Tuesday, July 19, 2016

The Looming Downturn in Commercial Real Estate

As I've written in past blog posts, I've been sensing / forecasting / predicting a downturn in commercial real estate in the near future. I'm certainly not alone in the prediction and it isn't exactly a particularly bold one given the historic run the asset class has been on for the last 5 or 6 years and the cyclical nature of real estate. Of course, forecasting exactly when the downturn will hit is nearly impossible.

In the back of my mind I've sort of believed things would be flat from mid-2016 till end-2016 with a correction starting Q1 or Q2 of 2017. The logic behind that thinking is 2016 will start to see a deterioration in fundamentals, but landlord expectations will lag reality. It'll take a few quarters for landlords to feel the pain of a softer real estate market, adjust expectations, and bring them down to earth, resulting in lower commercial real estate prices.

However, the past few weeks I've come across a few anecdotal data points that suggest the downturn is more imminent than I was previously thinking. Don't get me wrong, I'm just pontificating here--a downturn could be several years from now for all I know, but here's what I've heard / seen the past few weeks:

Data Point 1

My company was presented an off-market deal. The property is a class A building in a major downtown with national credit tenants. We were told the property would trade at a 5.5-6.0% cap rate on in-place NOI (here's a review of NOI and cap rates). Now, a deal like this normally doesn't work for my company's strategy. We're a value add group that targets 20%+ IRR's on deals. It's nearly impossible to generate a 20%+ IRR on a stabilized class A deal when you're buying at a sub-6% cap.

However, we wanted to at least provide the broker that brought the deal to us some feedback, basically as a courtesy, so we underwrote it and figured out where we would be a buyer. It turns out we'd only be a buyer at about a 7% cap on in-place NOI. We told the broker where we were on pricing and he told us to just draw up a LOI and submit it. We, thinking it was completely futile, wrote a LOI at a price $9M less than what we were told was the asking price, which equated to about a 7.25% cap.

The LOI was submitted. The next day, we receive a call from the broker and he tells us the Seller is very motivated and they countered us at a 7.0% cap. Whether or not we end up buying the property is sort of irrelevant. The fact that a Seller of a class A building in a major downtown is willing to sell at a 7% cap when a year earlier they could probably get a 5.5-6.0% cap signals a monumental shift in the Seller's expectations of the market. It shows the buyer pool is drying up and that perhaps capital isn't chasing deals like crazy anymore.

Data Point 2

The other day my boss and I were on a call with a 3rd party equity broker that we do business with. We began the call by discussing the state of the capital markets and overall what kind of appetite equity providers have for deals right now. The broker's response was shocking. She said there just isn't capital chasing deals right now.

She used to send out a deal profile to 20 equity providers and the next day would receive 5 or more term sheets at very favorable terms. Now, she'll send out a deal profile to 100 or more equity providers. After a few days of calling / harassing these equity providers they'll then receive 1, maybe 2 term sheets at very unfavorable terms, and that's a huge success because many projects aren't receiving any term sheets.

In her words, the institutions just don't have an appetite for coastal commercial real estate right now. In fact, she said many of these institutional equity groups are looking for ways to short the coastal real estate markets. Scary stuff if you work in commercial real estate in a coastal city...

Data Point 3

On deals in our local markets, the bid-ask spread has been increasing. Properties are staying on the market longer and owners are having to either lower their expectations on pricing or pull their properties from the market. We run a report after each quarter to see how many deals transacted in our universe as a way to track what our competitors are doing and to see what we missed out on. Usually, this report generates about 5-10 properties per quarter. However, this past quarter there were a grand total of 0!

To me, the fact that no properties traded when there would typically be 5-10 signals that the bid-ask spread is growing to the point where transactions aren't being consummated. Buyers, naturally, are going to be pessimistic and sellers are going to be optimistic about their properties. Right now, buyers are seeing a softening market and are no longer pricing in a lot of growth into their pro formas. Sellers, on the other hand, are still pricing in substantial, optimistic growth and want it reflected in the offers for their properties. The result is offers aren't getting close to what sellers want and transactions aren't happening.

Until sellers start to feel some pain (vacancy in their properties, lenders breathing down their necks, etc...), their expectations aren't going to change. Once that pain starts to hit though, and there are really motivated sellers out there, then it's going to be a race to the bottom in terms of pricing and buyers will finally start to have the upper hand for the first time in 6 years.

Again, these 3 data points are anecdotal and only based on my personal experience in my local markets. Alone, each one might not seem too convincing, but to me the fact that all 3 happened within a couple of weeks of each other is a bit more than a coincidence. Also consider that they  happened against the backdrop of an all-time historical run in the commercial real estate market and many players seem to have fatigue and the anecdotes become more meaningful. We'll see...

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