There’s light at the end of the tunnel for commercial real estate, but the industry’s recovery will play out in an “era of less”, according to the Emerging Trends in Real Estate 2011 released today by PwC and the Urban Land Institute.
Every property sector will be affected by macroeconomic transformations that have taken place. As a result, the conditions that caused property values to surge to vertiginous heights in 2007 are not likely to materialize again. What it means concretely is that the U.S. is seeing a return to multigenerational households. Children are living with the parents for longer due to diminished job prospects and high student debt loads. And baby boomers—with reduced savings—are increasingly living with their children rather than relocating to swank retirement communities. Indeed, recent data from the U.S. Census Bureau showed that between March 2009 and March 2010, the number of households rose by just 357,000—the lowest level since 1947.
In addition, scaling back will mean fewer cars, smaller offices and fewer distribution links. As a result, every commercial real estate sector faces some continued scaling back rather than any increased demand for new space in the near future.
In this climate, investors should anticipate high single digit returns for core properties and mid-teen returns for higher risk investments.
Jonathan Miller, the report’s principal author, and Stephen Blank, a senior resident fellow for real estate finance with ULI, revealed the annual report’s findings at the Urban Land Institute’s Fall Meeting being held in Washington D.C. from Oct. 12 through Oct. 15. Miller and Blank both emphasized that the outlook for commercial real estate had clearly improved from a year ago, but were quick to point out that any enthusiasm should be restrained by the many challenges that remain.
What may be frustrating for the sector is that its future is not entirely within its control. As one respondent said, “Our problems are much bigger than real estate, and solutions are well beyond the scope of our industry.”
Most significantly, respondents identified job creation as a key determining factor of the sector’s health, but “nobody knows where the jobs are going to come from,” Blank said. As a result, Blank projects the U.S. economy is looking at something more like a “reverse J” recovery as opposed to a V- or L-shaped recovery.
In addition, the outlook is uneven. For example, the investment picture remains bifurcated with only top assets in the best markets trading. In fact, according to Miller, some respondents even expressed reservations that investors may be overpaying for these assets. In all, property values are continuing to re-set to levels below the 2007 peaks and the pricing on some deals does not appear to take this into account. Meanwhile, for lower quality assets “it’s hard to tell at all what their values are,” Blank said. “Investors don’t want to look at them at all.”
Debt remains an overriding issue in assessing the investment climate. Equity is available. In fact, many buyers are sitting flush with cash. More than 55 percent of respondents to the survey said that equity was either “moderately” or “substantially” oversupplied. On the flip side, more than 78 percent of respondents said that debt was either “moderately” or “substantially” undersupplied.
“Regulators looking the other way for a long time certainly have helped,” Blank said. “Low interest rates and [other conditions] have helped lenders” and put them in a position to originate loans. “But they only want to look at the best assets.”
The outlook also varies by market. According to the report, the top 10 markets in the country are Washington D.C., New York, San Francisco, Boston, Seattle, Houston, Los Angeles, San Diego, Denver and Dallas. What the best markets have in common is that they are generally 24-hour cities that boast high concentrations of brain power, echo boomers, empty nesters and are investor magnets. On the flip side, housing bust markets—such as the Southwest and Florida—and the Midwest have the bleakest outlooks, according to the report.
When it comes to property types, apartments ranked as the most attractive investment option among all property types, according to survey respondents. The sector received a score of 6.19 on a scale of 10 followed by industrial at 5.07, hotels at 4.78, office at 4.72 and retail at 4.50.
In the retail sector, only fortress malls and top-tier neighborhood centers in infill markets are performing well. Class-B and class-C malls continue to struggle as do power centers and neighborhood centers built on the fringes where population growth has faltered.
As for development, survey respondents think it is still a long time before the industry will require large amounts of new construction. It could be three to five years before volume rises significantly and even longer than that for the retail sector, which respondents believe is the most overbuilt. No sector got a positive development rating in the survey. Apartments received a 4.85—on a scale of 10—while industrial scored 3.12, hotels 2.33, retail 2.26 and office 2.06.
As Blank put it, "We don't need anything new."