Summary
The combination of a slowing economy and turbulent debt markets has finally hit the US commercial office market. Although a great deal of equity capital remains ready to invest, between the meltdown and risk-adjustment in the financing markets, deteriorating operating fundamentals and herd mentality withdrawal from the market, office investment transaction values are down 70% from last year as reported in the May 21, 2008 edition of National Real Estate Investor. Moreover, what deals that are getting done are being transacted at cap rates 50-100 basis points above where they were a year ago, to an average of approximately 7% nationally. If every commercial property in the US were appraised today at these higher metrics, the implication would be a loss in value of nearly $200 billion.
Analysis
The public REIT markets--which typically forecast the private markets with a lag, telegraphed this last fall, when they fell as much as 45% off their highs across a broad number of product types. Moreover, large publicly traded brokerage firms like CB Richard Ellis and Jones Lang LaSalle that make their money from closing these transactions have also seen their stocks drop dramatically. And this is the good news. the bad news is that what few assets are trading are selling considerably below seller expectations, and when the market finally starts to clear, many properties bought at the recent peak will be turned over to lenders or will trade at a loss.
There are three key forces driving down values and pushing up cap rates, which move inversely to value. The first is the state of the debt markets. The high leverage, low constant, covenant-lite terms that were available through the CMBS markets as recently as a year ago are gone: these are the loans that pushed prices up and cap rates down as low as the 3 to 4% range and enabled frenzies like the EOP/Blackstone sale. Now, with CMBS on life support, what is available mainly from banks and insurance companies is, on a good day, at eye popping spreads 350-450 over the curve and with underwriting standards and covenants that barely put the loan to value over 50%. This has not only cramped the investment market for leveraged buyers--particularly of larger transactions--it is putting recent purchasers with near-term debt maturities in the cross hairs. Recent press shows that even seasoned industry veterans like Harry Macklowe are not exempt from these trials. Moreover, as even high quality CMBS tranches trade at high (and we believe mispriced) spreads reflecting credit default markets as opposed to underlying real estate fundamentals, investor capital is being pulled to debt investing or lending and away from equity positions, pushing up equity cap rates. Bottom line: a massive deleveraging is in the works that has led to severe illiquidity in the real estate capital markets and, even when the storm blows over and the CBMS market returns, it is clear that between new government oversight, a return of common sense lending standards and more intelligent risk pricing the securitized debt markets will never be the same.
The second issue is what we euphemistically call in our industry the denominator effect, or what happens when the herd suddenly wakes up and realizes it either bought too high--or failed to sell product into the high--and as a result is overweight real estate at precisely the time it is worth far less. The result is twofold: these same buyers go into hibernation on the buy side, and then attempt to sell product into an environment that is suddenly devoid of buyers for the same reason. This has sidelined many institutional, low leverage domestic buyers that sellers were hoping would give them an exit, and even dollar-arbitrage foreign buyers are on the sidelines as they calibrate the implications of a weakened us economy on its office market. the result: market illiquidity and lock up in the real estate private equity markets.
The third reason, which in many ways drives the other two, is that operating fundamentals are deteriorating, the smart money knows it and it is being priced into their offers. According to a recent Colliers International report, in the first quarter of 2008, the national office market saw its first loss of net occupied space--3.7 million square feet of it--since the first quarter of 2003 due to a slowing economy and implosion of many office using industries like construction, housing, mortgage banking, and finance. Although this barely affected the 4.7 billion square feet of existing office space that Colliers tracks--national office vacancy moved up a paltry 35 basis points to 13% in the first quarter of 2008--these vacancy numbers are deceiving, because they do not reflect massive amounts of sublease space becoming available as tenants downsize or the 120 million square feet of under construction office space that will be delivered over the next 24 months into a weakened economy. And, although many of these new buildings are preleased, a vast majority of them are cannibalizing other existing Class A buildings to do so, so vacancies will continue to move up, driving rents and values down.
It is also important to understand that the national office market moves like a supertanker; years of cycles show that once it gets headed in the wrong direction it takes a while to turn it around. And the statistics bear this out: although perennially strong markets with solid franchises and real supply constraints like Midtown Manhattan, West LA, and the Boston, Seattle, San Francisco and Washington CBD's will weather the vacancy storm relatively well and are continuing to see sales at strong prices, suburban and secondary markets will see vacancies skyrocket towards 20%. A classic case in point is the Miami downtown; although Colliers shows the downtown at a relatively benign 12% vacancy, nearly 2 million square feet with almost no preleasing--representing a 15% increase in supply--will be delivered over the next few years into an economy already buffeted by the Florida housing meltdown. Absent a major improvement in the job or absorption picture, Miami's downtown could see vacancies approaching 30% by 2010.
These trends have extraordinary implications for value. By way of example, a move from a 6% up to a 7% average cap rate on the existing 4.8 billion square feet of office space in the 50 some odd office markets Colliers tracks would lead to a $182 billion loss in value--a 15% mark down--if the buildings traded. And therein lies the rub; most aren't trading, and won't until buyers see the bottom and seller pricing adjusts to reflect the increased risk. So, as an investor, how to play the current environment?
(1) Pursue one-off transactions, particularly with owners with low acquisition bases: Savvy investors buy buildings as much as markets, and we at Steelbridge have been tracking and buying specific buildings with good competitive positions in submarkets or micromarkets with good long-term fundamentals for years. If you can actually find a true market seller--particularly with good assumable financing--run, don't walk to make the deal if you can buy below replacement cost. If you can't consider some sort of preferred equity structure to buy yield in return for helping the seller deleverage.
(2) Look into buying investment grade or even B piece CMBS tranches on relatively sound assets--spreads are so wide that in many cases you are being overcompensated for the risk, and so far CMBS delinquencies are low. Whole loans could be available too, so get friendly with lenders; many of them are in intense discussions with their more recent borrowers as refinancing issues loom, and many will be reluctant to foreclose. Lenders figured out in the last meltdown in the early 1990's that they were better at lending money than managing foreclosed assets, so chances to buy loans at a discount or approach owners through the lenders will increase.
(3) Be a lender. Borrowers will accept low leverage loans at 300-400 over the curve on even high quality assets because they can't get anything better
(4) Get back into REITs. Many are trading at attractive discounts to net asset value for the first time in years and although many experts are saying they have further to fall, they deserve close scrutiny.
Barring any of this, you can just be patient and join us for some good bone fishing in the keys until the market clears. Whatever happens, we are in for a very interesting few years and smart buyers with ready capital will profit from them.
Gavin Campbell is Managing Principal of Steelbridge Capital, LLC a real estate private equity firm based in Chicago, Illinois and Miami, Florida.
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