Jay Epstien and Scott Weinberg oF DLA Piper LLP (US) discuss the slow but steady recovery of the commercial real estate industry.
In the face of slower-than-expected job growth, real fears of a double-dip recession, and looming government debt concerns in the United States and a handful of other countries around the globe, the commercial real estate industry is quietly buffeting these political and economic uncertainties as it slowly recovers from the global financial crisis.
Deals are being made, assets are trading hands and the highly publicised billion-dollar “wave” of maturing commercial real estate debt has yet to truly materialise. However, there is reportedly more than $181 billion in official distressed commercial real estate volume, led by the following sectors:
- Office - $43.3 billion
- Apartment – $36 billion
- Hotel – $34.9 billion
So, what’s next? Simply put, this is the question on every commercial real estate industry executive and lawyer’s mind right now and the so-called “answers” continue to spur debate.
Market reports continue to present conflicting industry data on the strengths and weaknesses of key US regions and sectors on a daily basis, but industry fundamentals continue to hinge on one major factor: job growth.
Unfortunately, economists do not expect job growth to pick up significantly in the near term with both the US and European economic recoveries clouded by debt concerns or looming defaults.
Despite the potential political and economic headwinds facing the fundamentals of the commercial real estate industry, a handful of key trends are helping to chart the path of the industry’s US recovery – wherever it may take us.
REVIVAL OF CMBS
To start, the commercial mortgage backed securities (CMBS) market is undergoing a pivotal revival, marking the return of a critical financing vehicle to the marketplace. With more than $20 billion in domestic CMBS issued so far this year, volume is expected to more than double from 2010, representing a significant spike up from the less than $3 billion issued in 2009.
This industry-wide recovery in securitisation has been led by rising rental rates in key markets and a capital markets recovery, as well as the expectation that interest rates will remain low, avoiding any significant increase following the recent conclusion of the US Federal Reserve’s quantitative easing program.
It is worth noting that this rapid revival has recently been met with several bumps in the road, including investors insisting on widened spreads to purchase CMBS, especially in the junior classes, and increased scrutiny from the agencies that rate CMBS products, which are searching for better ways to analyse and standardise the risk of the underlying assets. For instance, S&P abruptly withdrew its ratings at the last minute on a recent $1.5 billion CMBS offering, forcing the issuers to cancel the transaction. S&P said it had uncovered an inconsistency in how it calculated debt service coverage ratios and announced that going forward it may change its methodology for determining its ratings in order to better protect investors in different CMBS tranches. So while we are in the middle of a CMBS revival, this marketplace will continue to remain fluid as the various market participants work to bring more transparent – and consistent – CMBS offerings to market that satisfy the evolving needs of investors and rating agencies.
RENEWED INTEREST IN CDOs
Beyond traditional CMBS, interest seems to be building in commercial real estate collateralised debt obligations or “CDOs”. These CDOs are similar to CMBS but allow for broader categories of collateral, including types that are not eligible to be included in a Real Estate Mortgage Investment Conduit (REMIC) structure, such as REIT debt. Consequently, CDOs are a unique and important complement to CMBS, providing a more flexible securitisation vehicle.
Though no commercial real estate CDOs have been issued since 2007, a $670.5 million offering sponsored by Prima Capital recently reached the marketing stage before being pulled at the last minute, at least in part due to market uncertainty resulting from the government debt crisis and the S&P ratings withdrawal referenced above.
It is interesting to note that this CDO was to have been markedly different from its predecessors of the last industry boom. It was to feature only AAA and AA tranches of debt and was to be backed by a static pool of assets, many of which were single-property or single-borrower, making it easier for investors to analyse and underwrite.
Meanwhile, though existing CDO delinquencies have risen steadily this year, according to Fitch Ratings, this should not be viewed as a bad sign. Instead, this is an indicator that the industry is finally emerging from its “kicking the can down the road” approach as lenders and owners are allowing assets to be worked out or foreclosed, and then sold and financed at today’s market prices.
Another bright spot for the industry has been the strong performance of real estate investment trusts (REITs), whose returns this year have trumped those of the broader equity markets as office, retail and apartment landlords have been paced by their ability to increase rents and recruit more tenants.
This strength has led to a series of REIT IPOs and secondary offerings, creating an industry buzz as REITs remain the dominant player in the industry, driven in part by investor interest in REIT dividends. With fundamentals improving in a number of property sectors and REIT merger rumours beginning to swirl again, this sector will continue to shine as long as job growth continues to support rent and tenant demand.
“GATEWAY CITIES” LEADING THE WAY
Trophy assets are selling at record prices and rents are rising in key “gateway cities” across the United States, markets that are significantly outpacing all others.
Led by larger urban markets like New York, San Francisco and Chicago, among others, these “gateways” feature the most class A buildings and have been buoyed by stronger office markets. Meanwhile, smaller urban markets and their surrounding suburbs are struggling to digest an oversupply of space with little prospect of corporate expansion or organic employment growth. As a result, the gap between the gateway cities and the other markets is expected to continue growing, further tilting the dynamic toward the US’s largest urban areas.
There is no doubt that the US commercial industry real estate is showing encouraging signs that point to a continued recovery with large property portfolios trading alongside the return of key structured finance vehicles.
This recovery is creating a number of opportunities for commercial real estate investors, owners, developers – and lawyers. The rate and health of the industry’s recovery, however, requires that job growth remain of paramount importance to US policymakers as they continue to grapple with solutions to boost the US economy and right its monetary policy.