Concerns about financing and a sluggish U.S. economy won’t deter commercial real estate investors.

Despite a softening economy and turmoil in the capital markets, investors continue to have confidence in the U.S. commercial real estate industry. A survey of more than 1,000 private and institutional real estate investors shows only one in five respondents believe the economy will be stronger in 2008, yet the majority want to invest more funds in the sector. 

“To see that a majority of investors are still planning to increase real estate holdings and that the percentage is higher than last year is a strong validation that they are separating capital markets issues from commercial real estate fundamentals,” says Harvey Green, president and CEO of Marcus& Millichap Real Estate Investment Services.

The survey, dubbed the 2008 Real Estate Investor Outlook, was conducted jointly by National Real Estate Investor, Marcus & Millichap and Countrywide Commercial. This is the fifth year in a row this exclusive survey has been administered to U.S. real estate investors. 

The survey reveals that 62 percent of respondents plan to increase allocations in real estate over the next 12 months compared to 60 percent in 2006, 69 percent in 2005 and 74 percent in 2004. Only 7 percent of real estate investors plan to decrease their investments in real estate over the next 12 months (see figure 1).

“Investors are going to invest more in real estate because pricing is more attractive and they’ll be able to get slightly higher yields,” says Chris Tokarski, managing director of Countrywide Commercial’s real estate finance group. Of the investors who plan to increase their real estate holdings, the average estimated increase is 21 percent.

“Availability and cost of debt may have changed, but healthy occupancies, rent growth, lack of overbuilding and moderation in prices are the drivers behind the optimism,” adds Green.

Investment sales activity in 2007 is on pace to eclipse 2006’s $356 billion, according to Real Capital Analytics Inc. As of October 1, the New York-based research firm, which tracks all deals $5 million and above, had recorded $356 billion in sales of the five main property types (office, apartment, retail, industrial and hotel).

For the first two quarters of 2007, U.S. commercial property provided a cumulative return of 8.21 percent and is on track to at least meet the 2006 annual return of 16.6 percent, according to the National Council of Real Estate Investment Fiduciaries.

“People who have invested in real estate over the past several years have enjoyed really good returns,” says Rick Cavenaugh, president and COO of Fifield Cos., a Chicago-based developer and owner that specializes in multifamily and office properties.

“We believe there will still be ample capital flowing into the real estate sector because returns will still be pretty strong, even as they come off the levels where they were.”

In order to gain an in-depth understanding of investor attitudes and expectations about the commercial real estate industry, NREI, Marcus & Millichap and Countrywide Commercial collected data from August 16 to September 17, 2007. Similar to previous years, private investors account for the largest group of survey participants (45 percent). This year’s survey also questioned a large number of developers – roughly 13 percent of overall respondents. The survey also includes the views of 92 institutional investors.

Respondents have an average of 19 years’ experience in the industry and an average of $36.6 million invested in real estate. On average, 62 percent of respondents’ portfolios are allocated to real estate.

Among the key findings:
• Only 16 percent of respondents predict the economy will be stronger in 2008 than it was in 2007. Another 41 percent expect the economy will stay the same, while 42 percent expect it will be weaker. When compared to respondent responses from previous years, this survey indicates concerns about the economy have grown significantly since 2004 when 63 percent expected the economy to be stronger over the next 12 months and only eight percent expected it to be weaker (see figure 2).

• Availability and cost of financing moved up to the top concern for 2008. Unforeseen shocks to the economy rank as the second-highest concern among all groups except developers; 43 percent of developers express concern over rising interest rates (see figure 3, page 4).

• Investors are optimistic about rental increases, although not as much as they’ve been in the past. Seventy-eight percent of respondents expect to see an increase in effective rents for one or more property types compared to 84 percent in 2006. Investors feel most positive about rental increases in the apartment sector.

• Replacement cost continues to be a key criterion for investors when they make acquisitions. Almost 90 percent of investors agree that replacement value is important. Nearly two-thirds of respondents indicate their most recent acquisition was at or below replacement cost, while 12 percent of respondents say their acquisitions were above replacement costs.

• Sixty-one percent of respondents say that returns are artificially low, with 38 percent predicting that returns will rise back to long-term averages as conditions change and 23 percent forecasting returns will rise as conditions change but will not reach long-term average levels.

HOUSING HURTS

John Donne’s famous quote ““No man is an island” definitely applies to the commercial real estate industry. Despite the industry’s insistence that the troubles in the residential real estate market had absolutely nothing to do with it, the commercial real estate sector has suffered.

“The commercial real estate industry has caught a cold from all the coughing and sneezing of the housing market, which is deathly ill,” notes Dennis Yeskey, national director of Deloitte & Touche LLP’s Real Estate Capital Markets Group.

Although everyone had high hopes the U.S. housing market would have a soft landing, increased foreclosures and the meltdown in the residential mortgage market caused the housing sector to crash-land. Even worse, the residential mortgage crisis spread to the rest of the credit markets, infecting everything from corporate bonds to commercial mortgagebacked securities (CMBS).