Real Estate’s Turning Point

It appears that this is the moment that a declining market is turning.

The consensus of economists and large portfolio investors involved in identifying trends—and investing money—is that upward movement has begun.

We now realize the extent of the economic casualty we have experienced since the “official” recession began in 2007. We seem to have emerged out of the teeth of the crisis. Experts say this because:

• There has been a broad-based recovery. The policies to stabilize the financial markets have worked. The Troubled Asset Relief Program and the fiscal stimulus package have apparently had the impact of ending the recession sooner rather than later. At what price we don’t know (inflation, higher taxes, more government?) but at least they have stopped the bleeding. Inflation is flat. Interest rates likely are to remain low for the foreseeable future.

• The stock market has risen. The Dow Jones recently was hovering above 11,000.

• Corporate profits are up. Much of this is because companies have been cutting jobs and productivity. Business balance sheets are much better. This positions companies to refinance debt and to grow as demand allows.

• Employment is expanding: March’s 160,000-person national job gain was strong. This is not nearly enough (it should be 250,000) but jobs are being added and not lost anymore. Temporary workers and healthcare employees led the growth, as well as workers hired for Census 2010.

The unemployment rate will rise over the short term, both because it is a lagging indicator and because of a behavioral anomaly: People who have been long-term unemployed, and who were no longer being counted, are now re-emerging, thus spiking up the numbers. The unemployment rate will go down gradually.

These are the factors that have enticed the players to play again. The numbers don’t lie. The market has been in virtual shutdown throughout the recession. Few were willing to make deals in a declining market. Deals weren’t available, while lenders were on the run or at least frozen in place.

During the past few years, investors big and small have been stockpiling money, on the theory that this moment will arrive.

But the question they are now pondering is if this moment has arrived with a thud. While the overarching economic prognosis suggests that demand for core commercial assets will steadily grow, the availability of those assets is quite limited.

The prevailing lending practice of “extend and pretend” has mostly served lenders, and perhaps the market, well. Many assets have not been let out of lenders’ portfolios principally because even though values have been driven down about 40% nationally on commercial assets, many of the holders of these underwater assets still are at least making the interest payments on their loans.

That has been good enough to hold off most foreclosures—for now.

As a result, there isn’t a lot of core inventory available. The few commercial assets that have become available have been trading at disproportionately high values (and low capitalization rates), even though current revenue doesn’t justify these high values.

Why? When employment growth resumes upward at a relatively mediocre pace, the numbers still suggest that the best office space eventually will be filled.

One caveat here, and it is a big one: The institutional definition of “core” real estate starts with Class A properties. These properties are in the best locations and are the most recent to have been built. To put this in perspective, of Orange County’s 110 million square feet of office space, roughly 50 million is considered class A. Of those class A buildings, an institutional investor might view 15 to 20 of them as “core.”

These are, as they say in the dog world, the best of class.

Investors are not looking at the rest. And that is the conundrum of the market. If the first wave of the recovery involves exclusive interest in, and perhaps trading of, a few “core” assets (and then, only if they are available), what happens to the rest of it? Nothing, at least for the time being.

There is a huge disconnect between the “core” and “non-core” buildings. There will not be a dynamic trading market until a gigantic “bid/ask” gap is rebalanced. Sellers eventually will take the hit and sell their properties at the discount, or their lenders eventually will stop extending and pretending and sell it themselves.

Then the real entrepreneurs will take over. The opportunities are in what I will dub the “Five Rs”:

• Realization: First, the losses will be realized. Once the assets are sold, the new owner will have a new, much lower economic basis from which to re-launch.

• Retrofitting: Modernization and new uses inevitably will be the answer for most commercial properties. Many office buildings can stay as offices but only if they undergo a complete facelift.

• Repositioning: Many buildings will be converted to another use. Even more retail projects and strip commercial will be converted to other uses, or mixed uses.

• Re-Entry: The old assets will re-enter the market as entirely new assets.

• Re-Pricing: A new base pricing will reflect these asset-use changes and the rents that can realistically be attained.

I sense that we are now entering the incipient stage of a robust entrepreneurial period, where creative people with new, big ideas will find investors and rebuild the current stock of assets according to the Five Rs.

But there will be few new development projects in the commercial sectors for many years, except build-to-suits. New projects will not be feasible until lease rates rise past their currently depressed levels, and then well past their last peak, then to a new peak.

Entrepreneurs and investors will most certainly take lower profits in the next wave because they simply will not attain debt unless they have 20% to 40% of their own money in the deals. That is a tectonic shift from the 10% or under days that ended with the last up cycle!

This market is not a “rising tide” where opportunity will abound. This is the beginning of a tough recovery period. These assets will have to be worked out one by one, market by market.

London is president of San Diego’s London Group Realty Advisors, which provides real estate consulting and economic analysis.