The latest Emerging Trends survey reveals varying investment prospects across the Americas, as Charles DiRocco, Mitch Rochelle and John Forbes report
Investment opportunities are expected to open up across the region according to the Americas edition of the ‘Emerging Trends in Real Estate 2011' report, published recently by PwC US and the Urban Land Institute (ULI).
Now in its 32nd year, the reports includes interviews and survey responses from more than 1,000 leading real estate experts, including investors, developers, property company representatives, lenders, brokers and consultants. The report identifies very different opportunities in the US, Canada and Latin America.
After three years of dislocation and unprecedented loss, commercial real estate industry investors and professionals hint at hopeful signs of tempered improvement in commercial real estate in the US, according to survey respondents. They suggest a lowering of performance expectations, anticipating high single digit returns for core properties and mid-teen returns for higher-risk investments. Without ample leverage and attendant risk, real estate assets cannot sustain higher performance, according to survey respondents. The survey finds that lenders with strengthening balance sheets finally step up foreclosure activity and dispositions of properties during 2011 and 2012, helping values reset 30-40% below 2007 peaks.
The market is predicting extreme bifurcation as the capital flight to quality creates a greater separation between the trophy and less desirable assets. Well-located and well-tenanted properties that can generate strong cash flow over the next several years are exactly what buyers and lenders want, according to survey respondents. As a result, prime apartments and office buildings in gateway cities are generating the most attention from the increasing pent-up sidelined capital.
Debt market loosens further in 2011
The report indicates debt markets thawing further in 2011 as banks continue to strengthen balance sheets, take their losses and step up lending, resulting in higher transaction volumes. Borrowers are expected to have improved chances to obtain refinancing if they own relatively well-leased cash-flowing properties. But overleveraged owners dealing with high vacancies and rolling down rents may face more uncertain prospects in the credit markets, including the increasing likelihood of foreclosure.
Markets to watch
Survey participants believe the 24-hour cities will always dominate and outshine secondary markets. This year, the top Emerging Trends markets selected by survey respondents offer no surprises - Washington DC pulls away from the pack, followed by San Francisco, Boston and Seattle, as the pre-eminent gateway cities. Houston and Denver solidify rankings and respondents show faith in South California's resiliency, despite recent setbacks. While ratings improved for markets from coast to coast over 2010's results, the gap between top and bottom continues to widen, and more than 60% of surveyed cities still fall below "fair" ratings for commercial and multifamily investment prospects.
Interviewees believe that global dollars looking for income returns will continue to gravitate to US real estate in 2011. "We're still viewed as the most stable market." Overseas investors tend to be long-term holders, who like the US for parking money as a safe haven. It is pretty much the same old story: they concentrate on the familiar brand-name coastal cities with direct airline stops from foreign capitals and business centres.
Offshore buyers have been in the thick of bidding on office buildings in New York City, Washington, DC, San Francisco, and southern California. "They like to invest in the cities they see back home on TV shows and at the movies." Besides downtown office property, they like retail and hotels (needing a place to stay on visits), and some consider industrial properties at primary seaports. Highlights of interviewee comments about foreign capital flows include:
• Expect Canadians to step up activity. Their tight markets limit new investment opportunities; the action for them will be south of the border;
• German institutional investors jumped early into top-tier markets, but they become frustrated because more bidders drive up prices, and some retreat despite pressure to place more money. Secondary and tertiary markets are off-limits: "We're not going there.";
• Germans and other Europeans typically steer clear of apartments. "They're not familiar or comfortable with four-storey sticks-and-bricks projects." They question construction quality and do not like the short lease durations;
• The unsteady US economy and the value of the dollar raise more concerns than usual about currency exchange risk for euro-zone investors;
• Australian and Irish investors have disappeared temporarily. They overleveraged, bought at the top of the market, and now lick their wounds;
• "You see more Spanish, French, and Italian high-net-worth money competing for deals, as well as Russian entrepreneurs.";
• Middle East investors remain plentiful, but stay under the radar using US straw men to do business. "They like anonymity; it's difficult to tell how much they are doing.";
• Far East investors and sovereign wealth funds also look for opportunities. The mainland Chinese start to become more of a force.
Regulation and taxes
The US already has a reputation as a difficult place for foreign investors to do business because of the complex tax rules and filing requirements. Uncertainty over new financial industry regulation and future federal tax policy adds complexity and confusion to investment decision making, and many interviewees complain that businesses "can't move aggressively on expansions and growth strategies," which might help fill buildings.
"There are too many unknowns to make any decisions." Federal agencies scramble to write new banking rules - "the devil is in the details" - while lobbyists angle to gain favourable language (read: protect industry profits).
Among the biggest outstanding issues will be how reserve requirements are meted out. Must CMBS loan originators retain a certain percentage of junior B tranches to ensure underwriting vigilance, or will CMBS 2.0 operate like CMBS 1.0 off moral hazard? Investment banks, meanwhile, position themselves to shed asset-management funds if reserve requirements seem too burdensome on co-invested house money.
Tax policy presents another investor conundrum, especially capital gains treatments. Investors want to keep long-term rates at current low levels, but the government desperately needs enhanced funding sources.
Everyone grapples to secure new advantages or keep existing ones. "We need a tax policy to encourage long-term investing," says an exasperated developer/owner. "We should think about increasing shorter-term capital gains taxes and lowering long-term gains below current levels for extended holding periods. Right now there are no advantages to long-term investing, and assets like real estate are marginalized as a result. We trade and flip rather than build value over time."
Canada barely experienced recession and jolted into a V-shaped recovery. Now, 2011 promises slowing, steady growth and decent prospects for real estate investors as long as the US economy does not drag them down. "Relieved" Canadian property owners and financial institutions cannot help contrasting their reasonably healthy condition with parlous US markets.
Fundamentals trend near equilibrium, "employment bounces back," and banks boast sound balance sheets. Most industries experience growth, including finance and energy, which helps support the service sector. "The domestic consumer has been pushing the economy, and jobs levels bounced back to pre-recession levels. It's been phenomenal compared with the US."
Recent experience puts "Canada in a better place" and boosts confidence "that we can escape US problems." Always linked to its more populous southern neighbour, the nation "tries to diversify" beyond a dependence on US exports, extending trading relationships to Europe and Asia, particularly China. Still, a weak US dollar and sputtering US economy dampen cross-border commerce, hurting especially Ontario industrial markets, which serve Midwest manufacturing centres.
The big difference for Canada has been the sound condition of its banks, "you can get a loan for anything", since lenders maintained relatively strict underwriting standards and were never sucked into the CMBS maelstrom.
"We have no distress - no distressed banks, no distressed owners, no distressed sales." Now, rising interest rates coupled with tight bank requirements tamp down a recent home-buying spurt, particularly in Ontario and British Columbia, where purchasers stepped up activity before a new sales tax went into effect.
As one respondent summed it up, "In Canada, real estate behaves as advertised, producing steady cash-flow-oriented returns without much volatility, but an ownership hold mentality frustrates investors looking for opportunities to buy."
Where the US has gone boom-bust and Canada offers only modest growth, Latin America's story centres on the enormous potential of two emerging markets - Brazil and Mexico. Together they account for two-thirds of the region's population "and most of its growth dynamics."
But amid the swirl of young populations, an energized middle class, and the immense promise of expanding industries, investors deal with inevitable corruption and lack of transparency, the need to sort out the reliability of local partners, and - in the case of Mexico - the scourge of drug violence. Enticements and obstacles leave most North Americans intrigued by the possibilities, but not straying off home turf.
In the US, particularly, contending with difficult domestic issues distracts from considering emerging market investments. But for those who do, the action is all about two countries: "They take the oxygen away from all other Latin American markets."
Brazil: opportunities and limits
Emerging Trends interviewees express few doubts: "The boom period has legs, the cat is out of the bag, people want to be where the action is, and that's Brazil." The country is self-sufficient in agriculture and energy, and expands its high-tech manufacturing. More offshore institutions "get their feet wet", but find limited opportunities in existing real estate because only a handful of buildings meet investment grade. Then they confront hurdles from Brazil's transaction culture of "group ownership", which makes deal making difficult. "It's hard to get all parties to sell."
Development may be where the real action lies. "There's a ton of demand for a ton of new space. You can build housing forever, and people will want it." Plus, shopping centres are few and far between, and distribution warehouse facilities are in short supply to serve growing consumer appetites. "The middle class is huge, and dramatically increasing; populations concentrate in urban areas, creating intense demand for high-rise residential and retail." Again, local companies with big development platforms and insider connections have "a tremendous advantage and try to maintain a stranglehold; outsiders can't compete" and must make alliances. "Brave investors" enter secondary markets to develop malls, and strip centres will follow next.
Mexico: potential and concerns
Mexico offers obvious positives—a hard-working population, an expanding middle class, and the resulting increased demand for homes and consumer goods. But everybody reads about mind-blowing drug wars, police corruption, and political assassinations. In addition, real estate markets hit the skids when the US economy tanked. Prices declined 30-35% and now recover - more than "halfway back" - but it's been "tough sledding."
Finally, banks relax lending curbs after "a huge liquidity crunch" brought on by the worldwide credit crisis. Mexican investors did not over-borrow: patient equity players "take a patrimonial view" and count on long-term returns, relying on healthy demographics and controlled development. In fact, most cities and property sectors have avoided overbuilding.
Boosters suggest that "markets now align" for significant growth from pent-up demand, and highlight opportunities to fill the remaining capital gap. "There's a large hole to fill," especially for construction loans. New laws allow domestic pension funds to invest in real estate and infrastructure, which could increase property market liquidity and demand for product. "We're seeing the chequebook at the end of the tunnel."
But many jobs depend on the US economy - manufacturing of time-sensitive products or heavy machinery that cannot be shipped by boat from Asia, hotel- and tourism-related businesses, and call centres. Locals necessarily raise concerns about when and whether the US will emerge from the doldrums.
Industrial real estate "should improve during 2011" after a no-demand, no-development period. The US downturn cuts two ways: overall declines in manufacturing and distribution activity, especially from "hardest-hit" northern border states, have been offset somewhat by more US manufacturer relocations due to the weakened peso. Interior warehouse markets, serving Mexico City, suffered less. Retail "makes a good long-term play," betting on the growing middle class. Office markets show decent recovery and low vacancies in Mexico.
Charles DiRocco is director of real estate research for PwC in the US. Mitch Roschelle is a partner at PwC in New York and is the firm's US real estate advisory practice leader. John Forbes is a partner at PwC in London and advises real estate funds investing internationally