Anyone looking for evidence that the U.S. commercial real estate industry has taken a hit from the financial crisis gripping the globe need look no further than the level of foreign investment in U.S. real estate: According to Real Capital Analytics (RCA), 2008 foreign investment figures from January through July came in at $7 billion, compared to a total of $52 billion invested in the U.S. in 2007.
“This is obviously a dramatic slowdown, and if we continue at the rate we’re going today with foreign investment, we’ll be down to ’03 levels, which finished the year at about $10 billion,” said James Fetgatter, CEO of the Association of Foreign Investors in Real Estate (AFIRE). “Granted, 2007 was perhaps inflated due to a couple huge investments that were out there [specifically, separate investments by an Australian firm and a French firm at approximately $9 billion each], but even 2005 and 2006 each boasted investments of about $25 billion. The drop-off is particularly noticeable with some of our most dependable investors, such as Australians. They’ve been one of our top investors for five years and in 2007 accounted for 26 percent of all foreign investment in the U.S. This year, they’re investing only 0.4 percent of that amount. Germans, while still active, were at 22 percent of their previous year’s totals through July. Really, no matter how you look at it, transactions in the U.S. are way down.”
Of course, investment in American real estate is hardly a barometer by which to gauge the entire industry, particularly an industry that can be viewed from two main perspectives: the leasing side and the investment side.
Leasing: the Calm Before the Big Storm?
At first glance, leasing fundamentals are clearly slowing, but many asset types still appear to be holding fairly steady for now, mainly because this real estate downturn is primarily a result of debt markets rather than by oversupply and an over-stuffed pipeline. As a result, many markets are approaching supply/demand equilibrium with relatively low vacancy rates and rents that haven’t yet dropped dramatically. But because commercial real estate tends to lag the rest of the economy by six to 12 months, it is widely expected that the ultimate consequence of today’s economic environment will be the industry’s worst year since the 1991-1992 downturn. Already this year, Reis, Inc. is reporting negative net absorption of more than 19 million square feet of space, the highest it’s been since late 2001 and early 2002, when reverberations from the 9/11 attacks were felt in the real estate industry. Without a doubt, the year-to-date loss of more than one million U.S. jobs is having an impact, and it’s likely to worsen as commercial real estate fully catches up with the rest of the economy.
“Many other asset classes adjust all at once, but with real estate it always feels a little like getting sent to the principal’s office when you’re a kid,” said Geoffrey Dohrman, CEO of Institutional Real Estate, Inc. (IREI). “You know you’re in trouble and will have to pay up, but for now you’re just sitting there, waiting for it to happen. You don’t know exactly when he’s going to call you back to his office or what he’s going to do and it’s the sitting and waiting that’s just so horrible.”
The Investor Blues
Meanwhile, the mysteries of the when and how are on full display on the investment side of the business—where the effect of the credit crunch and global financial crisis is currently being felt the most strongly. And the picture, unfortunately, is a decidedly gloomy one. Throughout the Americas, RCA reported that third quarter ’08 sales volume was at just $30 billion, compared to $131 billion during the same time period in 2007. In the Asia Pacific region, third quarter volume dropped from $66 billion the year before to $18 billion; and in Europe, the Middle East and Africa (EMEA), volume came in at $54 billion, down from $84 billion during third quarter 2007. All told, RCA expects commercial real estate sales in 2008 to be less than half of last year’s $514 billion level.
Investors are also backing out of transactions at a fast clip; according to Cassidy & Pinkard Colliers, more than $14.5 billion in deals have been scrapped in the U.S. this year alone.”The numbers just dropped off a cliff as we moved into 2008,” said Ray Torto, global chief economist for CBRE Torto Wheaton Research. “The reason is simple: real estate is expensive—it’s not like buying a $100 share of stock. It’s millions of dollars we’re talking about, and most investors need to finance those kinds of capital expenditures. The credit crunch—which stemmed from the collapse of the sub-prime home mortgage market last year and worsened with each foreclosure and failure of major financial institutions—essentially caused banks to tighten up and stop lending. And with that, it became a very simple matter. Without financing, investing in real estate dried up dramatically.”
“Adding to the industry’s woes is that nobody—nobody—wants to buy something at the wrong price in this market,” Torto added. “A buyer recently said to me, ‘I could buy today, but tomorrow’s prices will be cheaper,’ and I can’t blame him for that attitude. Call them bargain hunters, trend observers or market participants but nobody wants to buy and then have the market drop further, so people are sitting on their hands. It’s really a crisis of confidence in which banks aren’t confident and investors aren’t confident, and it won’t change until buyers and sellers feel they’ve found price equilibrium in today’s world. It’s not good for the economy or the brokerage firms, but it’s reality and it’s being replicated all over the globe. Some markets, like the UK, are a little ahead of us in that they’ve come down faster, while others, like Hong Kong and Shanghai, are behind us and haven’t come down as much. But overall, most countries are experiencing what we are here in the U.S.”
Debt capital is severely impacting the health of the industry, as well: “A year ago, investors could have gotten a loan-to-value ratio of up to 90 percent or even more, or interest-only loans,” Dohrman said. “You simply didn’t need much equity. Today, you need at least 40 percent equity and a 60 percent loan. If you do the math, assuming the same cash flow as you had before, you’re looking at two percent yields, and no one wants that. So the result is that no one is moving forward on investments because the deals just aren’t advantageous.”
The Urban Land Institute (ULI) and PricewaterhouseCoopers, in their Emerging Trends report, also indicated that total expected returns on private equity real estate investment in 2009 will likely register in negative territory for the first time in nearly two decades.
Meanwhile, people who have owned commercial real estate as independent investors are feeling the pinch in other areas of their finances, and it’s having a domino effect on their real estate investments. In December of last year, there was an estimated $42 billion in underinvestment; 10 months later, that’s completely flipped. “Real estate values haven’t gone down that much yet, but there’s no money to do additional investments,” Dohrman added, “and when you consider that Americans have lost up to $1 trillion in the value of their stocks and bonds, it’s understandable that they just don’t have very much left over to allocate to real estate.”
Another factor to consider is where investors are holding their funds; if a foreign investor is keeping funds in a New York bank waiting for an opportunity in New York, not much has changed. But if they’re in London with all their funds in pounds, they’ve seen a 15 percent reduction in purchasing power over the last 30 days.
Will Stimulation Packages Thaw the Deep Freeze?
Not surprisingly, global crises like these get global attention, and countries throughout the world have put forth fiscal recovery plans much like the U.S. $700 billion Emergency Economic Stabilization Act of 2008 in order to help financial institutions and investors alike. And while the majority of real estate experts do believe they’ll help, most view the recovery plans not as a long-term solution but as a fix that will help settle financial markets and increase investors’ confidence that markets are stabilizing.
“The idea behind these kinds of bills is to thaw lending, but it’s going to take a while for the benefits to really work into the system,” said Glenn Mueller, real estate investment strategist for the Dividend Capital Group and professor in the FL Burns School of Real Estate and Construction Management at the University of Denver. “The bigger question is how long will it take? A month, a quarter, a year? I think six months to a year is most likely.”
“They’ll help for sure,” Dohrman agreed, “but it’s a bit like the triage process on a battlefield. It will determine who survives, who doesn’t and who can wait. But like first aid, it’s not a solution to the root cause of the problem, which has more to do with regulatory flaws and the underwriting process in lending. These measures will stop the bleeding, give us the time to fix the underlying causes, and enforce discipline.”
Looking forward, blue skies are not impossible to find. According to Fetgatter, there is plenty of optimism that more money may be poised to come back into the U.S. because of the inherent advantages the U.S. market offers. “We may not be able to offer enormous market stability in the short-term,” Fetgatter says, “but transparency and stability are certainly U.S. hallmarks over the long term. That makes international investors feel that they can get better returns from established American real estate, unlike emerging markets, where there simply aren’t sufficient rewards right now to counterbalance the risks.”
But regardless of when we’ll start seeing capital pouring back into commercial real estate, there are some strategies to help weather the storm. Dohrman advises property managers to focus first and foremost on operations. “Keep your tenants happy in your buildings and focus on operations management,” he says. “Extend leases as quickly as you can, and remember that now is not the time to nickel and dime your best tenants. We’re in the eye of the hurricane, and things are going to get crazier, so think about strategy now, when you have the time to think. It’s probably too late to pay down your debt and de-lever, but find whatever equity you can, be realistic about valuation, and don’t wait for events to force you into something. Take control while you still can.”
Mueller urges patience, noting, “It’ll come back, but remember everything is relative. The longest recession, which lasted five quarters, was in the early 1970s. In 2003, the recession lasted only 2.5 quarters. I’m guessing this recession will be someplace in between particularly with so much money being pumped into the economic system through stimulation packages. I’m anticipating that the employment declines that started in the beginning of 2008 may extend through the second quarter of 2009, but then we’ll start back on the upward swing.”
As for the mythical crystal ball that everyone at some point wishes they had? Torto points out that it may very well be right under your nose. “I view commercial real estate as ‘the economy in a box.’ What goes on in the economy is reflected in our buildings—whether it’s job growth or unemployment, retail expansion or retraction. As a result, most of us have a better grip on the economy than we give ourselves credit for.”
Lastly, keep it all in perspective. As Dohrman points out, “We had a long party, and everyone knows that the longer the party, the longer it takes to clean up.”
About the Author: Stephanie J. Oppenheimer, APR, formerly the assistant vice president of communications for BOMA International, is principal of Skylite Communications, a freelance writing and editing company based in Falls Church, Va.
