No quick fix

By Business Observer Staff
| 6:00 p.m. December 4, 2008

Entrepreneurs

No quick fix

Commercial real estate on the Gulf Coast will feel the effects of the economic downturn in 2009. Here's how to prepare.

Chuck DiRocco begged his audience to forgive him.

Speaking at a recent Urban Land Institute gathering in Lee County recently, DiRocco pleaded: "Don't shoot the messenger. I do love Florida."

DiRocco is managing director of industry trends and analysis for the ULI, a Washington D.C.-based real estate group that publishes a commercial real estate forecast every year. To create the forecast, ULI and consulting firm PriceWaterhouseCoopers interviewed 270 real estate developers and investors this summer.

Their conclusion: Commercial real estate in 2009 will face its most severe test since the early 1990s. "Take a year off to better your golf game," DiRocco counsels. "In 2009, there's no escaping the minefield."

DiRocco ticks off the list of mines: delinquencies will rise, the mortgage-backed securities market is frozen, capitalization rates will rise, property prices will drop 15% to 20%, institutional investors are pulling money out of real estate and smaller markets such as those along the Gulf Coast will suffer more than their larger counterparts. "If you haven't sold your properties yet, it's too late," DiRocco says.

Despite the bad news, there's some light at the end of the tunnel, though commercial real estate isn't likely to recover until 2011 or later. By some estimates, there's $300 billion of equity on the sidelines waiting to be invested. By and large, most markets aren't overbuilt; the problem now is mostly a lack of demand. And home prices in Florida have dropped so much that some retirees may decide to buy a second home despite steep declines in the financial markets.

But until an economic recovery takes hold, commercial real estate owners will feel the pinch. "Owners are drowning in debt at this point," DiRocco says. "It's only a matter of time before we see more delinquencies."

In this environment, desperate owners will lower selling prices of commercial properties, driving down prices by 15% to 20% DiRocco says. Capitalization rates, a ratio calculated by dividing a property's net operating income by its value or cost, will rise over 8%, from 5% to 6% during the boom.

Strategies to deal with an ugly 2009 include:

• Be patient and husband cash. Sit tight and wait for prices to recover. Opportunities will arise as properties sell at substantial discounts and patience will be rewarded.

• Buy discounted loans. Lenders will sell more loans at increasing discounts, but investors need to focus on the underlying collateral.

• Distressed borrowers look for help. Some overleveraged owners will seek capital and investors will be in the driver's seat, getting equity returns for debt risk.

• Hold core properties. Well-leased properties should step up tenant relations to maintain occupancies and cash flows. Keep vulture investors away.

• Buy public real estate investment trust. The stocks of REITs, publicly traded real estate companies, have taken a big hit. But even if they fall further, they could be among the first to benefit from a recovery. Many larger companies are well capitalized with manageable debt loads. Low share prices make their dividends attractive, too.

• Pray for retail. Mall owners hope shoppers haven't shopped 'til they dropped, but spending is declining. Neighborhood grocery centers will fare best as consumers limit shopping to basics such as food and medicine.

- Jean Gruss

BY THE NUMBERS

2009: Higher cap rates

Capitalization rates, the ratio of a property's value to its net operating income, will rise in 2009 as property values decline. Buyers and sellers of commercial real estate use this ratio to value deals. Limited-service hotels will see the biggest change in cap rates, while industrial buildings will see the smallest increase.

Here are the cap-rate prospects for 2009 according to property type:

Property type Cap Rate July '08 Cap Rate July '09 Point chg.

Hotels (limited service) 8.18 8.91 .73

Power centers 6.91 7.57 .66

Suburban office 7.18 7.81 .62

Hotels (full service) 7.54 8.13 .59

Regional malls 6.19 6.77 .59

R&D industrial 7.31 7.83 .52

Neighborhood centers 7.01 7.54 .52

Central city office 6.34 6.86 .52

Apartments (moderate income) 6.38 6.86 .48

Apartments (high income) 5.95 6.43 .47