COVER STORY, JANUARY 2008

MARKETS FACE CAUTION
Investors take wait-and-see approach into 2008.
Daniel Beaird

Concerns and uncertainty from the residential real estate’s subprime lending crisis in 2007 are hovering over the commercial real estate market heading into 2008. While most involved in the commercial real estate market are cautious, there are some key factors that differentiate commercial real estate markets from residential real estate markets. However, 2008 will be a cautionary year as lenders, investors and developers alike will take a wait-and-see approach and hope the news is better heading into 2009.

The slowdown in construction, the liquidity crunch in the credit markets, and high oil prices have raised concerns about whether the United States economy could slide into a recession in 2008. 

As always the case, the commercial real estate scene is marked by regional differences. And for the Southeast, that means keeping one eye Florida’s real estate market for signs of further deterioration. Florida’s commercial real estate activity has been marred by the recent uncertainty that the condominium conversion bust has caused. As the state’s multifamily sector tries to recover, so do the office and industrial sectors as many businesses associated with the home-building market have down sized or closed their doors completely.

“Currently, the volatility in market spreads, which can be 100 basis points difference from week to week is causing uncertainty,” says Jason Isaacson, chief investment officer with Cypress Creek Capital in Miami.

Isaacson adds that the leasing market will not be strong enough in 2008 to see much development through the year. “From a leasing standpoint, 2008 will be slow as the office and industrial markets try to recover from businesses leaving the market,” Isaacson says. “Pricing has skyrocketed in the past 5 years, and for the first time, pricing is coming down slightly.”

However, many lenders and investors are still confident in Florida’s market for the long term. The cost of real estate taxes and insurance needs to drop, but Florida still boasts advantages in the biotechnology industry, tourism and the ports of Jacksonville and nearby Savannah, Georgia, that will keep the state relatively stable.

“Florida is an institutionalized market,” Isaacson says. “In cities like Tampa, Orlando and in South Florida, the long-term outlook is still strong.”

In fact, while investors typically shy away from smaller markets during a correction, some of the markets in the Southeast that are performing better than the rest of the country include Charlotte and Raleigh-Durham, North Carolina; and Nashville, Tennessee. And as the Florida market begins to correct itself, Jacksonville, due to its port location, is also predicted to outpace the rest of the country.  

As corrections have been severe for the residential real estate market, the belief is that the commercial real estate market will not face the same severity. Commercial real estate supply and demand is relatively strong, overall development is back in check and the fundamentals are still healthy.

So, as some of commercial real estate’s fundamentals remain strong, the long-term investor is predicted to just experience a blip on the screen in 2008. However, a correction in the market may penalize overleveraged buyers and late speculators as stricter underwriting standards will be implemented. 

As the Southeast looks to Florida for some direction, Florida’s overextended multifamily market is getting some help from the troubles caused by the subprime lending crisis on the single-family residential side. Many homebuyers cannot afford first home mortgages today and have been forced back to the rental side, causing more demand in the multifamily markets, not just in Florida, but across the country.

But investor skittishness due to the subprime market has led to a slowdown in Commercial Mortgage Backed Securities (CMBS). “Many investors are sitting on the sidelines, unwilling to bid even though the fundamentals of the underlying real estate are strong,” says Leonard Cotton, vice chairman of Centerline Capital Group.

However, there are many differences between the subprime market and the CMBS market that should peek investors’ confidence. According to Cotton, the CMBS market is very transparent as market information is readily available, and lenders and investors can quickly evaluate the risks about financing properties or buying securities. In contrast, the subprime market that has so many investors worried heading into 2008 does not contain that same transparency, leading homebuyers into taking out loans without having an understanding of the risks, especially the risk of defaulting on the loan.

If the market corrects as expected, mortgage borrowers will be required to put more cash equity into commercial property transactions and to have adequate reserves for their properties, according to Lisa Pendergast, managing director of RBS Greenwich Capital. “CMBS investors will be more fairly compensated for the risks they are taking all across the credit curve,” Pendergast says.

But as investors remain leery, it seems as if the first quarter of 2008 will be very quiet as predictions abound that large portfolio trading will be cautionary and significantly less single asset sales will take place than in recent years.

However, as the fundamentals remain healthy in commercial real estate, there continues to be no shortage of capital available to invest in commercial real estate. Allocations continue to be increased and funds have unspent equity, so price is not likely to fall significantly. A boom in commercial real estate development during recent years is not expected to slump as much as residential real estate development, which should cause investors to be more optimistic about commercial real estate’s future.

As the entire country watches the commercial real estate industry with caution in 2008, the Southeast has its eyes on Florida’s volatile markets. As its multifamily markets regain strength, it will lead to its office, industrial and retail markets stabilizing, which should have a positive effect on the rest of the Southeast markets.

“Let’s hope the uncertainty heading into 2008 works itself out and the predictions are better heading into 2009,” Isaacson says. “The market should be able to bounce back.”

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