The performance of the commercial real estate market in 2011 was divided into two segments. By most measures, during the first half of the year, it appeared the commercial real estate market was turning around. Many existing lenders as well as new participants reestablished their “originate to securitize” lending units. In the second half of the year, many of the same firms closed down these divisions or greatly reduced their outlook. The reason for this transition was multifold. The economic indicators, gross domestic product, unemployment and property values, generally did not rebound as originally expected. For example, unemployment, one of the main drivers in commercial real estate, languished and failed to realize any meaningful gains. These pressures caused lenders to focus their origination efforts on major markets, trophy or class A properties, high underwriting standards with loan-to-value (LTV) ratios of less than 55%, debt service coverage ratios (DSCR) more than 1.6 and strong sponsorship support. Additionally, continued pressure was realized on the net operating incomes (NOI) during 2011.

Looking forward into 2012, we believe the commercial real estate market will continue on the same path. In most property types, continued pressure is likely, as NOI continues to slide, or at best, remains consistent. At the same time, the market will demand high capitalization rates (cap rates) in order to compensate for an uncertain market outcome.

Looking forward into 2012, we believe the commercial real estate market will continue on the same path. In most property types, continued pressure is likely, as NOI continues to slide, or at best, remains consistent. At the same time, the market will demand high capitalization rates (cap rates) in order to compensate for an uncertain market outcome.

MIAC believes commercial real estate investors will begin to look at secondary and tertiary markets to find additional investment opportunities, but the focus will be on specific asset classes such as multi-family, grocery-anchored real estate and industrial where demonstrated predictable leasing demand can be established.

Economic Factors

The U.S. economy continues to move along with sluggish and uncertain results. The consistent reoccurrence of “good news / bad news” in the U.S. and global economies weighs heavily upon any growth that may occur going forward.

Additional challenges, such as continual foreclosure activity, high unemployment and global economic risks will put a drain on the overall U.S. economic performance. The continued issues coming out of the euro-zone sovereign debt crisis weigh on the U.S. economy, causing severe stock market volatility, uneven commodity prices and reduced investor confidence. Banks as well as other lenders continue their conservative credit policies limiting available credit for businesses with expansion plans. In turn, businesses continue conserving cash by reducing employment, capital investment and inventory.

This approach will continue to dampen growth in 2012 and into 2013.

Approximately 70 percent of GDP has been attributed to consumption, while the remaining 30 percent is attributed to governmental activities. With this likely to be the situation going forward, we could expect a slow near-term growth while inflation begins to erode increased personal income.

On the positive side, corporate profits remain high. Additionally, and as a result of high unemployment, worker productivity is higher than pre-recession levels because employees are asked to do more than previously required.  This productivity pressure will continue, even though employee performance will peak if it hasn’t already.

Many challenges must be overcome over the next few years in order to regain sustainable and normalized growth. Among them:

• The US debt-ceiling issue along with a possible credit downgrade lowers global confidence. Uncertainty about increased federal taxes could damage the willingness of consumers and businesses to spend and invest.

• An improved job outlook, wage growth and progress in crisis resolution will be required to prop up consumer attitudes.

• Foreclosures and short sales make up approximately 30 percent of sales transactions. Single-family home sales fell to 4.3 million units while the median sale price declined 3.9 percent to $165,600 over 2011. This trend must reverse before the economy can regain its footing.
   

Unemployment Rate

The private sector added 2.04 million jobs in the last 12 months as of November 2011. Year-end hiring was concentrated, and was led by business and retail trade, leisure and hospitality, professional and business services as well as health care. The decline in unemployment in November 2011 to 8.6 percent was partly due to a reduction in overall labor force by approximately 315,000.

The economy is forecasted to add 1.7 million jobs by year-end, with the unemployment rate remaining stable near 9 percent. Sub-par employment growth is likely as GDP struggles to surpass its historical average of a quarterly 2.5 percent increase.

Maturing Loans

Many of the loans which were originated during the boom times of 2005 to 2007 are scheduled to mature in 2012 and 2013. Many of the properties are defaulting and owners and lenders are facing the realization that they are worth a lot less than once thought.  Since these loans were originated during times of economic booms, the projected optimistic cash flow scenarios never materialized. This, in combination with tighter credit standards has made it difficult or impossible to refinance loans.  Borrowers who are unable to pay off their loans at maturity have few choices

Lenders, realizing this situation, have begun to work with borrowers through special servicing in order to modify loans rather than foreclose. As reported by Cushman & Wakefield’s Capital Market Update of 11-4-11, loan modifications account for approximately 60% of all CMBS loan resolutions as opposed to foreclosures or property sales. The “All Commercial Loan Maturities” graph illustrates that although the bulk of the maturing loan issue is behind us, 2012 and 2013 will still have challenges needing to be addressed.

Capitalization Rate

Capitalization Rates (Cap Rates) have mostly remained steady during the third quarter in three of the four main commercial property types. However, rates for apartments have declined and remain at significantly lower levels than the other three property types. These are mixed signals, as declining cap rates generally mean favorable commercial valuations and that was not apparent in the most recent quarter.

 Net Operating Income

Continuing the recent trends, net operating income (NOI) declined in three of the four major property types during the third quarter. Industrial, Office and Retail properties saw another quarter with declining NOIs while the apartment sector continues to buck the trend. NOIs in the apartment sector have been, increasing since 2009 and continue to increase although at a less accelerated pace.

Commercial Property Price Index

The Commercial Property Price Index (CPPI) is down over 41% percent from the high in October 2007; however it has steadily increased since the end of last year. The most recent month -end data released in October shows a 2.4% increase in the national index.

CMBS Loans in Special Servicing

Last month, the amount of CMBS loans in special servicing declined 5.4%, which marks the largest single month decline in some time. The overall percentage of loans in special servicing fell to 12.8 percent. This decline in both volume and percentage is misleading, because as loans are removed, others are being added and therefore it doesn’t necessarily indicate that market conditions are improving. More notably, it illustrates that special servicers are finding successful workout plans and moving loans back to master servicers. The performance of apartment loans has continually improved; their delinquency rate fell in the most recent month to 8.8 percent and they make up 20.1 percent of all loans in special servicing. Office and retail saw a slight increase in special servicing loans during the most recent quarter. 

Office

Even though there was significant economic uncertainty, volatile financial markets and consumer and business pessimism, the commercial office market vacancy levels improved slightly through 2011. The net absorption of 6.6 million square feet was realized in the third quarter of 2011 alone. Although in the fourth quarter of 2011, the market seems to be pulling back from these levels, leaving uncertainty of future performance. Vacancy rates recorded a modest decline to 17.4 percent at the end of 2011, but mostly due to modest completions, which totaled approximately 3 million square feet. This vacancy rate declined on 20 basis points on a year-over-year basis. Asking rents as of third quarter remained 5.2 percent below the peak, while effective rent was 10.7 percent below the peak.

The national vacancy rate will likely remain elevated, even though current trends reflect positive changes. This is due mostly to lackluster employment growth. The office sector continues to raise red flags, illustrating few positive demand-side drivers. If the economy remains tepid, many companies may downsize as existing leases terminate. Additionally, companies that have already downsized may still carry enough shadow space to accommodate expansion at a later time.

Wide variances have resulted within the office section; determining factors are: market and submarket characteristics, local economic performance and asset class. The strongest rates of recovery in vacancy and rents have been realized in the major markets located on either coast as well as in Texas. Some secondary markets have recently begun to exhibit improved results, but it is too earlier to call it a trend. There are significant differences when comparing absorption in property classes. There is a clear flight to quality by tenants. Class A space offered at depressed market rents may compel companies with leases terminating to upgrade while rents remain low. This pattern is expected to continue as lease renewals occur throughout 2012 and 2013. As the amount of available Class A space declines, we foresee upgrades beginning to be realized in the Class B space.

A surge in sales of central business district (CBD) properties in secondary markets and suburban properties in primary markets signals a move on the risk/return spectrum by investors. These two segments exhibited a decline in cap rates in the third quarter, down 60 and 40 basis points, respectively. Cap rates for CBD assets in primary markets, while still low, flattened to 6.2 percent, on par with CBD properties in secondary markets.

Retail

Retail sales performance departed from negative expectations, posting gains led by clothing stores followed by restaurants. Retail property operations also showed positive momentum with third-quarter 2011 net absorption totaling 17.6 million square feet. Completions remained moderate, totaling nearly 9 million square feet and resulting in a vacancy decline of 10 basis points over third-quarter 2011 to 9.9 percent. Modest year-over-year decrease in asking and effective rents were realized, netting a 0.2 percent fall. This is a slower pace of decline for the fourth consecutive quarter, indicating a possible bottoming of retail rents.

Despite higher levels of new supply by year-end, forecast net absorption should also trend higher, outpacing completions and subduing the national vacancy rate.

Consumers will remain under pressure until disposable income begins to trend positively. Additionally, uncertain confidence and price sensitivity will eventually cause a slower sales pace and challenge business confidence.

End of year 2011 retail sales recovered from summer’s lows, with activity being realized in all major categories. Total retail sales have increased 5.7 percent on a year-to-date basis compared to 2010. In the low interest rate environment, a volatile stock market and higher core inflation may encourage more spending, particularly among wealthier consumers.

Throughout the recession, many retailers repositioned stores by optimizing locations, closing under-performing stores and opening new ones. Retail operators continue to improve overall efficiency through technology and by decreasing their footprint. National retailers target premier locations in primary markets rather than secondary or tertiary markets. We believe this trend will continue until full absorption within the premier locations is realized. This is not expected to occur during 2012.

Class A properties located in secondary markets are likely to provide more attractive pricing going forward into 2012, although NOI growth will not meet the performance of similar properties in primary markets. However, with consumers under pressure and questions about the sustainability of retail sales in the face of eroding wage and income growth, investors may be reluctant to take on too much risk until payroll growth gains significant momentum.

Multi-Family

A major driver of the increasing success of multi-family properties is due to a variety of factors, including continued foreclosures, lackluster home sales, value declines and a sharp reduction in credit availability. By some estimates, lenders have foreclosed on more than three million homes since 2009.

The national homeownership rate was reported to be 66.3 percent in the third quarter 2011, which is a drop of 20 basis points from a year ago. This represents approximately 660,000 displaced owner-occupied households within a three-month period. Despite record-low mortgage rates, single-family home sales volume and pricing remain 29 percent and 32 percent below the 2005 peak, respectively.

Apartments have overcome the slower economic environment by posting universal gains in net absorption. The sector secured significant reduction in vacancy and solid rent growth. Tight supply conditions will continue to bolster apartment performance, but apartments are thriving from profound shifts in demographic, economic and social patterns.

This sector will move into the third year of positive momentum as sweeping improvements in apartment operations tighten vacancy across the country. Third-quarter 2011 apartment vacancy measured 5.6 percent, which is a 30-basis-point decline from the second quarter and measuring 150 basis points lower than one year ago. The apartment sector has moved into a moderate sustainable expansion.

Cap rates have declined as investors gravitated to higher risk/higher return strategies as evidenced in the pickup in transactions in secondary markets. The cap rate compression in primary markets has slowed as investors explore secondary and tertiary markets.

As payroll growth gains momentum, demand for apartments should progress at a consistent, yet slower pace. Looking forward, stronger employment growth will generate higher immigration levels, a critical component of rental demand, and growing ranks of Echo Boomers will continue to form new households.

Industrial

The industrial real estate market began a slight rebound in the second half of 2010. Overall vacancy has steadily increased since that time, but a main driver is historically low construction levels. Approximately 21.9 million square feet was completed in 2010, of which 4.7 million square feet was speculative development.

In addition to the reduction of available inventory, the industrial properties have now recorded four consecutive quarters of positive gains with 54 of the 67 industrial markets posting positive absorption. The constrained pipeline is a key difference in the current recovery. In the third quarter 2011, 9.3 million square feet of space was added to the market, bringing the year-to-year total for new construction to 21.8 msf.

Conclusions

While the economy is expected to continue expanding, the overall pace of GDP growth is projected to be lackluster. Economic headwinds like historically high unemployment and uncertainty about the future fiscal, tax and regulatory environment must be resolved before a robust and sustained recovery can truly take hold.

With the recovery likely to remain slow in the near term, industrial demand, which depends heavily on rising consumer demand, will continue to improve, but at a measured pace.

Joseph A. Furlong, Vice President &

John Togneri, Associate

 Capital Markets Group

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