A friend from NYU forwarded me this paper, it’s such a good summary of what’s happening in the market that I want to share it with all of you. The paper is by Steve Coyle of Cohen & Steers, it’s entitled “Gravity Returns.” The paper discusses the ongoing re-pricing and de-leveraging of commercial real estate; how far private real estate prices have fallen and whether further downward movement should be expected; what the public markets are telling us and the private markets aren’t; and, finally, when and where the opportunities may lie. Leave your thoughts in the comment section below.
Date: July 6, 2009
To: Cohen & Steers Global Realty Partners’ Clients and Friends
From: Steve Coyle
Re: Gravity Returns
A lot has transpired in the past 18 months: the demise of Bear Stearns and Lehman Brothers and the government re-capitalizations of AIG, Citi, GM, RBS and Hypo, to name a few. While these events surprised us, we had predicted as early as January 2008 that the United States had entered a recession, and that a global meltdown in the credit markets would cost upwards of $800 billion. Things certainly got much worse than anyone anticipated, and we expect more pain will come over the next year or so.
However, through this economic pain and distress will come opportunity.
We have been waiting very patiently for these opportunities to emerge, and we believe that this patience will be rewarded. In fact, we expect the market’s distress to create one of the best real estate buying opportunities in a generation. These opportunities will first appear in debt and later in equity. We believe it is now time to begin readying oneself for the buying opportunities that will begin to emerge late this year and early next year.
Real Estate Re-Pricing and Leverage
Real estate around the world is re-pricing, and we project that most markets are approximately halfway through this process. Globally, we expect that unleveraged real estate values will fall 40% to 50% from their peaks. Some markets are likely to witness declines of 60% or more.
There are three factors leading to this unprecedented decline: (1) rising real estate yields, (2) declining net operating incomes (NOIs) and (3) over-leveraged properties. Taken in tandem, these three effects are especially devastating to real estate values.
With the exception of a handful of markets, real estate yields are increasing rapidly from the record-low levels that were achieved a year or so ago. In many cases, current yields are double their previous levels. (For example, a New York City office building that commanded a 4% cap rate in 2005 recently traded at an 8% yield. In London’s West End an asset that had traded at a 3.5% yield recently transacted for 7.5%).
Rising yields translate into falling prices; the only way that real estate prices can increase alongside rising yields is if NOIs increase. In fact, in order for values to remain flat in the two cases mentioned above, NOIs would have to double! As we will now see, in most cases NOIs are falling, not increasing.
In most markets around the world, NOIs are rapidly declining because occupancies and rents are both declining. (Occupancies usually decline as job losses occur.) While some real estate owners argue that their property types are immune from economic downturns, this is rarely the case.
Most U.S. markets are suffering from faltering demand and rising cap rates. While these factors are also at play in the London office market, a surge in new supply further complicates the U.K. situation- something that is also true in many other European markets. New supply is relatively low in Japan, but demand is especially weak and yields are rising. Emerging Asian markets are suffering from a pullback in demand, alongside a huge surge in new supply.
How Far Have Private Real Estate Prices Fallen, and Is There More to Go?
Commercial real estate prices in the United States are primarily measured by the NCREIF Index, which tracks values and total returns for unleveraged real estate. NCREIF values peaked during the first quarter of 2008, and since then have plummeted 19%.
However, this is only part of the story … One must not forget LEVERAGE … That Double-Headed Dragon. While leverage can juice returns on the way up, it can devastate them on the way down.
We have long advocated calculating returns on both a leveraged and unleveraged basis. NCREIF reports that the core open-end fund index, which is approximately 30% leveraged, witnessed a 27% decline in values over the past year. Based on our proprietary models, we estimate that a 19% decline in unleveraged real estate values would have led to a 35% value decline for a 50% leveraged property, and a 52% value decline for a 75% leveraged asset.
Further, private real estate markets are notoriously slow to reflect price changes. Whereas public markets tend to anticipate news and typically shift on the second derivative (aka the rate of the change), private markets tend not to adjust values until occupancies start to fall and/or rents peak. We expect that the NCREIF Index will witness another 20% to 30% decline in values over the next year or two.
Believe it or not, there is some good news here. While values are still slow to react, they are correcting significantly faster than they did in the last great real estate downturn of the early 1990s. Stress on current owners of real estate is likely to force them to sell at severely discounted prices. In many other cases, their lenders will become the forced sellers.
There are markets that are better than the U.S. in terms of reflecting price changes. The U.K. has a long history of having chartered surveyors assess values on a monthly basis, which has led to better information and a closer basis to “real-time.” How much better is the U.K.’s International Property Databank (IPD) Index? Significantly better, although it, too, is not perfect. The IPD Index peaked in June 2007, and values have declined 43% from that peak. We predict that unleveraged values in the U.K. will fall by 50% to 55%, peak-to-trough, due to oversupply of office properties, rising yields and falling rents.
What the Public Markets Tell Us
Public real estate markets have witnessed a peak-to-trough decline in values of approximately 73% in this recession. The real estate securities market peaked in February 2007, just as the Equity Office Properties Trust sale to Blackstone occurred. Values then suffered a stunning decline that lasted through March 2009. Many assume that this decline was an over-correction. We would differ somewhat with that conclusion.
On average, public real estate companies were 50% leveraged prior to the downturn. If unleveraged private real estate values fall a total of 40% (which is roughly what we predict), then 50% leveraged values will decline by approximately 70%. Thus, we do not see the public markets as having significantly over-corrected to the decline in values. Instead, they went from being 50% leveraged to effectively becoming 80% leveraged after the implied value decline.
Public real estate markets are significantly ahead of the private markets in terms of addressing this issue and solidifying their balance sheets. Over the past few months there have been nearly four dozen examples of U.S. public real estate companies raising an aggregate $16.8 billion to deleverage properties. Astute REIT managers have already addressed debt that comes due in 2009, 2010, 2011-and, in some cases, even 2012.
What the Private Markets Aren’t Telling Us
Private managers, on the other hand, still appear to be in denial. Most brag that, “we have no debt coming due until mid-to-late 2010.” While debt markets may ease somewhat by then, we sincerely doubt they will be able to address the huge amount of refinancings and defaults that are coming. There are very few lenders out there doing new business, and those who are originating new debt are reluctant to lend above 50% to 60% loan to values (LTVs).
We believe that it is just a matter of time before we see a huge wave of distressed sales and mortgage defaults. How long will that be? Anywhere from six to 18 months from now. However, in our mind two things are clear: (1) private real estate values will continue to decline, and (2) distress is inevitable, given falling NOIs, higher yields and lower LTVs. From this distress should come a number of buying opportunities.
Most value-added and opportunistic real estate managers utilized 65% to 85% leverage over the past five years. This not only results in most owners losing all their remaining equity, but it also results in significant (and in many cases, total) losses for mezzanine, B-note and B-piece lenders.
Today, most equity owners and their lenders are in the “Extend and Pretend” camp. We suggest that they ready themselves for the day of reckoning that will soon arrive. Investors will either have to mend their balance sheets or send the keys back to the senior lenders. “Extend and Pretend” will transition to “Mend or Send.”
Unfortunately, many owners have neither sufficient cash nor the structures in place to address these significant capital needs. The closed-end fund structure limits the ability to tap additional equity once the investment period has ended. While general partners enjoyed the fees and lockups that these funds created, as the market continues to turn sharply negative, many will find themselves in trouble.
Where Will the Opportunities Be?
The first investment opportunities are likely to be in distressed debt and new, whole-mortgage origination. However, investors need to be especially careful that they do not sacrifice multiples for returns. Too many debt funds achieve high gross returns at the expense of multiples, and the result is that the net proceeds to investors are often low. Investment structures and fees need to ensure that investors receive both adequate returns and multiples. We favor investments in funds that are in the senior-debt or whole-loan position. These could include both loan-to-own and hold-to-maturity situations. We are very cautious with regards to mezzanine debt investments.
As investments get recapitalized and mortgage debt is restructured, there will be opportunities to offer preferred equity to funds’ legacy investments. We are working with a number of fund managers in assessing some of these situations. Careful underwriting and caution are vital here, as many legacy deals are past the point of no return.
While we believe that it is too early to invest in private equity, the window of opportunity should begin to open during 2010. Before this happens, mortgage defaults need to surge to levels last seen during the early 1990s. Mortgage markets are already starting to weaken, and we believe that defaults and losses will significantly spike over the next 6-12 months. Commercial mortgage default rates rose to 2.3% in the first quarter of 2009, which was their highest level in 15 years. We believe that defaults will skyrocket over the next two years, and that losses on 2005-2008 vintage CMBS could exceed 11%-a record level! These losses will force banks to take over and sell real estate, and that is precisely when we believe private equity investments will be most ripe. There may be some opportunities to do equity investments before defaults and losses spike further, but these will be limited to the best assets in the best locations with relatively stable tenant bases; however, even then, real estate yields will need to be at least in the high single digits.
In terms of markets, we believe that the U.S. and the U.K will offer the first opportunities. Western Europe will eventually become a buying opportunity, but owners must become realistic about where current prices and yields are. German investors, for example, appear to be in denial with regard to valuations. However, we believe that it is merely a matter of time before today’s economic realities translate into stress for most real estate owners. While Japan may offer some great distressed buying opportunities, we believe that its recovery will be significantly behind the U.S., U.K. and Western Europe. We are very cautious with regards to most emerging markets. Further price and supply corrections are necessary in most markets, and we are very negative on Eastern Europe and Russia.
The Tide Is Turning
We are in the midst of the greatest re-pricing of real estate in at least a generation. Sound familiar? Many of us heard this during the bull market of 2003-2007. At that time, real estate markets were significantly overpriced, and now we are in the correction stage. It is a painful process, but one that should create new investment opportunities.
But we are not yet at the bottom. In fact, it is our view that job growth won’t return until the fourth quarter of 2010, net absorption won’t occur until mid-2011 and rents won’t grow until at least mid-2012. What does this mean for buying opportunities? It means that they should start to emerge in earnest during 2010, and will continue to emerge through mid-to-late 2012. Soon after rents start growing, capital will probably flood the market once again.
We are nearing market capitulation, but we are not there yet. When will it come? Soon, perhaps, but for many investors it will not be soon enough. Be prepared when it does come, though, because it should be the best buying opportunity in at least a generation.
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Copyright © Cohen & Steers, Inc. 2009. All rights reserved.
These materials are provided for informational purposes only and reflect the views of Cohen & Steers, Inc. and sources believed by us to be reliable as of the date hereof. No representation or warranty is made concerning the accuracy of any data compiled herein, and there can be no guarantee that any forecast or opinion in these materials will be realized. This is not investment advice and may not be construed as sales or marketing material for any financial product or service sponsored or provided by Cohen & Steers, Inc. or any of its affiliates or agents.
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