How Long a Climb?

By Eugene Gilligan

Steve Pumper is hoping to witness a large, market-changing deal.

“I’m looking for a major player to execute a major transaction,” said the executive managing director of investment services for Transwestern. Such a deal could signal that property values have hit bottom and that the buyer is betting that values are trending back upward. For Pumper, that could bring much-needed clarity to the investment sales market.

A worsening economy, a derailed CMBS market and more-conservative lending have all contributed to an investment sales environment that will likely see a steep falloff from 2007’s $435 billion worth of transactions, a new high-water mark, according to Real Capital Analytics Inc. Activity did decline in the latter half of 2007, owing to the credit crunch, and a paltry $50 billion transaction volume in the first quarter of 2008 portends a much slower year.

“Things should be very subdued for most of the year, at least through the summer,” said Doug Herzbrun, global head of research for CB Richard Ellis Investors L.L.C.

Investors that purchased large portfolios using access to high-leverage financing—often private equity firms— form one of the drivers behind the record-breaking 2007 but have largely disappeared. Sales volume swelled further when private equity firms frequently resold those properties. According to Real Capital Analytics, $211 billion worth of office properties traded in 2007, a 55 percent increase over 2006. But The Blackstone Group L.P.’s acquisition of the Equity Office Properties Trust portfolio and subsequent flipping accounted for $66 billion of that total. In today’s conservative lending environment, with conduit lenders sidelined, such highly leveraged megadeals are unlikely to be completed.

While the volume of those deals will be hard to replace, such buyers as institutions and foreign investors that can plow significant equity into a transaction are likely to become this year’s dealmakers. Thus far, though, investors have been slow to step up to the plate. “There is a wait-and-see attitude,” said Colliers International managing director Bill Collins. “They don’t want to be the first ones to step into this market, and many sellers are reluctant to sell. They don’t want to sell into a down market.”

That huge bid-ask spread on properties is not showing signs of closing, either, according to Allstate Investments L.L.C. senior managing director of real estate Sam Davis. “There are plenty of potential buyers—a lot of equity real estate funds—but they are looking for bargains,” he said.

Sellers’ reluctance speaks, at least in part, to the larger slice of the ownership pie to which institutional players have helped themselves, according to William Fryer, senior partner & head of the real estate capital markets practice group for King & Spalding L.L.P. Those owners are not distressed and can therefore wait for the price they want in order to sell.

Foreign players could also step up to become major players and inject much needed energy into the market. Russian investors, which have deposited much of their money in London and elsewhere in Europe, are becoming more of a force in the United States, Collins said. He also noted increasing investment from Norway, where oil wealth is rising. And Studley Inc. executive managing director Woody Heller reported more U.S. activity from Spanish and Asian investors. Sovereignty wealth funds—which the International Monetary Fund has estimated to have controlled $3 trillion worth of commercial real estate and corporate assets in 2007—could buy a significant amount of property.

Some experts caution against overhyping participation from foreign investors. The Association of Foreign Investors in Real Estate recently polled owners of $700 billion worth of properties, $230 billion of it in the United States. Of the respondents, 85 percent said the falling dollar would have no effect on their investment strategies in the United States. That comes as no surprise to Real Capital Analytics president Robert White. While the cheap dollar may be attracting Europeans to the United States to buy consumer goods and condominiums, he noted, real estate investors have a singular focus. “All investors look at yield.” Thus, many overseas investors may be biding their time because they, too, are nervous about the U.S. economy.

Added Fryer: “They’re going to buy when they see an economy that is going up, not an economy that is going down. I don’t see foreign capital rushing to the doors (to invest).”

There are, however, benefits to investing in U.S. properties. Office investors, for example, should find some more attractive yields, notably in Midtown Manhattan. Cap rates in that market averaged 5 percent in 2007, ranking 20th among major global commercial real estate markets, according to Colliers International. The two lowest-ranked markets, Tokyo and Hong Kong, traded at an average cap rate of 3.6 percent.

How Low Can It Go?

Whenever the market’s starting gun does sound, a significant amount of capital will be rearing up behind the gate. “(Before the credit crunch) it was common to say, ‘There is too much capital chasing too few deals.’ That capital has not gone away,” Herzbrun said. “Institutions need to deploy capital.”

He, too, believes that investors will return to the market upon news of a better economy. “There have to be clear signals that the economy is stabilizing and starting to improve,” he said.

And good buys do exist. Owners of properties that received financing with high loan-to-value ratios and easy terms may soon be ready to sell rather than contribute significant equity as the properties come up for refinancing. “The big barrier in the market is uncertainty,” said NAI Global executive director of investment services Gerald Monash. “The flip side of that is there are also tremendous opportunities: to turn around a property, to buy non-performing loans or buildings that are in foreclosure.”

Some of those uncertainties could clear up within six months, said Marcus & Millichap Real Estate Investment Services Inc. managing director of research Hessam Nadji. The economy may begin to benefit from the Federal Reserve System’s continued cuts in the federal funds rate, and the Treasury’s economic stimulus payments may have an impact by summer, he said. As the presidential election progresses, signs of either party pulling ahead could trigger sales among owners that fear a resulting increase in capital gains taxes.

White, on the other hand, sees two scenarios for 2008: a mild downturn in which asset prices hold relatively firm or a deep, long-lasting recession. “Debt would seize up if we were to become mired in a deep recession,” he said. “Reserve funds would dry up, as owners have to tap them to pay their debt service. The key to the kingdom will be if sellers are able to be resist selling their properties cheaply.”

Ultimately, though, a strong, rapid rebound could occur, thanks to restrained construction and equity capital that is allocated for real estate and waiting to be deployed, White stated.

Earl Webb, CEO of capital markets for Jones Lang LaSalle Inc., is meanwhile eyeing the Fed’s actions and consumer confidence levels, the latter of which constitute a leading indicator of economic activity.

And Trevor Michael, managing director of real estate acquisitions and joint ventures for TIAA-CREF, is on the watch for signs of inflation or hyperinflation. “Inflation means that credit is going to be harder to get and will be less affordable,” he said. “It will also mean that tenants will be less able to invest capital in their infrastructure. Also, how many deals are being transacted? If we are not seeing a lot of deals, that means sellers are not willing to sell. And we are not going to pay a price that doesn’t make sense to us.”

Investors should also track job growth this year, Herzbrun said. “Owners are going to have to keep their eyes on the fundamentals,” he said. “The capital markets aren’t going to bail them out.”

—Reach Eugene Gilligan, senior editor, at [email protected].