, commercial real estate - as long as it holds its own - becomes more attractive on a relative basis. It does not mean that prices continue to climb, but commercial real estate does maintain a more attractive position relative to stocks and bonds . With average yield rates on commercial real estate investments still higher than those for many other investment alternatives, commercial real estate likely will continue to be a preferred investment vehicle from a risk-adjusted basis. For example, National apartment fundamentals were strong during 2007, thanks to a great deal of help from the subprime lending fallout in the residential market. However, supply may begin to outpace demand, as unsold houses are rented and units slated for condominium conversion re-enter the market as rental units.

With continuing strength in overall commercial real estate fundamentals, it is no surprise that capital still is flowing into the market. However, the amount of funds has slowed, especially highly leveraged debt, and likely will continue to decrease this year. This trend will continue to affect asset pricing, working to move prices below the record-setting levels of the past year. This slow but steady downward movement should help to calm fears of overpricing in some markets.

Although we view debt capital as tightening the hatch and clearly as more discriminating and volatile, there is still an ample amount of debt capital to support the right level of financial leverage for commercial real estate. Further, there is plenty of equity capital from both domestic and foreign sources that is inclined to invest in commercial real estate.

2008: Markets to Watch

The following list of top 10 markets by property type is based on RERC's price/value analysis, which utilizes RERC's valuation expertise, market knowledge, and financial modeling capabilities to identify these markets.

Office Industrial Retail Multifamily
Salt Lake City Kansas City, KS Los Angeles Portland, OR
Austin, TX Sacramento Baltimore Austin, TX
Sacramento Seattle Minneapolis San Antonio
New York Dallas Cleveland Chicago
Cleveland San Diego Charlotte, NC Washington, DC
San Francisco Houston Philadelphia Norfolk, VA
Los Angeles Cleveland San Antonio Seattle
Seattle St. Louis Las Vegas Charlotte, NC
Denver Minneapolis Miami Denver
Portland, OR Los Angeles Sacramento, CA New York

Despite the psychological drama of the credit crunch - from tightening underwriting standards to the global stock market plunge on Jan. 21 - plenty of capital is still available for deals in the $20 million to $30 million range, the core industry size, brokers say. However, overleveraged property investors undoubtedly will face loan defaults, workouts or foreclosures. This is the downside of overleveraging assets in a cyclical business, which forces property owners to go through a detoxification process so that the lending cycle can begin anew.

Industry confidence can be regained if fear doesn't overtake rational decision-making. "We can talk ourselves into recession. If we continue to terrify ourselves, and let this drag out, then it's going to become a self-fulfilling prophecy," said Randy Reef, senior managing director of Bear Stearns, at the CMSA conference in Miami. The CMBS market was overheated and poised for a reversal, but losses can be kept tolerable, he maintains.

Many echo the thoughts of Jack Cohen, of Cohen Financial in that the industry doesn't need new or more capital. Rather, in 2008 we need old capital confident enough to invest. This is only possible if everyone stops pining for the easy lending days of 2006 and the first half of 2007 and accepts the new world we live in for what it really is-good for business! The dislocation of capital happened for technical reasons; let's not make this worse by eroding commercial real estate fundamentals. Accepting the shift is the fastest path to a new foundation of wealth creation. Capital is still plentiful for deals that make sense and real estate investment banks like Cohen Financial are still able to finance deals and provide capital for those buyers and sellers who realize the market is still full of opportunities.

About the Author
Rob E. Lee, M.B.A., CCIM

Senior Associate of Investment Properties for Colliers International's Private Capital Advisors Group in Los Angeles and is currently serving as the President for the Greater Southern California CCIM Chapter. He can be reached at Robert.Lee@Colliers.com or (310) 787-1000. He is a 2006 alumnus from the Graziadio School of Business and Management.