Jammin’ at the ULI

I never fail to pick up some interesting market intelligence at the Urban Land Institute conferences, but at the fall meeting last week, the pickings were slim. It wasn’t because of the roster of seminars and speakers, which is always first-rate. I think it’s because the commercial real estate investment market hasn’t changed much in the last six months. There is still a flood of capital chasing a very narrow slice of the market – core properties in primary, supply-constrained markets. And the leasing market hasn’t budged much, either. All property types are positioned at or just past the bottom of the market and are recovering at a very sluggish pace, except for apartments (see below). Having said that, I picked up some anecdotes that are worth sharing:

One of my colleagues who works in the research department of an institutional investor came into the conference worried that his company is overpaying for core properties. By the end of the session, he said he was more at ease. After all, it’s his job to worry about overpaying. Still, he didn’t sound all that convincing.

In order to win the bidding contest, core property investors have to keep going-out cap rates very low, maybe 50 basis points above going-in cap rates or even flat. With the potential for higher inflation and interest rates in the future, this has some investors talking about increasing the holding periods, which is the norm in Europe for core property investors. The buy-and-flip strategy is risky if interest rates spike. Properties financed with long-term, assumable mortgages will benefit.

As an aside, my colleague, Jeff Majewski, executive managing director of Grubb’s capital markets group, says that most commercial mortgages (agencies, life companies, etc.) are assumable subject to lender approval and a 1 percent assumption fee. If a borrower locks in a 10-year Freddie loan today at 4.5 percent with 80 percent leverage, it’s safe to assume that rates will be higher in two years. Thus, a below-market, assumable rate for the eight years remaining could add value to the property. The rub is that an 80 percent loan in 2010 may be 70 percent in 2012. The agencies and the life companies will top off the tank and provide second mortgages behind the first for qualified deals. That is not possible for CMBS-financed properties, however.

In the closing general session, Donald Kohn, the recently retired former vice chairman of the Federal Reserve Board of Governors, said he doesn’t think inflation will be a problem in the foreseeable future because there is so much excess capacity in the economy (the labor market, residential and commercial real estate, factories, etc.), and the recovery is expected to be painfully slow with full employment – a jobless rate of 5 to 6 percent – several years away. However, he acknowledged a small chance for a blow-up if investors decide to stop buying U.S. Treasuries, which could cause a sudden spike in interest rates and change the strategy for investors on a dime.

The best news I heard came from J. Allen Smith, CEO of Prudential Real Estate Investors, who said investors will tire of paying premiums for core properties and will gradually take on greater risk. He termed this “bidding fatigue” and thinks the transition to a greater appetite for risk will happen at an orderly pace. This suggests a measured return to normalcy in the commercial real estate investment market and, by extension, the broader financial markets.

The apartment market is firming at a faster pace than most analysts thought possible 18 to 24 months ago despite the loss of 8.3 million payroll jobs peak-to-trough and the huge shadow supply of rental housing – unsold condos and foreclosed homes being offered for lease. This is due to a combination of factors: stricter standards to obtain a mortgage; uncertainty on the part of prospective buyers over whether home prices have bottomed and a more skeptical attitude toward the long-term benefits of homeownership; and a slowly recovering labor market with 863,000 private-sector jobs added so far this year.

By Bob Bach