Midway through 2011, a small but growing force of commercial real estate investors is forsaking the safety of well-located, fully leased properties in New York, Washington, D.C. and other gateway cities.

Fed up with intense competition for assets and high prices driven by bidding wars, these opportunity hunters are buying up semi-vacant office buildings, retail centers and apartments in primary markets, as well as assets in smaller cities that are only beginning to recover from recession.

“It's a world of two classes,” says Greg Merage, CEO of Newport Beach, Calif.-based MIG Real Estate, formerly Stoneridge Capital Partners. “You've got huge amounts of capital seeking the core plays in the primary markets, and then much less capital and players seeking out those distressed assets in the tertiary markets.”

In the past two years, MIG has invested $250 million to acquire 1.75 million sq. ft. of commercial space, chiefly in the Western states and Canada. Even as an all-cash buyer, Merage says his company is hard-pressed to compete for top-quality assets against institutional investors, such as the real estate investment trusts (REITs) that dominate acquisitions of core multifamily properties.

MIG finds better pricing and fewer competitors by seeking “outliers,” often older properties that need renovation or leasing to realize their full potential. Recent examples include Vista Commons, a 100,000 sq. ft., grocery-anchored shopping center it purchased in recession-blasted Las Vegas this spring.

Other recent acquisitions are the 177-room Courtyard by Marriott Edmonton Downtown in Alberta, Canada, as well as the I-225 Plaza, a 190,000 sq. ft. mixed-use project in Denver.

“A lot of those properties that we're looking at, both in hotels and office, require a lot of capital expenditure because they have really been neglected since the recession started,” says Merage. “There is less capital chasing those assets because of the heavy lifting required and the extra capital required.”

Appetite for risk

Three factors are driving investors up the risk curve, according to Robert Bach, chief economist at Grubb & Ellis. For one, competition has driven up prices to prohibitive levels on fully leased, well-located assets in primary markets. “Some investors are simply getting yield fatigue and moving on,” says Bach.

From a trough in December 2009 to March of this year, prices of non-distressed, trophy properties in primary markets had risen 26.7%, according to Moody's Investors Service. That's based on an index of properties valued at $10 million or more in the largest U.S. markets.

That's a steep gain, considering that real estate prices haven't even begun to climb for the U.S. market as a whole. Moody's comprehensive price index of U.S. commercial properties reached a post-recession low in March, down 47% from a peak in October 2007.

The second and third drivers behind riskier investing, according to Bach, are the increasing availability of capital and improving economic prospects in many secondary and tertiary markets. “Those three factors have changed from a year ago, and are encouraging investors to look at secondary markets and riskier assets.”

Financing is certainly cheap, thanks to benchmark interest rates near historic lows. The 10-year Treasury rate stood at 3% on June 9, down from an already low 3.36% at the first of the year.

As evidence that capital is growing more available, Bach points to the Federal Reserve's Senior Loan Officer Opinion Survey. In the first quarter of 2011, respondents indicated that they hadn't tightened lending standards since the previous quarter.

“For commercial real estate, this was the first quarter in about five years where banks have not tightened standards, meaning they are starting to loosen them,” says Bach. “The trend has been for banks to be willing to make more loans.”

That third driver of riskier investing — an improving outlook for local economies — means that pockets of demand for commercial space are opening up in recovering markets.

“The economic recovery is now almost two years old. Although it has been substandard, labor markets are growing again and business is being done,” Bach reasons. “There is some pent-up demand there where tenants have been postponing space decisions.”

Yet there are some risks that threaten all U.S. markets. Inflation can sap profitability from assets with long-term leases, for example, and rising interest rates can push borrowers with floating-rate loans into default.

Much of investors' risk stems from the direction of the U.S. economy and job creation, which is a prerequisite to space absorption. In the summer of 2011, betting on that outlook appears risky indeed.

Midyear slowdown

The U.S. economy has slowed its pace of growth, hampered by supply chain disruptions stemming from the earthquake and tsunami in Japan, weak hiring, and rising food and energy prices.

Gross domestic product (GDP) grew at a lethargic annualized rate of 1.8% in the first quarter, down from 3.1% in the fourth quarter and 3.7% a year ago.

Economic growth affects real estate directly with employment growth, which is necessary to fuel absorption. Unfortunately, that growth also has slowed. Employers added a net 54,000 jobs in May, not enough to shift the unemployment rate from 9.1% and far short of April's 232,000 net new hires.

The U.S. needs to create about 1.5 million jobs a year, or 125,000 jobs a month to keep unemployment from going up, says Richard Green, director of the Lusk Center for Real Estate at the University of Southern California in Los Angeles.

But to generate renewed demand for commercial real estate, there is lost ground to be recovered. “We're in a seven million-job hole at the moment, if you compare it to where we were before the crisis,” says Green.

Even if monthly job growth again tops 200,000 as it did in March and April, it will take three years just to bring jobs — and commercial real estate occupancy — back to 2007 levels, predicts Green. “We're not going to need new office, industrial or retail buildings for quite some time except in very specific places for very specific reasons.”

At least slow economic growth and weak job creation reduce the risk of inflation, a risk that has some investors worrying about the future. Expectations of inflation lead to higher interest rates, and that in turn raises the cost of capital for borrowers.

Many industry observers had predicted interest rates would rise this summer with the end in June of the Federal Reserve's quantitative easing program, in which the central bank bought up massive amounts of U.S. Treasury bonds in order to reduce supply and keep prices up and bond yields low.

“The Fed has been buying 70% of newly issued Treasuries,” says Shlomi Ronen, managing director and the co-founder of Lucent Capital, a Los Angeles-based intermediary. Once the Fed ceases to buy Treasury bonds at that volume, says Ronen, “that will undoubtedly cause an increase in long-term rates.”

The 10-year Treasury rate has defied that logic, however, and at just over 3% in late June was at one of its lowest points this year.

Holding pattern

Economists say the surprising stability in U.S. Treasury rates reflects increased buying of the securities by investors from around the globe. Despite some concerns that the mushrooming national debt threatens credit quality, investors are following the longstanding practice of parking funds in U.S. government securities during times of economic uncertainty.

This time around, that uncertainty comes from natural disasters in Japan, political unrest in some oil-producing regions, and efforts by the central governments of China, Brazil and other countries to slow economic growth and control price bubbles in their markets. So for now, at least, interest rates in the United States remain low.

The Fed will begin raising interest rates to stave off inflation when it sees wages rising as a result of high prices, says Victor Calanog, chief economist at Reis. That isn't likely to become necessary until next year.

U.S. consumers are struggling with high gas and food prices. That is mostly due to limited supply and growing demand for those products in China, India, Brazil and other developing countries, economists say. With many of those nations slowing their economies to control inflation, demand and prices should ease.

“We don't expect interest rates to be increased any time this year, but people are building in expectations that interest rates will be increased next year, if policy makers are sure economic growth is on a solid footing,” says Calanog. “They don't want to choke off growth prematurely.”

Lenders reach out

Low interest rates mean leverage is affordable, but it is still challenging to find lenders who will finance deals in secondary and tertiary markets. “Capital is being very selective,” says Ronen of Lucent Capital. “We're reaching out to 50 or 60 different capital sources to find two or three that are willing to finance a deal.”

Lenders may offer higher loan-to-value financing on high-quality assets with partial vacancy, or in a market where property values have bottomed and are poised to appreciate as the economy recovers, says Ronen.

That's because the lender understands that the asset's value and cash flow will likely increase over time, which decreases the relative size of the debt on the appreciating property.

By contrast, prices on core assets in primary markets reflect a maximized income stream, leaving little room for value appreciation after an acquisition.

Lucent Capital recently arranged a mortgage and mezzanine loan that amounted to 90% financing for a client. The borrower used the loans to purchase a vacant Los Angeles shopping center from a bank that had acquired the property through foreclosure.

The lender agreed to the deal in part because the purchase price was $90 per sq. ft. for a property that cost $300 per sq. ft. to build, and will be worth far more than the purchase price once it is leased. “It's like you're hitting the reset button on these assets,” says Ronen. “What's this asset worth based on today's lease rates and today's cap rates for that asset?”

Lenders are more likely to be interested in financing deals in a secondary market if they know that specific market is in recovery mode, says Ryan Krauch, principal at Mesa West Capital, a portfolio lender based in Los Angeles. “We can get very comfortable in markets we believe have come to a low point in their cycle.”

Mesa West has placed approximately $750 million in commercial real estate loans since the third quarter of 2010. In particular, the lender seeks to finance Class-A properties that stand to benefit from local tenants upgrading to higher-quality space.

That was the case earlier this year in Phoenix, where Mesa West provided a $40 million mortgage loan to finance two prominent office buildings known as Anchor Center. “You'll definitely see money flow first to the highest-quality, best-located properties in those secondary markets,” says Krauch.

Long-term commitments

Investors who buy distressed properties or acquire assets in markets where property values are only beginning to stabilize may have to wait several years before those properties generate income, much less a profit.

Merage of MIG Real Estate says that's a risk he is willing to take because he believes that the economic recovery will eventually usher in steady rental income and healthy property values.

“We're a patient investor, so it comes down to the long-term viability of the marketplace that we're pursuing,” he says. “In a lot of these markets, it's going to be a long time before we see a significant recovery.”

Matt Hudgins is an Austin-based writer.

ECONOMIC PREDICTIONS FOR YEAR-END 2011

NREI asked four forecasters to predict the near-term direction of leading indicators. Here are their responses:

Robert BachChief Economist, Grubb & Ellis

Prediction:“The slowdown that we're seeing now is a head fake; growth will be stronger by the fourth quarter.”

Victor Calanog Chief Economist, Reis

Prediction: “Multifamily is the belle of the ball, benefiting from further adversity in the single-family housing market.”

Hessam Nadji Managing Director of Research Services, Marcus & Millichap

Prediction:“We can expect to see a gradual drop in vacancy across all property types.”

Ken Simonson Chief Economist, The Associated General Contractors of America

Prediction: “There will be a major new source of oil by the end of 2011, either a new discovery or the beginnings of expanded production from a Middle Eastern or North African country.”

Bach:

Annualized GDP growth: 3.0%

Core CPI inflation rate: 1.5%

Monthly job gains/losses: +190,000

10-year Treasury yield: 3.25%

Crude oil (price per barrel): $85

Calanog:

Annualized GDP growth: 2.9%

Core CPI inflation rate: 2.0%

Monthly job gains/losses: +180,000

10-year Treasury yield: 3.2%

Crude oil (price per barrel): $100

Nadji:

Annualized GDP growth: 4.2%

Core CPI inflation rate: 1.6%

Monthly job gains/losses: +250,000

10-year Treasury yield: 3.6%

Crude oil (price per barrel): $95

Simonson:

Annualized GDP growth: 4.0%

Core CPI inflation rate: 1.5%

Monthly job gains/losses: +400,000

10-year Treasury yield: 3.0%

Crude oil (price per barrel): $85


Three tips for investing in risky markets

Maverick investors are taking on vacancy, renovating tired properties and snatching up high-quality assets outside the primary markets in order to reap larger profits from their investment dollars.

For buyers who are new to this part of the risk curve, here are a few tips from the trenches that may help to close deals.

  • Buy with cash — To win deals, buyers with sufficient capital are acquiring with cash and then financing their acquisitions after closing the transaction. For distressed sellers in particular, a fast closing may be more important than garnering the highest possible price in a sale.

    “You've got to move fast,” says Michael Frankel, managing partner at Rexford Industrial, a Los Angeles-based property investment firm that owns and manages about 5.5 million sq. ft. of small industrial properties in that market.

    “If you're targeting distressed situations, if you're not ready to act, you may not be the right solution for the seller.”

    Paul House, managing director in the Houston office of Jones Lang LaSalle, suggests that investors look at it from the perspective of a bank that wants to liquidate its real estate owned, or foreclosed assets.

    “Do you sell to someone who says I'll close in 30 days with all cash,” he says, “or do you sell to someone who's got to take 60 days to get a loan in place?”

  • Understand lender preferences — The days when a single lender would consider lending on a variety of commercial real estate property types are gone, according to Ryan Krauch, principal at Mesa West Capital, a portfolio lender based in Los Angeles.

    The most likely lender for a stabilized, high-quality asset is probably a life insurer, while a similar asset that requires additional leasing falls under the forte of portfolio or balance-sheet lenders. The dominant lenders for core assets in the gateway primary markets are U.S. pension funds.

    “It's not as simple as sending a package out to 50 lenders,” says Krauch. “You have to understand where the deal fits into the universe of lenders today.”

  • Lock in rates — Mortgage rates are near historic lows, offering great opportunities to finance commercial real estate. But the choppy economic recovery, growing federal deficit, and soaring food and energy costs mean interest rates could easily spike in the next few months.

Financial intermediary Shlomi Ronen at Lucent Capital in Los Angeles has been advising his clients with loans maturing in the next 12 months to lock in interest rates for those loans now.

In exchange for a small premium of about five basis points per month, clients are able to obtain a borrower's commitment to honor today's interest rates in a loan negotiation several months from now, explains Ronen.

“You already know you're going to get your loan amount and everything is uttoned up.”