Cash Takes the Throne
- Jun 01, 2008
.By Anthony GrazianoSophisticated private and public commercial real estate investors staring into the headlights of downfall projections should take heart. The market is actually shifting back to equilibrium, where cash and good judgment will reign.The past two quarters have been turbulent for the real estate capital markets. Barrels of ink have prognosticated whether or when the other shoe will drop. Will the increased cost of borrowing drive capitalization rates up, thereby lowering prices? Will higher debt-coverage ratios balance the pricing equation by driving asset prices downward?Much of the dialogue has centered around the principal differences between the last commercial real estate slide and the current investment climate. An oversupply of physical product drove the situation in the early 1990s. Large speculative buildings stood vacant, throwing underlying economics—vacancy, rent and expenses—into free fall. Today’s problem is not an excess of physical inventory affecting the supply-demand equation but instead a glut of debt paper and a burn-off period associated with writing down those potential losses. Since August’s credit squeeze, sensible investors have been evaluating whether to invest at the nexus of a possible market change. At the same time, Wall Street and the large investment banks have strived to avoid the practice of trading new paper based on rosy projections of exit pricing in order to save the day. The intersection of those behaviors in good measure forced the investment logjam the industry now faces.Sophisticated, well-capitalized buyers, though, will find significant opportunity during the rest of 2008 and in 2009. Asset prices escalated in 2004 and 2005 in response to real user demand, anticipated rental growth and construction costs that rose with the prices for materials. Some opportunities will arise from the financial structures that have since taken up residence in the market. By 2005 and through the middle of 2007, investors were using interest-only debt product with much higher loan-to-value ratios. This packaged debt was recycled in the CMBS market until September. Certainly, future quarters will hold some opportunities to buy overleveraged commercial projects at price discounts. Furthermore, many of these deals were structured as interest-only debt for necessary lease-up or renovation/reposition planning, offering value-add possibilities.But product will not flood the market, forcing prices to slide, as occurred in 1991. Much of the existing investment paper is tangled with multiple tranches, making possession and liquidation of real estate assets much more difficult in this cycle. To a large extent, this will mitigate the capability of the debt market to package large portfolios and dump them into the supply, as during the days of the Resolution Trust Corp.Investment money and private equity funds that await a property fallout or pricing that is lower than replacement costs will find better opportunities in land plays on approved residential development tracts, given the likelihood of protracted three- to five-year holds. Investors can apply this strategy to landowners waiting for the market to equalize before breaking ground or before near-term, real demand for land can return.The development market is probably in for some short-term adjustment. Changing economic conditions have stalled lease-up projections for new office and retail developments, as jobs and consumer spending decline. At the same time, materials pricing and new-construction costs are not expected to decline, and commodity brokers reveal that oil and steel prices are going nowhere but up, sending replacement costs for properties in the same direction. Supply-and-demand dictates that rent growth must reach equilibrium before new supply will be supportable. As the development pipeline slows for 2008, the supplies of new projects and highly leveraged buyers will decline concurrently. This will place downward pressure on commercial land pricing until construction-input costs moderate or rent economics support new construction.Those investors interested in existing properties will find opportunity for rent growth as construction slows. The principal limitation on income-producing investment deals in 2008 will be competition from foreign direct investment. The weak dollar aids crossborder buyers, which find U.S. assets to be a relatively good hedge. They will likely remain so for the balance of 2008.Those competing for properties or land in today’s market will discover a return to basics in which cash buyers win the best deals and garner the rewards of investing in physical, cash-flow-driven real estate.Anthony Graziano is a principal for Integra Realty Resources Inc.’s South Florida and coastal New Jersey offices.