Investors are having to take on more risk and look deeper as competition for top properties intensifies. Stephanie Schwartz-Driver reports

Investors in US real estate are manoeuvring through conflicting data to find stiff competition for top properties. Although the economic news is ambivalent, showing a soft recovery at best, real estate transaction volume is dramatically up, competition is high, and investors are being forced to look up the risk scale.

The US economy seemed to hit a bump in the spring, as existing home sales fell 0.8% in April from the previous month and the median sales price for homes fell by 5%. High foreclosure inventories continue to threaten recovery in the housing sector - the inventory of homes for sale would take nine months to clear at the current sales volume.  At the same time, job creation slowed in May, and the unemployment rate rose slightly again.

Against this background, however, are broader signs of health in commercial real estate. Deal volume is up; over 7,000 properties were sold in the first half of the year in the US, and Real Capital Analytics charted $8.7bn (€6bn) on few sales listings in April in office alone (indications are that May will surpass this).

Commercial mortgage-backed securities (CMBS) are also back in force. For the first half of 2011, issuance topped $14bn, compared with only $600m by the same time in 2010. This news comes with a caveat, however, notes Jack Foster, head of Franklin Templeton Real Asset Advisors. "Recovery in the securitisation market is not an indicator of recovery in the property market. To suggest that securitisation will lead recovery is not real - if anything, if it comes back in a strong way, there is reason to be a little wary," he says.

"The economic news creates a murkier view, but there is definite improvement in commercial real estate," says Pat Halter, chief executive officer of Principal Real Estate Investors. "It is somewhat ying-and-yang-like - but it is always like that in some ways. There is always a lot of conflicting news."

In Halter's view, the commercial real estate market is on a slow path to recovery. Although recent data signalling weaker economic activity and rising oil prices take their toll on the psyche in the marketplace, he still believes in modest sustainable expansion.
One of the challenges that the market is facing now is in gauging the trajectory of the recovery, not only in terms of pace but also its geography. In what Foster calls the urbanisation factor, the economic recovery is already stronger, and will continue to be so for some time, in the major cities, where there is a combination of high demographic concentration and economic diversity. "There is not going to be an even recovery. The regional bifurcation makes this economic recovery different from its predecessors, which had been marked by a discrepancy between city and suburbs on a broader scale," he explains.

Foster cautions investors who believe that they are playing it safe by sticking with core properties in major markets. In his view, pricing is not the only challenge. "One of the key challenges with core is that the risk of core has increased more dramatically than investors realise," he says. The definition of core properties once meant an unleveraged prime shopping mall or office building with long leases with credit tenants. Today, these properties could be 50% leveraged, or with only short leases in place. "We see an opportunity to mitigate some of the risk in the core space. If core is very expensive it is important to dig in and find out where the risk really is," Foster says.

Franklin Templeton is seeing opportunities in managers who work with ‘zombie landlords' - landlords who are stuck, cannot make their payments, cannot lease up, but the banks will not foreclose. "There are opportunities here for astute managers who can work with the banks and the landlords to recapitalise these properties," says Foster. These are one-off, individual situations that exploit inefficiencies in the market but not a big market theme now. "Taking this kind of deal on involves a great deal of depth, to have the capital to underwrite the deal quickly," stresses Foster, who says that he is seeing some opportunities with the potential for up to 20% returns without leverage.

At Principal, Halter is focused on the good news. "We continue to see opportunities to take advantage of improving fundamentals, an improving technical background, and the return of capital to the market." Like many other investors, Principal is focused on high-quality assets. However, Halter acknowledges that pricing on core properties is a challenge. "The gateway markets, frankly, have reached the high-water mark on prices," he says. The firm is looking at the next top 10 in the US - cities such as Houston, Seattle, Denver, or Dallas. In a leased core strategy, they are also looking at challenged core properties lacking solid leasing structures, which can benefit from better management to get them leased and keep them tenanted.

"In general, investors are looking at more markets today, clearly widening the markets they will invest in, as well as their risk tolerance. There is clearly a stronger directional view towards more value-added investment strategies as well," says Halter. He sees these shifts as a sign that investors have more confidence in improving fundamentals.

"Because of rising competition, people are slightly raising their risk tolerance, because they need to get the returns - and they are seeing better risk-adjusted returns by taking on a little more risk. But we are not seeing disconnectivity yet," stresses Halter.

Although the move along the risk spectrum might open some opportunities for investors and managers, Standard & Poor's is noting some worrisome trends in CMBS, motivated by a creeping acceptance of risk in response to greater competition. In a report issued in May, S&P pointed to a limited return of pro forma underwriting, as well as questionable appraisals, including those that are building in upsides in rent and occupancy based on forecasts, rather than in-place rents and tenancy at closing.

"Even though the aggressive appraisals are not widespread yet, they are reminiscent of the peak years when assumptions were built in before they occurred," says Kurt Pollem, CMBS/new issuance analyst. "Based on the trend that we see to date, we do not see this changing in the near future." He notes that he has recently talked with the Appraisal Institute, which also has begun to see the same trend. "They do not want a repeat of 2005-07, when appraisal rates turned out to be unrealistic. They also validated some of the concerns we pointed out," he says. These appraisal issues tend to be for larger loans, particularly for office and hotels in primary markets.

Principal's Halter has taken note of this trend. "There has been a little deterioration in underwriting, but subordination levels are adequately reflecting that deterioration," he says. "We are not too concerned yet."

Pollem attributes some of the problems with the current CMBS vintage to the competition dynamic in play. Investors are looking for larger, more institutional-quality assets that performed relatively well during the last downturn, and a broad pool of lenders, including the life companies, wants to provide financing. "In this environment, it is being more competitive to own and to lend on high-quality assets. At the same time, we are told a lot that investors in CMBS want to see perceived high-quality assets in the pools," he explains.

Pollem says that hotels are starting to be put into CMBS pools, along with assets that are dealing with refinancing issues. With these, it is difficult to make assumptions about future performance. S&P is also seeing greater top-10 loan concentration, averaging around 60%. At the same time, the May report points out that "many recent top-10 loans are located in non-primary markets", which likely reflects greater competition for loans in the primary markets.