A Dose of Fear

A Dose of Fear

COMMERICIAL REAL ESTATE by Jean Gruss | Editor/Lee-Collier

This year's gathering of commercial real estate executives at the Urban Land Institute's Emerging Trends in Real Estate conference in Bonita Springs was more somber than in years past. But there will be opportunities in 2008.

It's time to get back to income strategy.

In the recent real estate boom, investors who overpaid for commercial properties counted on capital appreciation to justify lofty prices.

No longer.

"The theme this year: A dose of fear," says Dean Schwanke, senior vice president of development trends and analysis for the Urban Land Institute, a Washington, D.C.-based think tank. Developers, economists and consultants gathered in Bonita Springs to discuss the forecast for commercial real estate in 2008.

The conclusion: commercial property owners are going to see mid- to high-single-digit percentage returns next year, but none of that will come from capital appreciation.

Overshadowing everything is the credit crunch that has emerged from the wreckage of the subprime debacle. The problem now is that it's hard for anyone to get a handle on the size of the problem and lenders may overreact by shutting off the lending spigot. "The opaqueness of the debt markets is incredible," Schwanke says.

But the news is not all grim. There will be opportunities for well-capitalized investors as they seize assets for which earlier buyers had overpaid using excessive leverage. "Private equity buyers won't be out there as much," Schwanke says.

Pension funds, REITs and foreign investors will replace private equity as the main buyers next year. "There are funds being formed to buy residential land," Schwanke says.

But they won't overpay. One measure of value in commercial real estate is capitalization rate, which is the ratio of the purchase price to a property's annual net operating income. The higher the price, the lower the "cap rate." In recent years, for example, cap rates in Southwest Florida fell from over 9% to below 7%, according to Real Capital Analytics. Next year, Schwanke says rates in general will rise 0.25% to 0.5%, reflecting lower prices.

Development slows

Development already has slowed in Southwest Florida.

"The good news is construction prices are down 15% to 20%," says Todd Gates, chairman of Naples development firm Gates. "But the bad news is that I have nothing to build."

Gates' firm has expanded to Panama in Central America as it seeks to diversify away from Florida's residential and tourism industries. Panama has become a financial-services haven that is focused on international trade.

Southwest Florida's economy is not well diversified, Gates says, relying on just three industries for its health: real estate, agriculture and tourism. Two of those - construction and agriculture - are down now, leaving tourism to keep the local economy afloat. "When things slow down, you realize your weaknesses," Gates says. "Tourism is strong, but it's very fragile."

The recent wave of development means there's now a surplus of commercial space. Retail space and hotels are two particular areas of concern, developers say.

Michael Timmerman, a Naples-based residential consultant, says the high number of vacant homes means there may be too much shopping-center space for now. "Vacant homes don't buy groceries," he says. "We need more households to substantiate the retail that's been built."

Timmerman expects the housing market to start recovering in 2009. "We'll be prepared for a long expansion cycle," he says.

But in the meantime, taxable sales in Southwest Florida have been dropping, reflecting declining consumer confidence as the economy slows. That means people will spend less when they shop.

But boosting sales will take more than improving consumer confidence. Local governments often are the biggest obstacles to job creation.

Builders and developers assailed taxes on new construction, or so-called "impact" fees, and permit-application regulations that can take years. For example, Collier County has the highest impact fees in the state and builders have blamed those for exacerbating the economic downturn.

"You're not focused on why companies don't come here," says Timmerman. Competition for jobs is coming from neighboring states in the form of tax breaks. "The Carolinas are really taking advantage of the situation in Florida," he says.

What's more, Lee and Collier county commissioners have discussed imposing moratoria on new development, threatening the area's principal job-creating industry. By some estimates, one out of three jobs in Southwest Florida is reliant on new construction and real estate.

"Moratorium means failure," says Gates. "A moratorium means you have given up."

What's more, it sends a message that Southwest Florida is anti-business. "Leaders need to have the right attitude," Gates says. "Having the highest impact fees and taking three years to permit aren't helpful for balancing the economy."

Opportunities may appear

Schwanke says the Urban Land survey revealed widespread thinking that the downturn will reveal opportunities for those with cash to buy.

For example, real estate investment trusts and homebuilder stocks may be a bargain after investors have pushed them down by double-digit percentage rates. However, Schwanke is not prepared to time the market. "I'm not going to tell you when to buy them," he says.

Even downtrodden homebuilder stocks could be a bargain. "There have got to be opportunities there in the coming years," Schwanke says.

Developers will be able to land new tenants by responding to the growing demand for efficient buildings because of the rising cost of energy. In three years, any building that doesn't have a "green" label won't be considered a "Class A" building. "Think green; otherwise you'll have an obsolete building," he says.

Developers are rushing to train their staffs to obtain designations as "green" builders to gain an edge over the competition. "It's not a passing thing that's going to come and go," says Gates.

BEST BETS FOR 2008

The Urban Land Institute, a Washington, D.C.-based think tank, and consulting firm PriceWaterhouseCoopers, collaborate each year on a forecast. It's based on interviews with more than 600 industry experts, including investors, developers, property companies, lenders, brokers and consultants. Here is the consensus for 2008:

Investment

• Husband capital, build relationships

• Buy distressed loans

• Hold onto your best properties

• Concentrate on operations

• Buy real estate investment trusts (REITs)

• Buy broker, homebuilder and mortgage-company stocks

• Use demographic strategies to target properties such as seniors' housing, baby boomer resorts, second homes and medical office buildings.

• Staff up the workout teams

Development

• Think green

• Focus on mixed-use and infill

• Build transit-oriented development

Property sectors

• Buy multifamily

• Buy or hold industrial

• Buy residential building lots

• Exercise caution in office and hotels

• Chill on retail

REVIEW SUMMARY

Industry: Commercial real estate

Trend: Fear is back in the market

Key: Buyers with cash will have opportunities as over-leveraged owners look to sell.