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Transaction Market
By Steve Bergsman - Urban Land Magazine
January 2003 - Returns are what will keep real estate investment perking in 2003.
Nothing played out as expected in 2002. Immense contradictions pulled buyers and sellers in different directions. And the performance of the underlying real estate was awful. Nevertheless, it was the kind of year some companies pray for. "To tell you the truth, we are going to have our best year ever in 2002," says Tim Welch, an executive managing director of Cushman & Wakefield in New York City. "2002 is going to be a record-breaking year," concurs Sean Sovak, chief acquisitions officer for sale/leaseback specialists W.P. Carey & Company LLC, also in New York.
As for whether the 2003 real estate investment market will stay as irrationally exuberant as it was in 2002, it is hard to tell with factors like the sheer unpredictability of the economy, the direction of interest rates, the performance of real estate, as well as the flows of capital. Last year began drearily, with little investment movement as the country slowly recovered from the terrorist attacks of September 11. Then, by the second quarter, investors began dishing out dollars. As 2002 closed, real estate service companies boasted huge pipelines of deals, but no one was predicting this would be a harbinger for the coming year. "The year 2002 was unusual because there were some great transactions, bordering on unbelievable, in markets like New York," observes Stephen Siegel, chairman and chief executive officer of Insignia/ESG Inc. in New York. "On the other hand, judging from the number of transactions, business was down. Secondary and suburban markets had been softer than usual." Similar contradictions will abound in 2003, Siegel adds. More product should come into the marketplace, he predicts, which should drive prices down. But, he adds, that will not happen because so much capital is pouring into real estate that it will drive cap rates lower-meaning buyers will be paying more for deals instead of less.
In the fourth quarter of 2001, the Shorenstein Company, a San Francisco owner and operator of Class A office buildings that has amassed a portfolio of 22 million square feet around the country, closed on its sixth investment fund-its largest, which raised $602 million. That gave Shorenstein significant buying capacity and even though the investment market was slow early in 2002, the company remained active. It began the year by buying 500 West Monroe, a 940,000-square-foot office building in Chicago; and then such trophy properties as 450 Lexington Avenue, a 911,000-square-foot office building atop the Grand Central Post Office in New York; and Two Liberty Place, a 1.2 million-square-foot building in downtown Philadelphia.
Shorenstein remains in the market for office buildings, but with so much capital flooding the market, the company is seeing fewer buying opportunities. "Prices are going up," reports Bob Underhill, a Shorenstein executive vice president and cohead of its Capital Transactions Group in New York. "Buildings are being bid up too high and we are just not going to play on that. You see a large number of bidders on every property." Asked if it was beneficial to have so much capital in the market, Underhill responds by saying, "It's a good thing if you are selling." And that may be Shorenstein's position in 2003. "We are trying to respond to what is happening in the capital markets and, as a result, we are looking at this as an opportune time to sell property into a very aggressive capital market," he notes.
The poor performance of other types of investments is what is driving the investment rush to real estate. With the stock market doing poorly, the bond market questionable, and the rate of return on other types of fixed-income investments very low, investors have been looking for new places to throw their dollars-and in 2002 they rediscovered real estate. Even though the returns on real estate are no longer in the double digits, even a 7 percent return is better than losing money in the stock market or getting a 2 percent return on a certificate of deposit.
At the end of 2001, close to $20 billion of equity capital was in the hands of U.S. real estate private equity funds, reports Dale Ann Reiss, global director of real estate for Ernst & Young in New York. "On a conservatively leveraged basis, this amounted to $90 billion of capital looking to be invested in commercial real estate," she says. "Our most recent survey [end of 2002] suggests no real letup in equity raising."
Besides private equity funds, opportunity funds, offshore investors, and pension funds also are looking for deals in commercial real estate, points out Reiss. "CalPERS, the largest pension fund in the country, announced an increase in its real estate portfolio allocation from 8 to 9 percent-a $1.4 billion expansion of its real estate investment program."
According to Real Capital Analytics Inc., a New York research firm, through the middle of last October, buyers closed or signed contracts for office building deals totaling $32.1 billion, compared with $24 billion for the entire year previous. "There is still a lot of capital that wants to be in real estate," maintains Robert White, president of Real Capital. "I heard there could be $40 billion to $50 billion still sitting on the sidelines ready to invest."
The dispersal of capital has not, however, been uniform. Investors have been willing to shell out top dollar in primary markets such as New York and Washington, D.C., but secondary office markets have not attracted much in the way of investment, nor have suburban markets. A list of the major office transactions in the third quarter has been compiled by Robert Bach, national director of market analysis for Grubb & Ellis Company in Indianapolis. Of the ten top deals, four were in Manhattan, three in southern California, and one each in Miami, Chicago, and northern Virginia. Some of the highest prices for buildings were achieved in cities like Chicago, Los Angeles, and New York, notes Insignia's Siegel. In fact, the average price per square foot on deals closed in 2002 ballooned to $449.95-showing major upward movement from the 2001 average of $273.31.
"Where this really shows up is in cap [capitalization] rates," says Bach. "When cap rates go down, buyers are willing to pay more relative to operating income. At the end of the third quarter, cap rates hit 9.07 percent, down from 9.88 percent at the end of the fourth quarter last year. That's the lowest level since the first quarter of 1998," he adds. In urban markets, there was "plenty of harmony between buyers and sellers in terms of cap rates," says Siegel. "If there was a disconnect between buyers and sellers, it was in certain product types and in particular geographic areas."
The most frustrating disconnect occurred in the hotel sector, he notes, where what sellers wanted for their hotels and what buyers were expecting created gaps in deal closings. Siegel predicts 2003 will be a better market for hotels, adding that by the end of 2002, a number of deals already were beginning to shake loose. In regard to office markets, the current environment mainly benefits the major urban areas, but investor interest in apartments and shopping centers has generally spread throughout the country. "Grocery-anchored shopping centers will continue to be attractive investments because as long as you have a grocery store in there, the income stream is predictable and not highly risky," observes Cushman & Wakefield's Welsh. "The key to grocery-anchored shopping center investments is to get the top one, two, or three grocer in the market, especially if it has a history of good credit." As to other asset classes, he notes, almost all institutional investors have been clamoring for industrial properties, while the ardor for multifamily properties has cooled down-except in particular markets such as southern California, where the pricing remains very aggressive.
In 2001, W.P. Carey & Company did $400 million in transactions; in 2002, that number jumped to over $1 billion. In 2003, the company expects to do between $800 million and $1 billion. The company's sales volume has been helped by a confluence of factors, including a flow of equity into real estate (including funds that W.P. Carey itself raises), a wider acceptance by corporate America of the sale/leaseback mechanism, and turmoil with synthetic leases (an off-balance sheet finance mechanism). After it was discovered that Enron misused off-balance sheet financing, all similar financings, including synthetic leases, came under regulatory scrutiny by such organizations as the Financial Accounting Standards Board. Over the past two years, a number of companies including PetSmart Inc., Danka Business Systems PLC, Medtronic Inc., and Cisco Systems Inc. have unwound existing synthetic leases, and some like Danka have chosen to go forward under a sale/leaseback structure.
In addition, the low interest rate environment has been helpful to the sale/leaseback market, but in some regards it has been harmful, too. "Low interest rates have been a double-edged sword," says Sovak. "While it allows us to be more competitive and aggressive in our pricing so we can leverage, it also means it has been a very cheap borrowing environment for companies." With the cost of capital inexpensive, some owners of real estate have decided not to sell and, instead, have refinanced. Banks especially have been very aggressive in getting out shorter-term, floating-rate mortgages at just points above London interbank offered rate (LIBOR)-deals almost too cheap to turn down. Still, Soyak says the investment firm expects a very good year in 2003. "The economy unfortunately is still going to bump along near the bottom and bank and credit markets are going to be restrained. People are looking for alternative sources of capital, and the sale/ leaseback is very competitive."
While things are looking rosy for sale/leasebacks, another specialized type of deal, the 1031 exchange, was squeezed out by the slew of investors rampaging through commercial real estate. This year should be a different game. As strong as the 1031 market has been in the past, 2002 was not a good year principally because there was not enough product in the market to buy, says Glenn Esnard, a senior managing director of Investment Properties at CB Richard Ellis in Irvine, California, who oversees the company's private client group, focusing on private investors and investments, including 1031 activity. A 1031 exchange allows property owners to sell-then buy-like properties without paying capital gains taxes. The challenge, Esnard says, has been finding replacement property. "There has simply not been enough product," he observes. Potential sellers in a 1031 shied away because they felt they could not find the next investment, notes Esnard. With interest rates so low, owners who might have sold into a 1031 deal instead have refinanced, thus, for the time being, taking product out of circulation. Even with all those problems, Esnard says he takes a very optimistic view of the 1031 market in 2003. "There's going to be more product, so sellers will be confident that they will find a replacement property, and the Internal Revenue Service has given the industry greater flexibility in terms of reverse exchanges and tenant common structures," he points out.
"We had enough misery and uncertainty in the market in 2002 to make it a challenging year. Next year, we will have more misery, but less uncertainty," muses Ron Sturzenegger, managing director and head of real estate and lodging corporate and investment banking with Bank of America Securities LLC in San Francisco, which involves providing investment banking services to the entire Bank of America platform: large homebuilders, lodging companies, real estate investment trusts, and opportunity funds. According to Sturzenegger, Bank of America Securities has worked the single-asset market, but lately it has focused on selling portfolios of real estate and businesses that own portfolios of real estate.
The two economic factors that will most affect investors next year are interest rates and real estate fundamentals, he says, which could end up being both good-and bad-for investors. "Interest rates will remain low for the bulk of 2003-at least through the third quarter, which will mean there will be a continued trend toward refinancing [and not selling]," he contends. "This is why the CMBS [commercial mortgage-backed securities] and conduit business has done so well. A lot of people are refinancing for shorter terms, five to seven years, as opposed to pulling a 30-year life company mortgage." On the other hand, Sturzenegger maintains that real estate fundamentals are getting worse. Tenants are not doing well and could end up looking for cheaper digs or retrenching into smaller space, he points out. "There is going to be continued pressure on apartment and office rents. Operating results are not going to be any better for landlords in 2003 than they were in 2002," says Sturzenegger. These difficulties could cause owners to decide it is time to unload properties, especially when there are so many buyers, he predicts. "People say there is a really good buying market out there, but only the top 3 percent of assets are trading. The other 97 percent have not traded."
What is driving real estate investment today is the underlying capital market, adds Glen Whitmore, a senior managing director in the New York office of Holliday Fenoglio Fowler, a mortgage banking firm that bills itself as the largest intermediary of commercial real estate capital in the nation. "The unprecedented low interest rates in commercial real estate have driven everybody's yield requirements downward," says Whitmore. Holliday Fenoglio Fowler has been telling its clients that since the first quarter of 2002, through the fourth quarter, cash-on-cash yield requirements have declined upwards of 100 basis points, he notes. And, that the internal rate of return (IRR) on the best properties, which in 2001 would have achieved around 10.5 or 11 percent, is now migrating into the 9 percent range. The IRR has come down because investors have begun to increase their holding time, says Whitmore. Prior to 2002, many real estate funds were driven by an opportunity horizon of three to five years; now, even the most aggressive opportunity funds are going to a longer horizon of up to ten years. "This allows them to get through what might be perceived to be some very significant near-term market risks," points out Whitmore. All in all, what will keep real estate investment perking in 2003 are the returns, he adds, and IRR could drop another 1 or 2 percent and still be seen as advantageous. "Even Warren Buffet has said that a 7 percent yield should be looked upon as very positive, whatever the investment is."
Steve Bergsman is a freelance writer based in Mesa, Arizona
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