The investment market held its collective breath late last week as the 10-year US Treasury touched 4% before settling at 3.79% on Friday. The sharp upward movement of the 10-year was a reminder of how important debt is to the overall economic recovery and our business in particular. Over the past twelve months, we’ve seen the continuation of a number of debt trends that are shaping the deals that close today: assumable debt that drives transactions; regional lenders filling a lending void for smaller (sub-$25MM) deals, and Fannie & Freddie drawing buyers to multi-family with attractive first mortgage financing.

The potential for out-sized returns created through in-place debt is helping to make larger purchases possible, as we experienced with the sale of Corporate Center last week, a 1,046,811± SF multi-headquarter office campus located just off I-84 in Danbury, Connecticut. Constructed as the Union Carbide World Headquarters, Corporate Center is primarily leased to major credit quality tenants including Boehringer Ingelheim, Praxair and Honeywell, and was 62% occupied at the time of sale. The property’s $72.4 million price was driven, in part, by existing short-term financing that yields a nearly 20% first-year cash-on-cash return based on the in-place NOI. The amenity-rich headquarter property and strong in-place financing made Corporate Center an attractive investment.

The Corporate Center transaction also highlighted something we’ve discussed in the recent past on this blog: the reemergence of the private buyer. Patiently waiting on the sidelines for the past few years, the private buyer is back and bidding more aggressively.

We cover this and much more in our team’s Summer 2009 newsletter.

By Dr. Peter P. Kozel, Ph.D.
Senior Managing Director, Consulting Group
FirstService Williams   

    Just like the national economy, Manhattan office market fundamentals seemed to hit a wall as 2008 ended and 2009 began. The office availability rate for Manhattan as a whole–space that is being activity marketed for leasing–increased from 9.7% at the end of the third quarter 2008 to 12% at the end of the first quarter of 2009. In Midtown, the increase in the availability rate was even larger, rising from 10.4% to 13.3%. The availability rate in Midtown is now already higher than it was in mid-2003, the peak level during the previous cycle. Meanwhile the average asking rent is down 15% to 20% from the peak reached in early 2008.

    However, the actual effective rents, which include adjustments for tenant improvement allowances and the free rent period, are down by substantially more. The decline in rent levels has been more rapid and larger than the consensus was projecting only a year ago. Of course, the increase in rents from 2006 through the early months of 2008 was much larger than the basic supply/demand fundamentals seemed to justify.

    Everybody knows that the office property sector has suffered reversals during the past year, so the numbers just reviewed above shouldn’t be very surprising to anyone. What business or economic fundamentals, however, are driving this pervasive sense of weakness? Through March 2009, the preliminary numbers report that seasonally adjusted total nonfarm employment is down by 100 thousand from the peak level reached in early-2008.

    By comparison in the early 1990s, total employment fell by 350 thousand, about 10%, and the loss was close to 200 thousand in the 2000/01 recession. The Federal Reserve’s forecast, along with other projections, predict that national employment will continue to decline through 2009; even with that outlook, it doesn’t seem that the property markets should be performing so badly; but they are. Not only do the usual demand drivers seem to be less important this time, but the relative performance among the city’s major submarkets is not following the usual pattern.

    The declines in occupancy and rent levels during the current cycle occurred earlier and were more pronounced in the Midtown market than the Downtown and Midtown South markets versus previous cycles. Obviously, a more complex set of forces are at work in the markets today than one would find in a simple business cycle. Is it really that important that we attempt to find out what these new forces are?

    I think the answer has to be yes. The questions plaguing property owners, tenants and third party investors are how long this weakness will persist and how robust will the rebound be once the bottom has been achieved. If we can figure out the dynamics of the downturn, then we might be able to provide a reliable outlook. Going forward, we will investigate these issues and propose some answers for these important questions.

There appears to be an increasing air of optimism among real estate owners and investors with the recent increase in housing starts and apparent stabilization in the stock market. However, financing remains limited and expensive as spreads remain very wide and LTV’s very low.

Unlike the early 1990’s, when banks and the FDIC dumped real estate assets, the banks today are exercising far more patience and appear willing to hold and manage foreclosed assets until pricing improves. Based on the proposed federal assistance that the feds plan to give to banks and the relaxation of mark-to-market accounting sales, we expect many banks will partner with third party real estate operators to augment the condition and ultimate value of their foreclosed assets.

With further white collar layoffs projected, certain office markets will face increased pressure on rents and occupancy. Apartment projections are holding up best among all of the food groups, despite slightly increasing vacancies.

Overall, investors for multi-family and industrial assets are moving off the sidelines while many retail and office investors remain cautious.

As we approach the 2nd quarter of 2009, several trends are becoming apparent:

Many institutional owners are under pressure to sell assets in order to redeem capital to their investors and, in some cases, to avoid violating loan covenants.

Special servicers for CMBS commercial loans in default appear increasingly willing to provide time to negotiate terms. Many want a pay down in the debt balance – most start foreclosure proceedings at default.

Strong regional and National banks are making more acquisitions and refinance loans, particularly for well capitalized owners. Their terms are often more competitive than life companies and CMBS lenders.

New “private capital” and offshore buyers are entering the market while most public REITs and pension funds remain on the sidelines. Private capital will account for an increasing share of acquisitions in 2009.

 As we rapidly approach the end of January and seek to find some form of clarity on valuations moving forward, we continue to be faced with tight credit markets and deteriorating property fundamentals. While we are encouraged by the strong level of investor interest in a number of our property offerings and the fact that two of our deals have gone “hard” over the last two weeks, as well as the amount of equity on the sidelines, risk aversion continues to be the primary focus of many investors. Assets with any significant level of risk suffer from investors requiring disproportionately higher risk premiums similar to high yield corporate bonds. The highest quality properties with long term investment grade cash flow and stabilized properties below $25 million will likely drive the sales market in the early half of 2009 as investors seek safe yields and pursue properties that can be financed as lenders have less exposure in this price range and less equity is required from investors.