Wednesday, February 9, 2011

US facing a Jekyll and Hyde market

THE US real estate market remains a huge albatross on the recovering economy's back largely due to underwater homeowners suffering with high mortgages on properties worth as little as half their value of only three years ago, dampening consumer spending, the main growth engine for the US economy.

But at the same time, almost amazingly, for investors in US commercial property here, the real estate market is back.

This emerging best-of-times, worst-of-times bifurcation between the residential and commercial real estate markets was illustrated last week when the US Commerce Department reported that new sales of single-family houses in December were running nearly 8 per cent behind December 2009's sales, pointing to the dire straits in which the US housing market still finds itself more than two years into the bursting of the real estate bubble.

On the same day, bond trading firm Cantor Fitzgerald declared to a crowded room at the Commercial Real Estate Finance Council conference in Washington its entrance into the commercial real estate investment banking market, saying that it intends to issue nearly US$1 billion in new mortgage-backed securities next month.

'Commercial real estate (CRE) is recovering and investor demand for CRE debt is growing by the month. We intend to become a big part of the comeback of the real estate debt market,' said Anthony Orso, head of Cantor Fitzgerald, speaking from his Midtown Manhattan headquarters.

Indeed, while in the residential space, foreclosures are growing faster than sales, and homeowners and condo developers continue to bemoan the sorry state of affairs that has many economists predicting a double-dip recession for the residential market in 2011, the skies are brightening by the day for investors in multi-family, office, and industrial buildings, and even hotels, according to real estate analysts.

The commercial real estate industry is still buzzing over a wave of big property loans announced at the end of last year, highlighted by the Bank of China's US$800 million refinancing of a New York city office tower owned by Brookfield Office Properties, the largest loan for a single building in the United States since the bottom fell out on the real estate market and the economy in 2007.

'Commercial real estate investment momentum has been building through the year, culminating in December in the strongest monthly sales activity since 2007,' observed Sam Chandan of Real Capital Analytics.

'Apart from firming pricing, investors have been supported in recent months by a sharp improvement in credit availability and indications of more stable property fundamentals,' he said, noting that 2010 saw US$115 billion in commercial real estate transaction volume, up from US$54.6 billion in 2009.

Challenges ahead

'There are still real challenges ahead of us, such as the management of legacy distress and risks from rising interest rates, but the tailwinds are clearly pushing investment forward on the path to normalisation,' he said.

It wasn't so long ago that Wall Street analysts such as Mr Chandan were calling the commercial real estate market the next big shoe to drop on the financial crisis.

With US banks holding more than US$1.5 trillion in potentially distressed debt on commercial property developed during the bubble years of 2005 to 2007 with outlandish valuations and income projections coming due by 2012, many analysts worried that loads of non-performing loans would break the backs of the already fragile banking industry, and would be enough to push the US economy from severe recession into an outright depression.

'Those were very scary times and justifiably so. It was hard to imagine how real estate could recover when we were caught in this downward spiral of plunging valuations, foreclosures, and economic contraction,' said Bob Leinfeldt, a real estate investment trust (Reit) analyst at Avenue Advisors.

'Just as with the depression in the residential real estate market, there didn't seem to be any way to dig ourselves out,' he said.

Indeed, that kind of pessimism was echoed and even exaggerated by investors, who sold off their holdings of Reits, the publicly held real estate investment companies that trade as stocks, at a more panicked level than the bearishness seizing the overall equity market in 2008 and 2009, matched only by the race to unload financial giants such as AIG, Citigroup, and Bank of America and even Goldman Sachs.

By March of 2009, the S&P Reit index had crashed by nearly 80 per cent from its peak, with even the strongest Reits, such as Boston Properties, Vornado Realty Trust, and SL Green Realty Trust, off 95 per cent and in danger of being deserted by investors to the point of outright failure, a la Bear Stearns and Lehman Brothers.

'There were even calls for a bailout plan for the real estate companies like what we had for the banks, recalled Art Hogan, chief market strategist at Jeffries. 'It was that bad.'

But the government's bailout of the banks allowed many of them to put off dealing with most of their failing commercial loans while the market was at its worst, a process that came to be known as 'extend and pretend' in the real estate industry, giving both lenders and borrowers some much-needed breathing time to let the government's stimulus spending and near-zero short-term interest rates re-inflate assets and get the economy growing again.


In the meantime, the Reits were able to recapitalise in the equity and debt markets as the financial panic faded in the summer of 2009, using the billions they raised to not only refinance highly leveraged loans but to build up robust war chests to scoop up big properties on the block at fire sale prices by debt-laden private developers such as Harry Macklowe, who famously bought up over US$7 billion of commercial properties in the boom of 2007 and early 2008, with less than US$50 million of his own equity, under one per cent of the purchase price.

Today, so many of the Reits are doing so well, after the Reit index turned in gains of 27.45 per cent in 2009 followed by 2010's 22 per cent advance, investors are looking askance at putting more money in the Reits because of their outperformance.

'Fundamentals continue to recover in commercial real estate and property prices should continue to grow as the economy strengthens, but valuations for the Reits themselves have gotten so toppy, equity investors should expect the real estate sector to trail the overall stock market's performance this year,' said Nino Jiminez, senior vice-president at Brinson Patrick.

If investors' appetite for real estate via the stock market is levelling off, it is only beginning to grow in the debt market, where demand for commercial real estate paper is being fuelled by a combination of rising confidence in the economy and yield-hungry investors tired of the anaemic returns of safe haven bonds such as US Treasuries, with the 10-year note only recently reaching a 3.5 per cent yield.

The once-moribund commercial mortgage-backed securities market, which peaked in 2007 with US$230 billion in mortgage-backed securities issued, a number that sank to less than US$3 billion in 2009, is expected to see banks originating up to US$50 billion this year, according to JPMorganChase analysts.

'As the securitisation markets open up a bit this year, you're going to see money flowing to not just the prime markets, in New York, Washington DC, and San Francisco, but to secondary locations as well, and that activity will lead to more transactions, and ultimately new development,' said Josh Zegen, managing principal at Madison Realty Capital, a commercial real estate specialist headquartered here, which made US$750 million in real estate investments in both equity and debt transactions.

Mr Zegen recently closed a US$300 million distressed property fund to new investors, and said that he's getting so much demand he intends to launch new funds in the coming quarters.

'There are still plenty of potential headwinds, but banks are finally willing to sell their distressed loans now because they can afford to take the hit to their portfolios, and that means a lot of opportunity in real estate for risk-based investors,' he said.

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