July Review for Commercial Real Estate Investors
In this interview, Mike and Dan speak candidly about the current market slowdown and the challenges facing commercial real estate investors today.
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DARBI: Hello, this is Darbi Worley your host for the "Capital Synergies" talk show for commercial real estate investors. Capital Synergies is brought to you by Steelhead Capital, your commercial loan advantage.
Today we have with us Mr. Dan Fasulo, Managing Director of Research for Real Capital Analytics. Leading the interview will be Mr. Michael Green, Principal and co-founder of Virtu Investments.
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MIKE: Hi, Dan. Welcome to the show.
DAN: Oh, glad to be here.
MIKE: You know, interesting times we’re in these days. I think a lot of the listeners will be interested to hear your take on...on this market. I think sometimes in real estate things move so slowly, and...and lately, it kind of feels like we’re in...we’re in the stock market with real estate.
DAN: Yeah. There’s no question that, you know, sales activity has really fallen off a cliff, you know, over the past 6 to 12 months, and we’re actually running at that level that we haven’t seen since 2004. The second quarter of 2008, we’re looking at about 35 billion dollars worth of sales transactions that Real Capital has tracked, and the last time we’ve seen numbers this low are back in the first quarter of 2004.
MIKE: Unbelievable. Obviously, we’re seeing a result of both the available equity coming into deals slow down and sit on the sidelines and be more cautious, but also the availability of debt, particularly CMBS, given that that’s had such a tremendous impact on rising values, how much downside do you see in real estate values in the United States, given that credits are not available right now?
DAN: We supply data to Moody’s, create the Moody’s real commercial property prices index, and, you know, this massive liquidity of debt that came into our markets through CMBS really apexed at the end of 2006 into early 2007, where, you know, it’s basically a free-for-all. Anybody purchasing a property could get that financed by the CMBS market. And if you look at the index...the pricing index, it shows a pretty clear 10 to 15% price spike over that period, between the end of 2006 and mid-year 2007. So, you know, we feel that that...that 15% froth, if you will, on the market has kind of been wiped out, and, you know, if you look at some of the price points coming in on the deals that are actually happening...
MIKE: They’re proving that out?
DAN: Yeah, pretty much across the board, especially in, you know... they are more global markets on the coasts. It’s a little different story for certain property niches and types; anything that has a value-add component to it is really getting discounted heavily because the banks don’t want anything to do with future income anymore. They’re very much focused on, as you know, on what the in-place income is and, you know, whether a property has a really good story to it.
MIKE: Yeah, we’re seeing a lot of that...the old days of recourse lending is back, you know, and we were able to accomplish a lot of our value-add place, you know, with non-recourse financing over the last three years, and that’s pretty much gone out of the window since. So...
DAN: That game is over.
MIKE: Yeah, sort of back to the old business of going to your local bank and asking them to fill... if they’ll back you on a certain asset—and even they are more cautious because their balance sheets have been affected largely by a...you know, a lot of the single-family residential development-type deals that they’re...they’re involved in, and they’re having a mark to market and it’s just turning their balance sheets upside down.
DAN: Well, I’ll tell you what has kept the market afloat over the last six months have been the ability of, you know, the local and regional banks to loan to the commercial real estate markets. And, you know, this group had a lot of pent-up demand because they were shut out and getting outbid by the CMBS conduits...
MIKE: Sure.
DAN: ... for, you know, a few years. But we’re hearing anecdotally from many of our clients that many of those community and regional banks are not only under pressure from the Fed to make sure that liquidity is in good shape, but we’re hearing that many are hitting their...their entire 2008 allocations; they’re starting to hit them already and we’re only here in July. So...
MIKE: Yeah, I’m sure the Feds don’t want to see, you know, a repeat of the SNL crisis. So, they’re focused on that, trying to chew up all these, you know...all these guys that were...were selling CMBS bonds, but also making sure that the...that the banks don’t start going under.
DAN: Well, you know, I think the other question about different property types and what’s performing better than others, if any. Once, I was reading your questions over the past couple of days, I was going to mention multi-family, you know, apartment sales, which have held up relatively well compared to the other property types, because of the availability of the agencies financing...
MIKE: Yeah.
DAN: ... Freddie and Fannie, but now with the report that came out this morning and, you know, possible liquidity troubles...
MIKE: I know that Fannie and Freddie’s stock has been under a lot of pressure over the last few days, but I didn’t see the report this morning. What’s the latest news?
DAN: Well, there was a report that came out at Wall Street this morning that’s basically questioning their liquidity.
MIKE: Their solvency, huh?
DAN: And whether they would need to raise capital to go forward. You know,, obviously we know that there’s a kind of implied government backstop there, but, you know, they’re certainly going to be under a lot of pressure as far as putting additional capital out to the market, which is kind of in their mandate; help build the dearth of capital that disappeared with the CMBS
MIKE: Sure, being an apartment investor primarily, you know, we do feel like we’re in the place to be right now given that the fundamentals, the actual operating fundamentals, of the business are strong because we’re seeing a lot of people come back out of homeownership back into apartments, and yet the cost of construction and the financing available for constructions limiting supply, so... you know, our portfolio is as healthy as it’s ever been and just, you know, kicking off good cash; fortunately, most of it has permanent financing, it’s just where we are trying to execute on any type of new acquisition or any kind of sale where we’re seeing the market just stagnate because of, you know, lack of financing available and where it is available; as you point out, it’s in the Freddie and Fannie world, and I’ll tell you, if something was to happen there, we would see an absolute grinding halt to the business.
DAN: Yeah, it’s certainly pretty troubling. And, you know, I was watching CNBC this morning and they said—actually, the...President Bush assembled a team to kind of, you know, review the agencies and what their actual position is.
MIKE: Right.
DAN: I’m definitely going to keep a good watch on that.
MIKE: Keep a close eye on that, sure.
DAN: I think you had an interesting point in there. Something that hasn’t been really out there and highlighted as much as I think it should, and that’s how hard new development got hit by the credit crunch. You know, certainly development activity has always been seen as kind of the riskiest way for...for lenders to enter the commercial real estate base, and, you know, unless you’re a very established developer with a huge track record and a project that’s in the perfect location, it’s very difficult to get debt right now, and then you throw on the rise in construction costs and, you know, this is going to have a tremendous affect on limiting supply...
MIKE: Right.
DAN: (...) which, in many markets, is already pretty tight. And so that’s one of the biggest factors that’s keeping me bullish over the, you know, next two to four years, that there’s going to be a huge wave of supply coming in on the commercial side.
MIKE: You know, I was...you know, it’s so interesting to be, you know, in a cycle that isn’t driven by the supply-demand fundamentals. Usually, we see our real estate corrections, you know, occurring on the operational side when supply exceeds demand, and in this case, we’re seeing it, you know...it’s occurring on the...on the capital side, and largely as it relates to the original subprime meltdown is now, you know, tripled into our business and constrained credit to such degree that, you know, our values are dropping, not because of supply-demand fundamentals but because of the availability of credit. It’s...and I don’t, you know...I remember suffering a little bit of this in the late 90’s with the Russian crisis, but that only lasted, you know, six months. Do you have any idea? I mean, are you guys looking out and seeing it improve any time in the near future?
DAN: Well, you know, I think we really need to get the CMBS market jumpstarted again, and, you know, we’re all pretty confident that it’s going to come back, it’s just the question of when and in what format. I think we’re going to start to see some new issues trickling in the fall, and I’m hoping we get back to, you know, a more normalized situation in the middle of next year. But I think when it does come back, it’s going to look a lot more like it did when the industry was just going to go: you know, very conservative, under-riding LTV, and actually makes sense to a lay person.
MIKE: Sure. Real solid coverage levels, subordination levels for triple B’s that all of a sudden make sense.
DAN: I’ll tell you, you know, we have a very talented group of analysts here at Real Capital Analytics, and they’re all real estate people. And some of the CMBS issues got too confusing even for my real estate analysts, and that can never be a good sign.
MIKE: No. I was actually talking to someone the other day about how it might reinvent itself and I think to simplify it—even to simplify it into product types. I mean, I don’t think people would...people thought when they were diversifying these pools—you know, cross-collateralizing office and mobile home parks and hotels with apartments and single-family—you know, that that created a diverse pool, but what it really created was something that no one could even understand the vehicle.
DAN: Yeah.
MIKE: And how do you underwrite those...you know, the various default rates because they all are...tend to be different? You know, that made it hard to value those bonds, I think, and...so I tend to think it’s going to come back in a form that’s more simplified. If you want to go buy a pool of apartment loans, you can buy a pool of apartment loans—or you want to buy a pool of office loans. And hopefully they’ll be underwritten differently and priced differently.
DAN: Well, and there’s definitely going to be much more transparency demanded by the buyers...
MIKE: Sure.
DAN: (...) of the bonds in the future.
MIKE: Well, another question I had which I had sent over to you and I think is...is interesting in this day, is this idea of the falling dollar and emergence of overseas capital. You’ve seen some large transactions where some of these, you know, sovereign wealth funds have come over and bought some prominent buildings in the United States. You know, given the strength of the dollar and also the fact that there’s a, you know, credit crunch, do you see that continuing, and can it have, you know, a bullying effect on the commercial market?
DAN: Well, I...you know, certainly, the falling dollar is one part of the equation, but I’m part of that camp that thinks that too much has been made on the actual dollar fluctuation. I think it’s a little naïve to think that, you know, these savvy investors from around world—you know, someone sitting in their office in London says, “The dollar is down 1% today, let’s go buy American real estate.” I think this is just occasional...international property players has gone to the point where they’re more interested in geographical diversification and, you know, if the currency is moving in their favor, fantastic; maybe they’ll wind up buying a little more here in the States. So I think it’s a part of a consideration, but I think it’s possibly a smaller part than...than many believe.
MIKE: You know, are there other macro trends besides, you know, the emergence of overseas capital that...that you...you all are looking at, that you think are going to, you know, sort of have a major impact on real estate investing over the next 12 months?
DAN: Well, I think the wildcard is the economy, and that’s where we’re going to have to watch very closely. You know, many of our markets that are linked to the global economy and its continued expansion are holding up very well. You know, you’re in Manhattan, D.C., San Francisco, or L.A., you know, activity and pricing has certainly held up much better than your more domestically linked markets here in the States. My biggest concern is, you know, a global slowdown in economic activity, which really affects our entire marketplace. So, you know, the economy is the wildcard, but I think we’re still in the middle of this major structural shift around the world with, you know, emerging economies developing and this demand from a rising middle class. I don’t think we’re at the end of that structural shift, and I think there’s going to be tremendous pressure for new modern commercial real estate product in the future—and that’s keeping me kind of bullish, at least over the next decade.
MIKE: Got you. You know, one of the questions that I had for you was...was this idea of deleveraging. You know, I was...one of my counterparts was in Sacramento this past week and talking about how much the retail segment of the market is suffering; you know, retail developments that are built now that have no one to fill them; you know, those retail stocks have been hammered, the death of the consumers being chanted, you know. Can you...can you sort of explain...if you see, you know, this consumer over the last decade has had more liquidity than maybe in...in any decade in recent history given their ability to borrow against their home and so forth? You know, do you think that we’re now seeing a fundamental shift; that we’re not going to see a consumer in the United States that’s as affluent and able to make those same buys? And do you...do you feel that it has a long-term negative impact on retail investing?
DAN: You know, we’ve been asked this question for years now, several years, and I just don’t understand the American consumers at all. I don’t understand how we could keep spending. I don’t know if you saw, you know, a top story in the Journal today—you know, Wal-Mart and a few other retailers showed increase in in-store sales. It’s just unbelievable how we keep spending and I...I just can’t get my arms around it.
MIKE: Where there’s a will, there’s a way, right?
DAN: Yeah, I mean, it’s...you know, we’re used to...we need to start looking at our economy more from a global perspective as opposed to just our local markets, because, you know, the falling dollar, if it has had an effect, it’s in tourism and, you know, in the personal level. You know, we’ve certainly seen a tremendous uptake in tourism and business travel from overseas folks. And in markets where there’s that strong attraction, it certainly helped to buoy the retail market from a slowdown—domestic slowdown. But, you know, back to your point, there’s no question that if there is one segment of overbuilding in our commercial real estate base, it’s in the...it’s in the retail property type in your secondary and tertiary suburbs around the country.
MIKE: Right.
DAN: But interestingly enough, one of the hottest property niches right now is urban retail, and we’re still recording record pricing on sales for urban retail around the country. So...
MIKE: Well, so...we...you know, the interesting part is we’re probably in the most turbulent real estate environment that we’ve seen in the last decade, which, as we all know, creates opportunities. So, yes, if we can maybe just end with you summarizing, you know, your views of some of those opportunities and what they may be, and give some of the listeners an idea of where, maybe if they have access to putting their dollars, they should be looking.
DAN: Well, if I know anything, the one thing I know is I’m not very good at telling the future. I’m certainly an Econ 101 guy, supply and demand, and I would much rather overpay in an expensive market where I know the supply dynamics are in a buyer’s favor; you know, coastal markets like Manhattan, D.C., San Francisco, L.A, and Boston, even...even some segments in Florida where there’s restricted supply. I really see the greatest potential for growth in those types of markets. And, you know, Real Capital Analytics is the midst of international expansion right now, and I’ll tell you, our rental rates for most commercial property types are starting to look very attractive when comparing our levels to locations overseas.
MIKE: Right.
DAN: It’s keeping me very, very bullish especially on the international markets here in the States.
MIKE: Well, Dan, where can our listeners go to learn more about the reports and subscription services from Real Capital Analytics?
DAN: They can certainly go to our website at rcanalytics.com. There’s a wealth of free data on commercial real estate markets up there, and they can certainly put in their e-mail and sign up for a free trial of our service.
MIKE: Okay. Well, thank you very much. I really appreciate the time. I’ve learned a lot. I think everybody else probably has, too, and I appreciate it. And hopefully we’ll catch up again soon because things are changing so fast that we...we may have some new things to say.
DAN: My pleasure.
MIKE: Thanks, Dan.
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DARBI: Excellent. All right. Thank you again to Dan Fasulo, Managing Director of Research for Real Capital Analytics, and Michael Green, Principal and co-founder of Virtu Investments for joining us today on Capital Synergies.
So guys, if you are an investor looking for expert assistance with financing commercial real estate, be sure to check out the new commercial loan programs offered by Steelhead Capital, your commercial mortgage advantage. Again, that web address is http://www.SteelheadCapital.com.
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