Hardly a day goes by without a fresh wave of negative headlines about the global commercial real estate market's challenges. The securitization markets that fueled its stellar growth between 2005 and 2008 remain largely moribund. Bank lending is restricted to the best credits. Slow growth or no growth in the major economies weighs on markets' prospects. Important categories of tenants such as large banks and other financial institutions continue to cut staff or hold the line on head count.
As usual, the headlines do not tell the full story. Surveying conditions in the developed economies, we see a more nuanced picture of real estate markets. In our view, there are five keys to understanding and identifying the opportunities in the major developed markets.
Income is expensive, but bricks are cheap
Established, core properties that produce long-term, stable income are richly valued across the major developed markets. For example, in the U.S. yields for these low-risk income-producing properties are often in the historically low range of 4% to 6%, indicating prices are expensive by real estate standards (particularly in light of the modest pace of job growth).
These yields still look attractive to investors who are comparing them to historically low bond yields around the world. For investors hungry for yield, 4% or 6% is a banquet when government bond yields in real terms hover near (or in some cases below) zero. This investor fixation on yield has driven stable, income-producing properties to valuations that already reflect a large part of the expected recovery in rent and occupancy over the next several years.
By contrast, buildings in which the income stream has more than a small amount of traditional real estate risk — vacancy or expiring leases, untenable capital structure, maintenance issues — are cheap, drastically so in some cases. This persistent risk aversion in many markets means there are comparatively few bidders for properties that need fresh capital and creative management solutions.
As traditional debt capital remains limited, new sources form
The debt-financing side of the real estate business is several years away from returning to normal, stable conditions. Notably, the U.S. commercial mortgage-backed securities market, where issuance totaled more than $230 billion in 2007, continues to sputter, with only $5.2 billion of new issues in the first quarter of 2012. The U.S. regional banks also have largely retreated from commercial real estate lending. The combined effect of these trends is serious debt illiquidity in both the middle market and the non-core segment of larger markets — a large part of the commercial property market. U.S. money center banks are back in the market, but with limited ability to securitize their loans and added regulatory burdens, they are highly focused on the lowest risk, most core-like part of the market.
The liquidity squeeze in Europe is worse. The pressure on European banks is particularly acute as they struggle with strong regulatory pressure, overleverage and recession. As an example, Euro Hypo, one of the largest property lenders in Europe historically, announced recently that it is exiting the commercial property lending business for good.
Into this gap has stepped an emerging cadre of private lenders. These non-traditional sources see opportunities to lend to borrowers who have good assets but need capital and expertise to turn them into the stable, income-producing properties so highly prized in a yield-hungry investment market. The loans might not provide the strong cash flow coverage available to core property lenders, but the per-square-foot exposures are conservative by historic standards and the favorable spreads provide very attractive risk-adjusted returns to these new lenders.
A steady supply of overleveraged assets will continue to come to market
It took years to create the broad overleveraging that existed in 2008 and it will take years to unwind it. Contrary to the statement made by some “vultures” that there has not been a liquidation of distressed assets in the U.S., we have seen a steady flow of transactions for the past several years. Large, bulk deals that were common in the Resolution Trust Corp. liquidation two decades ago are few and far between, but one-off assets and smaller pools have been steadily restructured or sold and this will likely continue for several more years. In the U.S., traditional lenders are a bit more than halfway through this painful process, while Europe is only in the initial stages. Japan is further along than the U.S. but still has a significant inventory of overleveraged assets. Large banks and other major institutions remain under pressure from shareholders and regulators to reduce their commitments and work through these troubled situations.
All told, as much as $1 trillion of debt will have to be rolled over in the coming five years in the U.S., and a comparable amount in Europe and Asia combined. Most of this debt will not find financing on its current terms, so the painful process of restructuring will continue for some time. Losses will have to be recognized and apportioned, and new capital brought to the table to get the deals done. The providers of this new capital will be well placed to acquire real estate assets at attractive levels or participate in favorable financing deals.
Fundamentals have bottomed in most major markets
While financing challenges abound, the fundamentals of the real estate markets — rent and occupancy — are stable or improving in most developed markets. In the major office markets, such as New York and London, rents have recovered solidly from 2009 trough levels but remain 20% or more below the prior peak. Rents in Tokyo are closer to 30% below peak levels and appear to be finding a floor. While we do not expect rents to move sharply up in the near term, we do very much expect that they will slowly trend up with job growth and ultimately approach (or exceed) the prior peak — that is, they will follow the pattern of previous cycles.
There are some bright spots as well. Office rents in tech-oriented markets in the U.S., such as Silicon Valley and the Chelsea submarket in New York, have shown strong growth. U.S. multifamily fundamentals are as strong as they have been in decades due to the secular change in home ownership that has emerged from the housing crisis.
Europe remains the least certain of the developed market areas, but despite the dire headlines — largely in the U.K. and the U.S. — parts of Europe, notably the Nordic markets, remain fairly healthy. Even amidst the recession, fundamentals in Paris and the major German cities are likely to flatten out rather than deteriorate sharply, and we expect London, particularly residential and retail, to remain reasonably healthy. Southern Europe is, of course, a different story. The Spanish and Greek markets are in serious disarray, and the shifting situation makes predictions impossible.
Mispriced risk creates attractive investment opportunities
As banks and other lenders work through the enormous inventory of overleveraged assets on their books, investors will continue to have a wide range of opportunities to participate in value-creating strategies. The yawning valuation gap between stable, income-producing properties and those properties with perceived risk creates a broad range of attractive situations.
New buyers can acquire at highly favorable prices properties that are fundamentally sound but have been starved for capital and attention while lender and borrower have been dancing. With an advantageous acquisition price and a new, sustainable capital structure, experienced managers can use the lower cost basis to offer rents that undercut the competition. In these situations, profitable levels of occupancy can be achieved even in situations in which there is little net growth in demand in the local market.
As a result, the property's value can increase substantially as it becomes the stable, income-producing asset so prized by the market in these low interest rate conditions. Investors can participate in this process in a number of ways, including through the acquisition of debt or recapitalization of projects.
These opportunities arise from a mispricing of risk that often occurs as the property market bottoms and begins a cyclical recovery. This uncertainty and inefficiency is exaggerated in times when the economic recovery is weak, global markets are volatile, and headlines are persistently negative. At times like this, the normal risk spreads between categories of assets can move out of kilter. Traditional capital sources retreat and are replaced by new market participants. It is precisely in these conditions that experience, research, and local knowledge can identify opportunities to achieve significant risk-adjusted returns.
David Sherman is president and chief investment officer of Metropolitan Real Estate Equity Management LLC, New York.