Previously, many loans were based on projected income streams rather than current income streams. Borrowers routinely closed highly leveraged loans, with loan-to-value ratios exceeding 80 percent. Moreover, interest-only loans (IO) were easy to come by, with many borrowers obtaining 10-year IOs.

Today, loan-to-values have returned to more traditional levels in the 70 percent range, while IO provisions have all but disappeared. “This was a muchneeded adjustment that will make our industry much stronger,” says Scott Derrick, chief acquisitions officer of SCI Real Estate Investments, a Los Angeles- based tenant-in-common (TIC) sponsor that is scheduled to make roughly $550 million in acquisitions this year.

The stricter underwriting standards and lower leverage limits are good news for SCI Investments and other investors with long track records that aren’t overly debt-dependent. “If you can find the right deals and can align yourself with financing, it can be

a good opportunity to invest,” says William Hughes, senior vice president of Marcus &

Millichap Capital Corp. “It’s a better environment for sophisticated investors because lenders are going to back borrowers with more experience and a longer track record.”

FROTHINESS FADES

The challenging debt markets and tighter underwriting standards are expected to impact asset pricing and cap rates.

 “We’ve seen the highly leveraged buyers leave the market because they haven’t been able to close loans,” Derrick says. “That means there’s less competition and less pressure on pricing.” In fact, SCI hopes to invest $700 million in real estate in 2008.

San Diego-based office and industrial investor Equastone also has high hopes for 2008 and is targeting a total investment of $1 billion, says chief investment officer Jeff Schindler. The firm had similar goals for 2007 but is “proceeding with caution” to make sure its acquisitions are priced appropriately. “Since the highly leveraged buyers have been sidelined, the market has lost some of its frothiness,” he explains. “There’s still some NOI growth that supports strong pricing, but there aren’t as many buyers showing up.”

Figure 5: Click to view larger image

While respondents are split on whether pricing for commercial property has reached a peak – 44 percent of respondents say yes and another 36 percent say no – most do anticipate a decrease in pricing for most property types (see figure 5).

That response is a big change from last year’s survey when the majority of respondents expected pricing to increase for all property types except for grocery-anchored retail and regional malls (see figure 6).

“I think we are entering a period of realignment between the rate of price appreciation and rent growth, but to say we have peaked implies prices across the board will stagnate or fall, and I do not believe that will be the case because of healthy fundamentals,” Green says.

Figure 6: Click to view larger image

In fact, Green expects rents to continue to grow across most property types, although the pace will be slower than it has been for the past several years. “The recovery period is behind us for office, apartments, industrial and hospitality, creating a more normalized market rather than a recovering market in which vacancies have a long way to drop and rents have a long way to climb. Retail, which never had a downturn, is now more likely to experience slower rent growth because of weakness in housing,” he explains.

Additionally, the slowing economy will reduce the pace of absorption, and in some markets – such as those that are vulnerable to financial services or mortgage industry cutbacks – vacancies will rise and rent growth will stall, at least temporarily.

“It all depends on the economy, and if the economy slows, we won’t see any rent growth,” Yeskey says. “But we won’t see any decreases either.” The majority of respondents agree – four out of five do not expect a decrease in the effective rents for any property type. In fact, 78 percent of respondents expect to see an increase in effective rents for one or more property types with apartments leading the way (see figure 7).

In addition to healthy fundamentals, commercial property valuations are well-supported by replacement costs. “It still costs far more to build a building than it does to buy an existing one, not to mention the difficult approval process in most markets,”

Figure 7: Click to view larger image

Nadji points out. “Replacement cost is still well above acquisition pricing in most markets and property types.”

And although construction costs may not be increasing at the rapid pace they were six to eight months ago, they’re still high enough to make development more difficult than acquisition.

“I expect there is going to be less development in 2008 because construction financing is much more difficult to get,” Tokarski says. “If a project is not already under way, I doubt it will break ground without pre-leasing.”

Last year, construction costs were one of the top three concerns for survey participants. This year, worries about construction costs were less acute.  However, seven out of 10 respondents experienced an increase in construction costs over the past 12 months, and more than half expect an increase in the next 12 months. The survey suggests that construction costs increased an average of 16 percent. Going forward, respondents forecast construction costs to increase six percent.

Many experts say the slowdown in single-family housing construction has decreased demand for commonly used building materials, therefore mitigating extreme price increases. However, construction costs continue to be a big concern for Chicago-based Fifield Cos., which develops high-rise apartments and office buildings.

“Demand for concrete and steel hasn’t dropped off because there are still a lot of projects under development that use these materials – particularly public projects,” Cavenaugh says, adding that global demand for these building products continues to be high as well.

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© 2007 Penton Media, Inc.