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Expectations & Market Realities In Real Estate 2011 - A Deloitte whitepaper

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  1. 1. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2 0 1 1BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTYDELOIT TE | R E a L E s TaT E R E s E a R c h c O R p O R aT I O n | R E a L c a p I Ta L a n a Ly T I c s
  2. 2. © 2011 | Real Estate Research Corporation, Deloitte Development LLC, Real Capital Analytics.All Rights Reserved.No part of this publication may be reproduced in any form electronically, by xerography, microfilm, or otherwise, or incorporated into any database or infor-mation retrieval system, without the written permission of the copyright owners.Expectations & Market Realities in Real Estate 2011 is published by:Real Estate Research Corporation980 North Michigan Avenue, Suite 1400Chicago, IL 60611Deloitte111 S. Wacker DriveChicago, IL 60606Real Capital Analytics139 Fifth AvenueNew York, NY 10010Disclaimer: This report is designed to provide general information in regard to the subject matter covered. It is sold with the understanding that the authorsof this report are not engaged in rendering legal or accounting services. This report does not constitute an offer to sell or a solicitation of an offer to buy anysecurities, and the authors of this report advise that no statement in this report is to be construed as a recommendation to make any real estate investmentor to buy or sell any security or as investment advice. The examples contained in the report are intended for use as background on the real estate industry asa whole, not as support for any particular real estate investment or security. Neither Real Estate Research Corporation (RERC), Deloitte, nor Real Capital Ana-lytics (RCA), nor any of their respective directors, officers, and employees warrant as to the accuracy of or assume any liability for the information containedherein. Unless otherwise noted herein, the data presented in this report is sourced from RERC and RCA.As used in this document, “Deloitte” means Deloitte & Touche LLP, Deloitte Financial Advisory Services LLP, Deloitte Consulting LLP, Deloitte Tax LLP, andDeloitte Corporate Finance LLC. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries.
  3. 3. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2 0 1 1BALANCING RISK AND RETURN IN AN ERA OF UNCERTAINTYDELOIT TE | R E a L E s TaT E R E s E a R c h c O R p O R aT I O n | R E a L c a p I Ta L a n a Ly T I c s
  4. 4. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T ySPONSORING FIRMSReal Estate Research CorporationFounded in 1931, Real Estate Research Corporation was one of the first national firms dedi-cated to commercial real estate research, valuation, and consulting services. Today, RERCis also known for its independent fiduciary services, management information systems,valuation management, and litigation support services. With its practical know-how anddiscipline, RERC serves as the independent fiduciary and oversees all real estate invest-ment- and valuation-related activity of the multi-billion dollar real estate accounts forseveral major pension funds. In addition, RERC provides web-based portfolio technologysolutions and valuation management for several other major funds. Further, RERC hasprovided fairness opinions on dozens of major acquisitions totaling over $1 billion. RERC’svaluation services also have proven rewarding to real estate owners and investors for taxappeals and expert witness testimony in partnership disputes.DeloitteDeloitte is a recognized leader in providing audit, tax, consulting, and financial advi-sory services to the real estate industry. Our clients include top REITs, real estate buyers,property owners and managers, lenders, brokerage firms, investment managers, pensionfund managers, and leading homebuilding and engineering & construction companies.Our Real Estate Services team provides an integrated approach to assisting clients mini-mize real estate costs and enhancing firm value. We customize our services in ways tofit the specific needs of each player in a real estate transaction, from owners to invest-ment advisors, from property management and leasing operators to insurance compa-nies. Our multi-disciplinary approach allows us to provide regional, national and globalservices to our clients. Our real estate practice is recognized for bringing together teamswith diverse experience and knowledge to provide customized solutions for all clients.Deloitte’s national Real Estate Services industry sector comprises over 1,200 profession-als supporting real estate clients out of offices in 50 cities; key locations include Atlanta,Boston, Chicago, Dallas, Denver, Houston, Los Angeles, Miami, New York, San Francisco,and Washington, D.C.Real Capital AnalyticsReal Capital Analytics, Inc. (RCA) is a global research and consulting firm with offices inNew York City, San Jose, London, Singapore and The Hague. Started in 2000, the firm’sproprietary research is focused exclusively on the investment market for commercial realestate. In addition to collecting transactional information for current property sales andfinancings, RCA analyzes and interprets the data, providing valuable insight on commer-cial real estate investment. Covering all markets globally, RCA’s investment market dataand analysis is relied upon by all segments of the real estate community: buyers, develop-ers, brokers, lenders and regulatory agencies. Among other reports, RCA publishes GlobalCapital Trends, US Capital Trends and Troubled Assets Radar. Timely, complete and accu-rate reporting of investment activity is the hallmark of Real Capital Analytics. © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 4
  5. 5. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yFOREWORDApril 2011Dear Readers,As we put the finishing touches on our annual forecast report, Expectations & Market Realities in Real Estate 2011, we arestruck by the challenges facing the commercial real estate industry in this uncertain world. Despite our experience and senseof having been through this all before, we remain cautious with our expectations and about the investment environment over-all. The recovery that took hold in the second half of 2010 continues, but we are well aware of the headwinds that could quicklyderail both the growth of our economy and the markets.As such, Real Estate Research Corporation (RERC), Deloitte, and Real Capital Analytics (RCA) are pleased to present this fun-damental guide for Balancing Risk and Return in an Era of Uncertainty. Our collective viewpoints, commentary, and analy-ses offer you an unbiased look at what you can expect regarding the expanding economy, capital markets, and individualproperty markets throughout 2011 and beyond.Thank you to everyone who has contributed to this report, including research analysts and data providers, economists, busi-ness associates, research survey respondents, and the many others who have shared your information and ideas. We alsothank you—our readers, clients, and consultants—for your interest in our report, and we hope you find Expectations & MarketRealities in Real Estate 2011—Balancing Risk and Return in an Era of Uncertainty helpful as we navigate through a still-fragile recovery.Sincerely, Matthew G. Kimmel, CRE, FRICS, MAI Kenneth P. Riggs, Jr., CFA, CRE, FRICS Robert M. White, Jr., CRE, FRICS Principal & US Real Estate Services Leader President & CEO Founder & President Deloitte Financial Advisory Services LLP Real Estate Research Corporation Real Capital Analytics, Inc. © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 5
  6. 6. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yACKNOWLEDGEMENTSSponSoRing FiRmS & ChAiRS RERC EDitoRiAL boARDmatthew g. Kimmel, CRE , FRiCS, mAi Deloitte Financial Advisory Services LLP Stephen blank Urban Land InstituteKenneth p. Riggs, Jr., CFA, CRE, FRiCS Real Estate Research Corporation David blankenship AEGON USA Realty Advisors, Inc.Robert m. White, Jr., CRE, FRiCS Real Capital Analytics, Inc. nicholas g. buss INVESCO Real Estate Susanne Cannon DePaul University - The Real Estate Center geoffrey Dohrmann Institutional Real Estate, Inc. Stephen Furnary ING Clarion PartnersContRibuting AuthoRS michael gately Cornerstone Advisers David geltner MIT Center for Real Estate Jacques gordon LaSalle Investment Management, Inc.barb bush Real Estate Research Corporation John Levy John B. Levy & CompanySam Chandan, phD. Real Capital Analytics, Inc. mary Ludgin Heitman Capital Management, LLCtodd J. Dunlap, mAi, mRiCS, Senior manager Dennis martin RREEF/DB Real Estate Deloitte Financial Advisory Services LLP glenn mueller University of DenverDavid garcia Deloitte Financial Advisory Services LLP Scott muldavin The Muldavin Company, Inc.Kenneth W. Kapecki, mAi, CRE, FRiCS, Senior manager Joseph pagliari University of Chicago Deloitte Financial Advisory Services LLP Richard Sokolov Simon Property GroupLindsey Kuhlmann Real Estate Research Corporation Allan Sweet AMLI Residential Properties, LLCAndy miller, manager Deloitte Financial Advisory Services LLP R. brian Webb UBS AgriVest, LLCDoug murphy Real Capital Analytics, Inc. Charles Wurtzebach DePaul University-The Real Estate Centerpeter Slatin Real Capital Analytics, Inc. Sam Zell Equity Group Investments, LLCpatrick terriault Real Capital Analytics, Inc.nina turner Real Capital Analytics, Inc.brian Velky, CFA Real Estate Research Corporationmorgan Westpfahl Real Estate Research CorporationEDitoRiAL oVERSightpeter Slatin Real Capital Analytics, Inc.DESign & LAyoutLuke baldwin 21FingersJeff Carr Real Estate Research CorporationothER DiStinguiShED ContRibutoRSRobert bach Grubb & EllisRonald Johnsey Axiometrics, Inc.Robert mandelbaum PKF Hospitality ResearchR. mark Woodworth PKF Hospitality Research © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 6
  7. 7. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yCONTENTS1 | intRoDuCtionBalancing Risk and Return in an Era of Uncertainty .............................................................................................................................82 | thE CApitAL mARKEtSCapital Begins to Flow .............................................................................................................................................................................113 | thE pRopERty mARKEtSPerspective and Analysis ........................................................................................................................................................................214 | outLooK FoR 2011 AnD bEyonDUncertainty and the Need for Balance ..................................................................................................................................................39SponSoRing FiRmS................................................................................................................................................................................................................... 44 © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 7
  8. 8. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y 1 | INTRODUCTION balancing Risk and Return in an Era of uncertainty When Real Estate ResearchCorporation (RERC), Deloitte, andReal Capital Analytics (RCA) first dis-cussed partnering together to publishthis forecast report, a distinct sense ofuncertainty about the economy, aboutthe capital markets, and about com-mercial real estate dominated ourconversation. Our unease was under-standable—we were barely out of thelongest and most severe recessionsince the Great Depression, the levelof U.S. debt was reaching epic propor-tions, and the number of new bankfailures attributed to their exposure tobad commercial real estate loans wasincreasing weekly. It seemed that the invest-ment environment was finally start-ing to turn around when a new Con-gress came to town and tax cuts wereextended for businesses and individu-als. We were thrilled when the stockmarket finally began to grow by leapsand bounds, and even more thrilled environment, although improv- in Real Estate 2011—Balancing Riskwhen institutional real estate returns ing, remains uncertain. Risk is ever- and Return in an Era of Uncertainty.increased to approximately 13 percent present and returns seem to be fleet- In this first introductory chapter toin fourth quarter 2010, according to the ing for all asset classes, as investors the report, we have focused on theNational Council of Real Estate Invest- try to balance these opposing forces. economy and the various risk factorsment Fiduciaries (NCREIF). associated with our fragile recovery as As such, investors are focusing the backdrop for investing in commer- As 2011 got underway, we on why they invested in real estate in cial real estate. Chapter 2 examineslooked for additional signs of recovery, the first place. Real estate is a tangible the debt and equity markets, as wellbut major world crises during the first alternative to the more volatile stock as the banking practices/new regula-few months of this year—the earth- market, and is more transparent than tions affecting the availability of capi-quake, tsunami, and nuclear power stocks. It offers reasonable income tal. In Chapter 3, we take a close lookdisaster in Japan, the unrest spread- returns, which investors are seeking at the office, industrial, retail, apart-ing throughout the Middle East, the today, instead of the glitz and glamour ment, and hotel markets, and analyzesovereign debt crisis in Europe and of Wall Street. No one wants, or can volume, pricing, capitalization rates,the downgrading of those nations’ afford, to make mistakes, and by focus- vacancy/occupancy rates, and rentalcredit ratings, continued threats of ing on the fundamentals of their prop- rates/revenue for the specific propertyterrorism, to name a few—reminded erty investments, investors are keeping sectors. In our final chapter, we offerus how quickly real events can temper things simple and direct. our collective assessment and invest-optimism. Now, as the year unfolds, ment outlook for the risk and returnthe economy still faces a series of That is what we have tried to do associated with the major propertyspeed bumps, and the investment in Expectations & Market Realities markets for 2011 and beyond. © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 8
  9. 9. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y consumers have recaptured a measure of confidence. Banks and other lend- ers, emerging from unprecedented upheaval, have loosened the strictures on credit, supporting a modest renewal of investment and spending. And whereas the initial return to growth was powered by a dramatic and costly surge in public activity, the private sec- tor has now taken the place of the gov- ernment in sustaining the expansion. However, employers have a long way to go in replacing the 8.7 million jobs lost in 2008 and 2009. Through early 2011, we have measured the slowest progress in the labor market’s recovery following any post-World War II recession. For most of the past year, the absence of robust payroll growth has followed from slack in the utiliza- tion of currently employed workers and strong gains in productivity. In recent economic history, these are typical fea- tures of a recovery in the labor market For policymakers and businesses alike, new threats to geopolitical and that lags the broader economy’s emer- global macroeconomic stability have added to the prevailing headwinds… gence from recession. commercial property investors and lenders have nonetheless powered forward, albeit unevenly, anticipating stronger fundamentals…. But exacerbating the expected lag in payroll gains, businesses have been navigating a more complicatedthE EConomy of the recovery has precluded a singu- route in the current recovery, manag- lar focus on the issues that are within ing the aforementioned uncertain-A “Qualified” Recovery Presents New our control. In the face of this remark- ties around the regulatory and policyChallenges able opacity, commercial property environment and, more recently, an investors and lenders have nonethe- increasing incidence of mismatch In the aftermath of this genera- less powered forward, albeit unevenly, in required skill sets and the skillstion’s deepest and most destabilizing anticipating stronger fundamentals as present in the unemployed labor pool.recession, many of our foundational the recovery progresses. In 2010, com- Job openings remain extremely lowassumptions about the American mercial property sales doubled from by any historic norm, but have beeneconomy and investment environ- the previous year’s nadir. The market’s increasing in recent months. However,ment have been upended. While the momentum has carried over into 2011, in many of the sectors that are mosteconomy has resumed its expansion, with broad metrics relating to liquid- crucial for a recovery in spending andquestions about the speed and dura- ity and credit availability reflecting direct space demand, hiring has notbility of the recovery have coincided investors’ optimism in the sector’s kept pace.with profound uncertainties relating the direction of monetary and fiscal The most recent data suggestpolicy and the changing relationship A Fragile Economic Recovery that hiring may accelerate modestlybetween government, business, and over the course of 2011. Barring anythe American people. For policymak- Even as investor activity has disruptive shocks, the consensus esti-ers and businesses alike, new threats picked up, the economy and labor mar- mates suggest that payrolls at midyearto geopolitical and global macroeco- kets have measured qualified gains. may be expanding at a fast enoughnomic stability have added to the pre- The recession has been over for longer pace to offset new entrants to thevailing headwinds; the broader context than it lasted, and businesses and labor force, thereby reining in broader © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 9
  10. 10. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T ymeasures of unemployment. Still, have curtailed their lending. This when some of the most aggressivelyproperty investors with heady expecta- improvement in mortgage availabil- underwritten loans have yet to mature,tions for job growth and space absorp- ity has been necessary for a broader remains an issue for the market. Whiletion must contend with the possibility move towards normalization in the a sudden outpouring of distress wouldthat stresses on cash flow may persist. sector’s capital markets. inevitably provide opportunities forRebalancing Investment The qualified economic tra-jectory has prompted investors toassign unusually large premiums tothe liquidity of assets. As a result, theindustry’s headline statistics belie astriking and persistent unevenness ofthe recovery in investment and credittrends. In a flight to quality, investorsover the past year have focused theirefforts on acquiring properties in thenation’s most visible and most liquidmarkets. This focus has resulted ina concentration of capital in a smallsubset of markets—New York City, Coinciding with the improving distress investors, it would do so byWashington, D.C., and San Francisco position of many lenders, the dominant undermining the price stability thatforemost amongst them. It is in these role of agency financing in the apart- has been crucial in driving improve-markets that competition for assets ment sector has moderated as other ments in sales and credit.has been most intense, supported by institutions have begun to competea diversity of domestic and foreign more aggressively for lending opportu- The Year Aheadinvestors, with domestic investors nities. In major markets, in particular,frustrated by the absence of opportu- institutional and securitized lenders’ Whether in primary marketsnities in distress and foreign investors readiness to provide new acquisition or further afield, the positive trendsless dependent on mortgage financ- financing on performing assets has in headline transaction volume maying. In some cases, pricing threatens to supported the shift in investor activity continue into 2011, barring a seriousdecouple from the fundamental basis away from the agency and private buy- reversal in the underlying economicfor value. ers that dominated activity in 2009 and and labor market recovery. But in early 2010. measuring this recovery, investors will Underpinning gains in major have to remain vigilant, particularly asmarkets and for the highest quality As an important facilitator of concerns the magnitude of job growth,properties, the availability of credit this healthier new acquisition financ- the regulatory and policy environ-in support of significant property ing environment, additions to distress ment, and the complex, nonlinear rela-sales, as well as for the refinancing of nationally fell to their lowest levels in tionship between broad interest ratesmaturing debt, has improved sharply 2 years in third quarter 2010, reflect- and cap recent quarters. Buoyed by the ing a slower pace of deterioration inaforementioned pricing trends and legacy mortgage pools and the positive In the realms of public and pri-nascent recovery in property funda- impact of more stable economic and vate markets, and at their juncture,mentals in major markets and some credit market conditions. Of course, significant risks may continue to exertproperty sectors, a broader range of slower inflows to distress and the drags on consumer and business con-lenders—including commercial mort- absence of distress investment oppor- fidence in a way that is material for thegage-backed securities (CMBS) con- tunities do not mean that deteriorating commercial property outlook. Givenduit originators, foreign banks, and mortgage performance is not a feature this unique environment of uncer-life companies—has re-engaged with of the market landscape. Rather, dis- tainty, and in planning for the future,commercial real estate investors in tress has been heavily intermediated, investment strategies that anticipatethe latter half of 2010, albeit on terms left unresolved, or is residing on bank the need for flexibility (as opposed tothat remain conservative by historic balance sheets. The question of how we relying on a rigid and deterministicstandards and even as smaller banks manage to draw down these balances, outlook) remain critically important. © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 10
  11. 11. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y 2 | THE CAPITAL MARKETS Capital begins to Flow responding to RERC’s institutional investment survey have seen the availability of capital for commercial real estate investment increase sig- nificantly from its low in third quarter 2008 (see Exhibit 2-1). In fourth quarter 2010, the availability of capital began to overtake discipline for the first time since the financial crisis began. Capi- tal flows increased from virtually every sector, including private investors, pension funds, real estate investment trusts (REITs), institutions, foreign investors, and others. Many respond- ents to RERC’s investment survey also stated that they intend to direct more capital toward commercial real estate during 2011 than they invested in 2010. This changing sentiment is Despite a residential market that of this will likely be directed toward also reflected in the Buy-Sell-Holdis still in decline, anemic employment commercial real estate, investors recommendations noted by RERC’sgrowth, and a record-high federal debt,the U.S. economy saw positive growth Exhibit 2-1. RERC Historical Availability and Discipline of Capitalthroughout 2010 and is expected tocontinue to grow, if slowly, over the 10next few years. This is no small feat, 9given the recent near-collapse of ournation’s financial system and a reces- 8sion more severe than any since theGreat Depression. It is a tribute to the 7nation’s economic resilience to havesurvived this crisis, and although a 6 Ratinggreat deal of uncertainty continues inthe economy, the geopolitical land- 5scape, and the markets, we are hopefulthat the broader recovery holds posi- 4tive prospects for forward momentum Disciplinein commercial real estate investment. 3 Availability 2 Capital has become increasinglyaccessible, as companies, funds, and 1individuals continue to regain some 1 2 04 05 06 07 08 09 10 3 0 0 0 20 20 20 20 20 20 20 20 20of the wealth lost in the crash; accord- 20 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Qing to some estimates, corporations Ratings are based on a score of 1 to 10, with 10 being high.are holding as much as $2 trillion in source: RERc, 4q 2010.reserve. Although only a percentage © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 11
  12. 12. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yinstitutional investment survey Exhibit 2-2. RERC Historical Buy-Sell-Hold Recommendationsrespondents (Exhibit 2-2). The Holdreference retains the highest-rated 10recommendation, reflecting quite 9clearly the dominant strategy withinthe market. But more interesting, and 8perhaps more relevant, is the narrow-ing gap between the Buy and Sell rec- 7ommendations, indicating increasingagreement on pricing and valuation. 6 RatingWhile we have seen transactions in thetop-tier markets for high-quality prop- 5erties at record high prices during thepast few quarters, demand is starting 4to extend to core properties in some of 3 Holdthe secondary and tertiary markets aswell, as investors move out on the risk Sell 2spectrum. Buy 1 01 02 03 04 05 06 07 08 09 10LEnDing StAbiLiZES AnD 20 20 20 20 20 20 20 20 20 20 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4QiSSuAnCE piCKS up Ratings are based on a scale of 1 to 10, with 10 being high. source: RERc, 4q 2010. As commercial real estate own-ers continue to deleverage, many keylending sources have become more approximately 23 percent of banks Still, certain commercial realflexible in the treatment of existing tightened their lending standards estate loan terms tightened in 2010. Thedebt, but have been less accommo- (this was down significantly from a Federal Reserve’s January 2011 Seniordating concerning new loan origina- high of 87 percent in fourth quarter Loan Officer Opinion Survey on Banktion. Commercial mortgage origi- 2008, immediately following the col- Lending Practices further stated thatnations, though increasing, remain lapse of Lehman Brothers). about 40 percent of domestic banks onsignificantly below peak-market levels. net reported having tightened loan-to-While new issuances from alternative Buttressing the warming trend, value ratios, and a moderately smallersources remain minimal, new lending about 10 percent of domestic banks fraction tightened debt service cover-is expected to continue at subdued lev- on net reported increased demand age ratios and maximum loan sizesels in the near term. However, stabili- for commercial real estate loans in during fourth quarter 2010.zation is apparent and signs of revitali- fourth quarter 2010, the strongestzation are evident. reading since early 2006. Foreign Despite examples of tighten- banks also reported that net demand ing, according to preliminary esti-Bank Lending had strengthened, according to the mates from the Mortgage Bankers Federal Reserve. Association’s (MBA) Quarterly Survey Banks initially responded tothe financial crisis by rapidly tight-ening underwriting on commer-cial loans, but in general, approvalstandards began to ease in 2010. TheJanuary 2011 Federal Reserve’s Sen-ior Loan Officer Opinion Survey onBank Lending Practices noted that infourth quarter 2010, approximately69 percent of banks left their lendingstandards for commercial real estatebasically unchanged, approximately 8percent of banks eased standards, and © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 12
  13. 13. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yof Commercial/Multifamily MortgageBankers Originations, mortgage bank-ers originated $110 billion of commer-cial and multifamily mortgages during2010, up a healthy 36 percent from 2009originations. The threat to banks associ-ated with bad loans remains great,but according to the Federal DepositInsurance Corporation (FDIC), thenumber of bank failures shoulddecline in 2011. Although 157 banksfailed in 2010 (the most since 1992during the savings and loan crisis) and played in the financial crisis, issuance required to execute. Additional fund-884 banks remained on the FDIC’s list dropped to nearly zero in 2009 (just ing sources are also emerging, includ-of problem banks at the end of fourth $720 million was issued in 2009). But ing covered bonds, which consist ofquarter 2010, the FDIC expects to see last year, lenders issued a total of $11.6 securities issued by banks and backedfewer bank failures in 2011. (For com- billion of CMBS, and improved condi- by a “cover pool” of mortgage or public-parison, there were no bank failures tions have led most analysts to expect sector loans. This vehicle is one of thein 2006 and only three in 2007.) $35 billion to $45 billion of CMBS issu- oldest forms of capital in the European ances in 2011 according to Standard & bond market, and could provide a newOther Sources of Mortgage Poor’s (S&P’s) estimations. However, funding mechanism as the industryOriginations that is still far off the market’s peak of attempts to rebound. Another simple $230.5 billion in 2007. and direct throwback that is being uti- Life insurance companies were lized is seller financing, in which thea leading source of lending in 2010, Securitized loans issued in 2009 seller provides a secured loan to thewith originations volume 155 percent and 2010 have been dubbed CMBS 2.0, buyer to finance a portion of a prop-higher than 2009 levels, although the and are characterized by simpler struc- erty’s purchase price.dollar volume was low in absolute tures that involve greater subordina-terms. Significantly, the MBA reported tion levels, fewer classes and loans, A breakdown of 2010 investmentthat originations for CMBS conduits and thicker tranches, all designed in commercial real estate by investorincreased more than 10-fold in 2010, to reduce the level of due diligence type is shown in Exhibit 2-3.and that government-sponsored enti-ties (GSEs) also saw strong volumes, Exhibit 2-3. Commercial Real Estate Investor Groups (2010)with increases in production for FHA/Ginnie Mae offsetting a decline in User/Other Privateproduction for Fannie Mae/Freddie 9% 30% Cross-BorderMac. Although the low absolute levels 7%dramatically inflated the growth per-centage, there were clearly positivechanges in borrowing and lending forcommercial real estate. Institutional Going forward, the expectation 13% Non-Listedis that more favorable market condi- REIT 9%tions for both lenders and borrowerswill likely help boost CMBS issuance inthe near term, although the level willremain below the 2007 peak over the Listed/REIT Equity Fund 18% 14%longer term. In 2008, CMBS accountedfor 25.6 percent of commercial mort-gage loans; however, due to the cen- source: Rca, february 2011.tral role these and similar securities © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 13
  14. 14. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yCommercial Mortgage Debt Exhibit 2-4. Fixed-Income Lender Composition According to the Federal Reserve Govt. Sponsored EntitiesFlow of Funds, the level of commercial/ Savings Institutions 16% Other 6% 5%multifamily mortgage debt outstand-ing decreased to $3.15 trillion in fourth CMBS, CDO andquarter 2010 from third quarter totals. other ABSAs demonstrated in Exhibit 2-4, the 9%largest holder of commercial debt con- Commercial Bankstinues to be commercial banks. 44%high DEbt mAtuRitiESREmAin A ChALLEngE Life Insurance While lenience by banks has Companies 20%helped cushion commercial real estatefrom a more severe downturn, the high Fixed Income Markets - $3.15 Trillionlevel of maturing debt remains a signif- Lender Compositionicant barrier to full recovery. The coreof the dilemma is that debt incurred at source: federal Reserve, 4Q 2010. The peak year for maturities is Stanley estimates that modifica- the market in 2007 and 2008 is set to expected to be 2013, when $367.7 tions have pushed CMBS maturities mature in 2012 and 2013. The peak year billion will come due, before the from the 2009-2011 range out to the for maturities is expected to be 2013, amount decreases modestly to 2013-2017 time period. As the major- when $367.7 billion will come due, $333.0 billion in 2015, and then ity of commercial real estate loans are before the amount decreases modestly subsides to less than $100 billion for a period of 5 years, a majority of to $333.0 billion in 2015, and then sub- by 2020. the debt incurred during the peak of sides to less than $100 billion by 2020. Exhibit 2-5. Commercial Real Estate Maturities Set to Peak in 2013the top of the market is now coming dueat a time when economic uncertainty $400and barely recovering commercial Otherreal estate fundamentals are making it $350harder for borrowers to generate cash Life Cosflow needed to make debt payments. In $300fact, Trepp, LLC noted that as much as CMBS60 percent of current commercial real $250 Banksestate loans maturing between 2011 Billionsand 2015 are considered “underwater,” $200indicating the amount of debt exceedsthe market value of the property itself. $150How Big Is the Dilemma? $100 Trepp, LLC predicts that an $50estimated $1.7 trillion in commer-cial real estate debt is set to come due $0between 2011 and 2015, a figure that 11 12 13 14 15 16 17 18 19 20could turn out to be even higher once 20 20 20 20 20 20 20 20 20 20the impact of “amend and extend” is source: Trepp, LLc, 4Q 2010 update.considered (see Exhibit 2-5). Morgan © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 14
  15. 15. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T y impact of “Amend and Extend”One of the main reasons for the unique nature of this has been reached, and further delaying the inevitable maydownturn is the way banks have approached troubled cause a more severe downturn in the future.debt. In their efforts to stem write-downs, banks havetaken a longer-term approach to potential losses, working guidance by regulators has certainly shaped banks’ re-to modify and extend soured commercial real estate loans sponse to their troubled loan portfolios. In October 2009,in anticipation of improving values. In previous cycles, the the federal financial Institutions Examination councilcombination of sharply declining property values and the (ffIEc), which includes the federal Reserve, fDIc, andcomparatively short duration of commercial real estate the comptroller of the currency, responded to concernsloans (generally 5 years) resulted in substantial write- about commercial property losses and debts coming dueoffs for lenders and increased foreclosures for owners. by issuing a policy statement suggesting that performinghowever, this downturn has been characterized by a new loans would not be declared troubled solely because of awillingness by banks to modify and extend the terms of decline in the value of underlying unlikely to return full value on principal and interestaccrued. This “amend and extend” strategy commonly in- While the ffIEc guidance was intended chiefly to improvevolves permitting below-market interest rates and stretch- consistency and flexibility in the treatment of commercialing out maturities for borrowers with troubled loans. real estate loans, the initial result was greater confusion in the market, with some lenders misinterpreting theThis has enabled owners to retain properties rather than guidance as a form of forbearance and an incentive tolose assets and investment, and it has also prevented the restructure maturing loans. In response, in May 2010, theinvestment market from being flooded with deeply dis- ffIEc held a conference call with 1,400 bank executives,counted properties—to the frustration of some opportun- explicitly stating that it did not intend for investors andistic investors. banks, in turn, have been able to delay and bankers to interpret the guidance as a call to amend andeven reduce write-offs on commercial real estate loans extend existing loans.until favorable conditions return, which helps to classifysome troubled loans as performing, thereby minimizing since the ffIEc’s original guidance, lenders have favoredthe amount of reserves banks must set aside. workouts over foreclosures. This is an encouraging sign that widespread commercial real estate foreclosures mayThe main disadvantage for this practice is that a protract- be delayed until the economy improves; however, it alsoed period of restructuring limits returns on commercial indicates that a significant number of maturing loans havereal estate. In addition, such extensions put a floor under yet to be included in the process.the market, making it difficult to know when the bottom © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 15
  16. 16. E x p E c TaT I O n s & M a R k E T R E a L I T I E s I n R E a L E s TaT E 2011 | b a L a n c I n g R I s k a n D R E T u R n I n a n E R a O f u n c E R Ta I n T yUnderlying Factors: Moderating Exhibit 2-6. Delinquencies Remain Elevated, but Starting to DeclineDelinquencies and Defaults 11 Although a high level of com- 10 Delinquency Ratemercial real estate debt remains in dis- 9tress, the recent uptick in restructuring Charge-O Rateand resolution of commercial loans is 8a positive sign and the pace of defaults 7and delinquencies has begun to sub- 6side, as shown in Exhibit 2-6. Percent 5 While the majority of outstand- 4ing commercial real estate maturi-ties are from loans issued by banks, 3loan delinquencies from other lending 2sources indicate a similar trend of lev-eling off but not subsiding. For exam- 1ple, Trepp, LLC reported that 30+ day 0delinquencies on CMBS loans climbed -1rapidly from 4.36 percent in Septem- 01 02 03 04 05 06 07 08 09 10ber 2009 to 7.61 percent in March 2010, 20 20 20 20 20 20 20 20 20 20 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Q 4Qbefore leveling off between 8.5 per- source: federal Reserve, november 2010.cent and 9.3 percent from June 2010through January 2011. Analysts expectCMBS delinquencies to continue rising 2008 and 2010 but at a slower pace in the keys for buildings valued below theat a modest pace, ultimately peaking recent quarters. amount of debt, and since commercialbetween 10.0 percent and 12.0 percent. loans are non-recourse, it is actually(Moodys forecasts that this rate will Although commercial real easier for commercial owners to walkreach 9.5 percent to 11.0 percent by the estate defaults may be moderating away from their loans than for home-end of 2011.) overall, there also have been more owners. While this may seem like an reports of strategic defaults, a trend extreme step, it is often the result of Aided by loan extensions, com- that has migrated from the residen- a pragmatic business decision to exitmercial real estate mortgage defaults tial to the commercial property sector. profit-draining investments in order tohave followed a similar trend as delin- Some of the nation’s largest property divert funds to performing projects orquencies, climbing rapidly between owners have recently chosen to return to shareholders. There has been a shift in direc- tion, however. As demonstrated in Chapter 3 of this report, although properties continue to go into default, there was an inflection point with the pace of resolutions beginning, how- ever slowly, to eat away at the moun- tain of distressed assets during fourth quarter 2010. REit REbounD ContinuES Commercial real estate funda- mentals may be in the early stages of a slow recovery, but REITs have already experienced a strong rebound. This disparity has occurred because while © 2 0 1 1 D E LO I T T E D E v E LO p M E n T L Lc , R E a L E s TaT E R E s E a R c h cO R p O R aT I O n , R E a L c a p I Ta L a n a Ly T I c s . a L L R I g h T s R E s E R v E D. | 16