Transaction volume is down sharply but investor interest remains, with both a flight to quality and activity in distressed deals. Meanwhile the threat of recession looms large, Stephanie Schwartz-Driver finds

 As the sub-prime crisis continues to roil financial markets, investors in US real estate can catch their breath as the overcharged atmosphere of 2007 gives way to greater calm and restraint in 2008.

Although the fallout from the sub-prime collapse has lost some of its ability to shock, the situation is far from resolved. According to a November report by AEW, there is nearly $2.5trn (€1.75trn) in high-risk sub-prime, Alt-A, and jumbo interest-only or negative amortisation mortgage loans outstanding - and these loans account for around one-quarter of all mortgage debt outstanding. 

In a worrying trend, mortgage defaults are also creeping up the wealth scale, as middle-class and upper-middle-class homeowners are being hit hard as their fixed rates expire and the variable rate takes over. Prime adjustable rate mortgages accounted for more than 18% of mortgages starting foreclosure in the third quarter of 2007, according to the Mortgage Bankers Association; in the same period, foreclosures began on 17.6% of prime mixed-rate mortgages. Although the Fed lowered interest rates in December, it was not a reduction that will bring much comfort to homeowners at risk of default. 

Washington's sub-prime rescue plan, also announced in December, may provide a measure of assistance to around 1m mortgage holders, although it will not extend to sub-prime borrowers who are already in foreclosure or to holders of prime-adjustable rate mortgages.

The biggest wild card for investors in US real estate going forward is the state of the economy. Although the word ‘recession' is on everyone's lips these days, and it is generally agreed that the risk of recession is higher than it has been in four or five years, most economists believe that the country will be able to avoid full-blown recession. However, a continuing slowdown appears inevitable. Currently, although job creation has slowed, people are still employed. The uncertainty for 2008 and even into 2009 is whether unemployment will shoot up - if that is the case, recession could become a reality. 

It is possible that, rather than a nationwide recession, the US will experience smaller-scale, regional recessions. Some markets have already been challenged, and others, such as southeast Florida, Las Vegas, Phoenix, and southern California, which had been experiencing historically very high growth rates, are feeling harder hit by the slowdown than other, less charged markets.

Increased economic uncertainty has combined with a dramatic decrease in the availability of credit for commercial property investing to change the dynamics of the real estate market. Overall, for the second half of 2007, there has been a marked slowdown in transaction volume across all sectors, although foreign buying has slowed less. 

The credit crunch is partly responsible. According to Commercial Mortgage Alert, $6.2bn of commercial mortgage-backed securities (CMBS) were issued in October, against more than $34bn in August. "Nobody's buying CMBS right now, so those lenders don't have the capital to lend," says Michael Acton, managing director and director of research at AEW. "This will clear at some point. The market will work off the backlog probably by the end of the first quarter of 2008 - at some point, someone will buy CMBS, even those packaged before the new underwriting standards." 

Jay Long, principal at the Townsend Group, agreed. "The debt markets have seized up. CMBS, which are a bigger part of financing in the US than anywhere else, have pretty much shut down - and this is not a surprise to anybody." 

Credit difficulties present opportunities for some pension funds, according to Jim Clayton, director of research at the Pension Real Estate Association PREA. "A few larger, well-capitalised funds are trying to take advantage of the credit crunch. They are being asked to rebid as deals fall apart. Others are putting money into distressed debt."

And, says Susan Stupin, co-founder and managing director of New York-based asset and investment management firm Prescott Group, "for well-conceived programmes and strong sponsors, there is still debt available". She has already seen indications of balance sheet lenders stepping in to fill the void.

For some real estate investment, this combination of factors has created a lot of volatility, particularly for REITs and private equity, according to Tim Pire, managing director, public real estate securities, at Heitman. "A year ago, risk didn't mean anything. Spreads were very tight, particularly spreads between different markets - there was not a lot of difference between an apartment building in Los Angeles and one in a market like Dallas."

But starting around March 2007, there was a major change in market sentiment. "Suddenly people started to think about risk. Cap rates and spreads started to widen." 
For REITs, this ushered in a period of instability, explains Pire. They were at the top of the market when Equity Office Properties (EOP) closed. But moving from February to August, they were trading at 20% discount to NAV. Following a brief recovery, REITs were hammered again in November and were again trading at the 20% discount.

"This is telling me two things," says Pire. "One is that it's cheaper to buy real estate on Wall Street. The other is that there's going to have to be a repricing on the private markets. Both things happened."

Although volatility is set to continue for the next six months or so, US REITs are finding themselves on a surer footing. "The REIT market has gone through a brutal correction. Will it get worse? Unlikely. Is there continued risk in NAVs? Possibly. But the fundamentals are sound, it's a pretty healthy market," says Pire.

Thinking about risk is good for market stability, agrees Acton. "I feel better about the dynamics of the market today." In his view, the peak of over-exuberance was the EOP mega-deal in February 2007, a deal that typified the feverish market conditions at the time. "Investors had to agree to short due diligence, had to waive contingencies. The pressure to go in hard with the deposit has now changed."

Acton notes that on core properties, when just recently there would have been six or eight or even 10 bidders going in hard, now there are just three or four, "but they are strong and solid investors. The swagger has definitely diminished - it's been replaced by heightened concern about the economy and the credit markets," he says.

This new caution has led overall to "a flight back to quality," says Clayton. "A lot of our members seem happy that we have come back to normal activity levels. We've seen the exit of those who make money through short-term buying and selling rather than through income. It's a nicer environment for transactions."

Again, in his view, the recent turmoil will ultimately give way to greater stability. "Every time we hit a bump in the road, we learn something. The real estate market does not seem like it will hit a boom-and-bust cycle again."

One major effect of the turmoil in the capital markets and credit markets is that pricing has altered. Long reckons that on the highest quality properties, pricing has definitely moved, about 10bps on cap rates. On the secondary markets, it is more like 50 to 100bps - and this holds true across all property types. "To an extent, this has been a reaction to the frothy levels: EOP was the pinnacle of extreme pricing," he says. "There is a distinct opportunity in the current market in terms of better pricing. Investors should be able to get higher cap rates and better discount rates."

As pricing corrects, European investors are also benefiting from the relative strength of the euro and other currencies against the dollar, making quality properties even more attractive. "The weak dollar is helping US markets - there is no shortage of foreign buyers," says PREA's Clayton.

Acton seconds this. "There is definitely still foreign interest, although the headlines over the past six months may have coloured it a bit. European investors are worried about what they read, but they do see that their currency goes so much further."

At the same time, US investors are increasingly looking globally. "In broad terms, the biggest change in the past year is the increased focus on what investors can do globally," says AEW's Acton. "But it is important to note that this is an adding of a global perspective, not a retreat from the US, especially in REITs."

Stupin has a caveat for those committed to increasing internationalisation of portfolios. "There has been so much focus on emerging markets and global investment. In many ways, the US market has been overlooked, and there are some very attractive opportunities across an array of product types."

Acton noted that investors are looking for different sorts of deals today than they were at the beginning of 2007. "Right now anything that has blemishes, that is location-challenged, or has significant vacancies is not coming to market," he says, noting that in early 2007 vacant space was worth more than full, as investors reckoned they could easily raise rents. "Today, just the opposite is true," Acton says.

"With some volatility," says Pire, "investors might be a little more defensive, looking at health care, retail, or office with longer leases." He recommended going underweight on apartments and on lodging, which is the sector most sensitive to the economy. (Anecdotally, he has already noted some belt-tightening on corporate travel.)

In Pire's opinion, REITs are a strong option at the moment. "If you can buy real estate on Wall Street at 80 cents on the dollar, why not make that trade?" Paraphrasing Warren Buffett, he points out that, "if you only open the Wall Street Journal once a year at the end of the year, you won't see any volatility in your portfolio". 

It is generally agreed that office and industrial are in a strong position at the moment, as underlying growth generators remain relatively robust despite the economic slowdown, and supply, in terms of new construction, is under control. As long as commodity prices remain high, the cost of new construction will limit new starts. It may well be the case that the effects of the slowdown in job growth could be mitigated by underlying supply and demand.

Yet even office is not immune to concerns. "New York City is expecting pretty significant lay-offs from Wall Street - as much as 10% of the investment bank staffing," says Long. "But it is expected to hold up better than in the past, moderated because it is a large market and it is thought that the banks currently have less excess space and had more difficulty expanding last time - so they will give back less space." Office markets that are consistently favoured are tech-markets, such as Seattle and San Jose.

Long believes that the retail sector is less favoured, because of expected consumer weakness. But others see opportunities. Stupin notes that the Prescott Group is investing in outlet centres, which have the potential to be counter-cyclical. "This sector has tended to be fairly robust in times of economic downturn," she says. Stupin also sees opportunities in specialised property types, such as medical office, student housing, and urban infill and mixed-use developments. Even multi-family can be counter-cyclical.

"As capital markets change and we see rising cap rates and more conservative lending terms, it is becoming more of a buyer's market. It's a good time to take advantage of the pricing shift, but investors need to look very carefully at growth generators," says Stupin. "These are times of potentially very great opportunity - those with significant equity are well positioned to step in, although the debt side of the equation is more challenging."

She points out that investors can find opportunities even in markets that might be hit by the economic slowdowns by looking for characteristics such as a location near a hospital or a military base.

Other investors are actively benefiting from troubles in the market. Long points out that, "higher-return opportunities exist in liquidity financials - that is, broken bridges, or mezzanine". A lot of the loans backing highly leveraged deals made during the heady period at the beginning of 2007 are coming due, and borrowers will be challenged to refinance on favourable terms. This may bring some trophy properties to the market at a time when most sellers are reluctant.

"Even the residential sector presents opportunities, such as broken condos or residential land opportunities as the home builders need to shed land off their balance sheet," says Long.

One such high-profile deal was Morgan Stanley Real Estate's $525m acquisition of around 11,000 home sites from the developer Lennar Corporation. Lennar has retained a 20% ownership stake in the venture and will have the option to buy back some home sites. "This kind of deal is not for the faint of heart," says Long. "The light at the end of the tunnel might be a train."

Whether real estate investors will go for distressed deals, or whether they will hold out for high-quality properties and a loosening of credit, depends on their goals.
"If you are looking for an income stream with inflation protection, you look at high quality. Other investors are more opportunistic," says Acton. "There is a broad spectrum of real estate investors and types of deal to look at, especially in a country the size of the US."