The US market is paralysed by uncertainty about the future, but plenty of capital is poised for a signal to invest. Stephanie Schwartz-Driver reports

Uncertainty is continuing to freeze up the US commercial real estate markets - uncertainty about pricing, about the way the economy is going, even about when the markets will finally thaw. Although there is significant capital sitting on the sidelines, nobody is sure what it will take to bring it into play again.

The collapse of the Tishman Speyer deal for ownership of Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan - which at the time was the most expensive residential real estate deal - shows, in a big way, the excesses of the last boom. Despite the venture going into foreclosure, Tishman itself is not at risk, having invested very little of its own money in the deal.

But the collapse of this venture is of limited significance in terms of market trends. As one industry insider said, “this doesn’t have a lot to do with the world collapsing. It has a lot to do with gross miscalculation at the time the deal was made.”

The direction of the US economy, particularly in terms of jobs, is a major area of uncertainty. On the surface, the outlook is more positive than it was a year ago. Peter Baccile, vice-chairman of JP Morgan Securities, says: “The fear of a systemic failure is gone, and that is why we feel better about the future.” However, job figures have not improved to a level that will significantly increase confidence in economic progress.

At the start of 2010, jobless figures remained relatively steady in the US - the unemployment rate stood at 9.7%, down from 10% in December. However, the unemployment rate does not take into consideration those out of work who no longer qualify for unemployment benefit. The number of people newly unemployed fell slightly, but the number of long-term unemployed (defined as those jobless for 27 weeks or more) continued to rise in January.

However, the economy overall grew at 5.7% for the fourth quarter of 2009, the fastest pace since 2003, and manufacturing was up significantly. Most firms have cut expenses tightly so, with any uptick, the economy is set to boom. Most economists expect around 3% growth overall this year. Some boldly assert that growth will reach around 6%, although unemployment will remain high, only falling to around 9.5% by the end of 2010.

“We are all expecting things to happen after a two-year quiet period,” says Eric Mogentale, principal overseeing marketing and client services at Walton Street Capital, a private equity real estate investment firm.

Investors are waiting for different signs that the bottom has been reached. “We need to see capitulation - capitulation requires lenders writing down to the true value of assets. Until we see that, we are not buying,” says Mogentale. While he sees change in process, he does not expect deal flow to grow measurably until the end of the year, despite the fact that there is undoubtedly significant capital sitting on the sidelines.

Reluctance is not just on the buy side, however. Steven Kohn, president and principal at Cushman & Wakefield Sonnenblick, notes: “With any property type and in any market, deal flow depends on seller motivation, and that is just not there right now.” He adds: “If you are going to sell, higher quality properties in top tier markets are the most saleable.”
It is true that most deal flow now in the market involves core properties in major markets. For this kind of opportunity, “we are seeing a lot of bidders, sometimes 10 to 20”, says Mogentale. “But we are not seeing sane pricing.”

Margaret McKnight, managing director, investments, at Metropolitan Real Estate Equity Management, says there is every reason to be positive on the buy side Although there is a lot of fear about investing too early, she believes that it is the time to take a look, based on in-depth local knowledge about real estate values.

“This is a time when prices are down and we can buy better quality at lower prices,” she says, noting that certain cyclical markets can be very interesting now. “We are focused on the top six cities for office and are looking at other cities for other property types,” she explains. McKnight gives the example of the recent purchase of an apartment complex in Nashville, “which we would not touch with a 10-foot pole for office.”

In fact, the US market is attracting interest from a broad range of investors. “Early on, the big focus from international investors was on staying in their own backyards,” says Baccile. “But for the last six or eight months, there has been a lot of interest, as if the USA is on sale.”

Mogentale of Walton Street notes the same trend. “The new emerging markets are the US and Western Europe,” he says.

The complexity of the situation with lenders is one key area of uncertainty. Whole-loan arrangements are simpler. Although the banks have been recapitalised, they are still unsure what to do with low-performing or non-performing loan portfolios. Borrowers and lenders alike are unwilling to go the foreclosure route, and the majority of the money centre banks are willing to consider extensions.

There are indications that lending will restart in 2010. A Jones Lang LaSalle survey of mortgage lenders, the annual Lenders’ Production Expectations Survey, revealed that 43% of respondents expect that their loan production will range from $2bn (€1.48bn) to $4bn in 2010 - more than double the rate reported in 2009. Respondents included banks, private equity lenders, government agencies, insurance companies, and commercial mortgage-backed securities (CMBS) dealers.

“Insurance companies are very anxious to get a lot of money out in 2010,” agrees Kohn of Cushman & Wakefield. However, he believes that there will be fewer banks as active lenders than there were previously.

In addition, the Jones Lang LaSalle survey found that more lenders will be willing to advance greater sums to single-asset allocation: 56% of respondents were willing to lend $50m or more for single asset acquisitions. This contrasts with findings in 2009, when the majority of respondents said that they would lend $10m to $25m for a single asset acquisition.

Although whole-loan lending has a positive outlook, uncertainty persists on the future of the CMBS market. It will revive, but in a different form, in the view of Baccile. “We are rebuilding this market from scratch,” he says, “with smaller deals, smaller markets. The number of B-piece and mezzanine buyers will also be smaller.” He estimates that the total market size will end up around half its previous size - growing to around $80-100bn, as opposed to the $200bn it stood at in 2006.

For the CMBS market to progress, however, the investor side of the market has to grow again, and new aggregators will be needed, Baccile points out.

In January 2010 US CMBS issues totalled $1.98bn. This is against a total for 2009 as a whole of only $3bn (figures from the CMSA Compendium of Statistics). At its peak, in 2007, CMBS issues amounted to $230.2bn in the US. While past vintages of CMBS will suffer from ongoing default issues - at the beginning of 2010, around 10% of all CMBS moved to special servicing - CMBS issuance from 2009 onward will benefit from tighter underwriting standards.

In the Jones Lang LaSalle survey, refinancing is given priority. More than 67% of life company respondents, for example, reported that between 40% and 60% of their portfolios will be allocated to refinancing maturing loans.

The need for recapitalisation and refinancing is creating opportunities for real estate investors who see great opportunities on the debt side of the business. One company that has found significant opportunities with debt strategies is Aviva Investors, says Ed Casal, chief investment officer. The firm is benefiting from the corporate finance expertise in its multi-manager team.

“This is not the aesthetically creative side of the business - it’s more like shoring up the foundations,” Casal says. “Many funds know how to build or rehab buildings, but now they need help on the corporate finance side.”

The need for recapitalisation has changed over the past year, explains Casal. “In 2009, recapitalisation was driven by financial distress, a need for debt service, or LTV covenants, or loan maturity with a lender not prepared to extend. In 2010, however, even if a lender is willing to extend, tenants are going to well-capitalised owners. The tension is on the operating side, with the leasing and management teams.”

Casal makes an interesting observation by comparing the US and UK markets. Both were seized with paralysis, but the situation has changed only in the UK. “It is hyperactive now,” he says. “The pension plans have decided that the bottom has been reached. And tenants are on the move, trying to trade up, taking advantage of cheaper prices and trying to get longer leases.”

In the US, the institutional investors are still quiet, held back by a fear of stepping in too early, and tenants remain cautious. “On the tenant side, they are trying to do some of the same things as in the UK, but they are still uncomfortable about their own plans. The recovery still feels somewhat tenuous,” Casal says.

Aviva Investors is also active on the secondaries side, but Casal points out that it is very challenging. One key task is to do a rigorous corporate finance analysis on the liability side to see if the deal will need recapitalisation in the future. “We do not want the LP position to be diluted or to face a demand for liquidity to do the recapitalisation.”

Aviva bids on around 5% of secondaries shown to the firm, partly because they have a success rate of only 10 to 20% in the US. “We cannot expend resources to look at a broad portfolio with very little chance of success,” Casal says.

Metropolitan Equity Real Estate Management is also active on the debt side, says McKnight. “We are value buyers. We are buying debt: some can be restructured; some is loan to own. Sometimes we provide recovery capital, when the owner needs to put capital in a building to get a loan restructured.” McKnight is positive about this line of business right now. “It offers debt-like risk, but equity-like returns,” she says.

REITs are also a force to be reckoned with again in the US market. It is a truism that REITs ‘predict’ the real estate market as a whole. Based on REIT asset values, the Green Street Advisors Commercial Property Price Index shows that, by the end of January 2010, commercial property values rose a little more than 10% since their bottom in May 2009; pricing is still off about one-third from the peak in 2007.

“REITs have become strong again,” says Casal. “It was a painful and highly dilutive process, but now they are well capitalised and can do acquisitions, lease space, without worry that debt is coming due.” They raised cash by issuing some $24bn in new stock during 2009, but only bought $4.6bn of property that year, according to figures from Real Capital Analytics. Many REITs are now sitting on fat wallets, which will allow them to make deals of a size that non-listed investment vehicles might find too pricey.