Commercial Recovery

NEW YORKOct. 26, 2011In 2012, U.S. commercial real estate must resign itself to a slow, grind-it-out recovery. It will follow a period of mostly sporadic growth in a few real estate markets that offer 24-hour transportation hubs with global access, according to the Emerging Trends in Real Estate 2012 report released by PwC US and the Urban Land Institute (ULI).

According to the survey, economic doldrums and a lack of dynamic job generators are weighing down real estate markets. Businesses have learned that they can increase profits with less space, and a drag in consumer spending compromises growth in retail and industrial occupancies and rents.

“Job creation is clearly the critical ingredient for a sustained recovery in commercial real estate, and the market participants we surveyed uniformly struggled to identify new employment engines,” says Mitch Roschelle, partner, U.S. real estate advisory practice firm, PwC.As a result, businesses are focused on squeezing profitability out of productivity gains, and families are using less square footage.

In 2012, investors expect pricing to level off in the top markets; overall buy sentiment will subside, selling appetites will increase, and more owners will hold until the economy untracks. This is part of ˜the new normal as investors are coming to grips that they may not be selling for more than they paid.

Survey participants predict that 2012 will see an increased supply of properties for sale; however, due to economic uncertainty, interest among buyers may diminish.

Return expectations continue to recalibrate

Although return expectations will further recede, well-leased core real estate in leading markets will continue to produce solid single-digit, income-oriented returns. According to the report, more opportunistic investors will ratchet down forecasts  even projections of returns in the mid-teens appear to be a stretch as risk increases from questionable supply/demand fundamentals.

Many players will back off from bidding on trophy properties in top-tier markets, fearing that pricing is outpacing the potential for recovery in net operating incomes, says ULI Senior Resident Fellow for Real Estate Finance Stephen Blank. “Additionally, investors believe that cap rate compression has ended and a leveling off is expected with possible upticks in cap rates for some property sectors in certain markets.”

Respondents best investor bets for 2012:

Caution still rules. Investors should concentrate on the few markets showing hiring and leasing gains.

Blue-chip gateways. These relatively safe harbors all have issues; but over time, assets in 24-hour markets dependably outperform other because they lie along important global commercial routes and attract money from all over the world.

Job centers. Head to the few cities where employment growth actually occurs, including gateways and those that rely on energy, high-tech and health care-related industries, as well as universities and government offices.

Value-add plays. Look for class B properties in good infill markets that have been neglected over the past five years.

Fixed-rate debt. Owners should lock in long-term, fixed-rate financing on assets while they can.

 Recap troubled equity. More motivated borrowers, working with senior lenders, will strike favorable deals on mezzanine debt and preferred equity to stabilize; at low interest rates, investors can achieve especially favorable risk/return spreads.

Distressed debt. Banks and special servicers will continue to dribble out loan pools with various embedded gems.

Land holds. Cash buyers can claim single-family lots for cents on the dollar.

Markets to watch

Despite tenuous economic outlooks, only one of the 51 U.S. cities surveyed for Emerging Trends failed to improve its investment score over last year report. More than 60 percent now rate as fair or better prospects, compared with only 40 percent in 2011.

Highlighting investor angst, Washington, D.C., the No. 1 city for the third consecutive year, suffered a slight downtick on the Emerging Trends ratings scale as interviewees wonder if the market has become too frothy in light of all the political talk about federal cutbacks.

Just behind Washington, Austin, the Texas capital, sneaks into the No. 2 spot, benefiting from dynamics created by its large university, the local tech industry, government jobs, and the regional energy-based economy. Buoyed by high-tech-hiring, San Francisco leapfrogs New York City to No. 3 and No. 4 respectively; Boston holds onto the fifth position; and Seattle, also a software and Internet hotbed, stays at No. 6.

The top markets also ranked highest in the survey City Walkability Scores a measure of walkability among the national cities. Increasingly, convenience counts as more people shy away from car-dependent places.

Property types

Investment and development prospects continue to advance across all major property sectors, led by apartments. Besides apartments, interviewees prefer downtown office buildings in 24-hour cities, warehouse properties producing cash flow in prominent port and airport gateways; full-service hotels in the major markets; limited-service hotels without food and beverage; and neighborhood shopping centers serving stable infill suburban communities.

Sentiment diminished for power centers and malls: owners will not sell the best fortress, and most other regional centers face a shaky future. Suburban offices score the lowest investment marks; commodity buildings in campus settings isolated from urban amenities also receive a big thumbs down.

\ 2011 Florida Realtors