The following is what I wrote for my company’s annual market report. It’s a bit heavy on the jargon so if you need clarification or have questions drop me a line.
This past year saw a dramatic drop in the number of investment sales. This was primarily the result of the collapse of the commercial mortgage backed securities (CMBS) market. Up until 2008, roughly 70 percent of commercial real estate acquisitions were financed by these CMBS lenders which originated loans, packaged them into pools, and then sold bonds backed by these pools. CMBS lenders originated nearly $137 billion worth of debt through the first six months of 2007 alone.
In the fourth quarter of 2007, as a result of the residential mortgage meltdown, investors became hysterical about anything related to mortgages. Despite the fact that commercial real estate leasing fundamentals remained sound, these CMBS bonds stopped selling, and as a result CMBS loans could no longer be originated. The volume of CMBS loans originated dropped by over 90 percent.
Picking up the slack in financing commercial real estate today are life insurance companies and local and regional banks. With many more financing opportunities to choose from than in the past, these lenders can afford to be very selective. As such, the majority of new loans are being made on high quality, well located real estate. Terms of these loans have been tightened considerably: rock-bottom floating rate loans along with fixed-rate interest-only loans are largely a thing of the past. Where CMBS lenders regularly offered 80 percent leverage with no personal recourse, 60 to 65 percent leverage is the norm today. Amortizations in the 20 to 25 year range are now more typical than 30 year loans.
This dramatic change in loan terms and pricing has driven up loan constants — the annual cost of servicing a loan expressed as a percentage – by as much as 200 to 300 basis points. Further, yields on alternative investments such as corporate bonds are rising in this recessionary climate – into double digits in many cases. All this has pushed today’s yield expectations on suburban office and industrial real estate up 50 to 300 basis points from a year earlier. This change in yield expectations occurred much more quickly than in previous down cycles as the contracting debt market corresponded with – or rather effectively helped initiate – the recession that began in early 2008.
Today, many owners of commercial real estate that are taking buildings to market are doing so because they must, either because of near-term debt maturity or some other need for cash. So far there are few owners in the Washington-Baltimore area that “must sell” and as such the volume of investment sales in our region is down 37% year-over-year. Roughly half of the commercial real estate investment sales that occurred in 2008 involved the buyer assuming (typically CMBS) financing that was already in place. This fact highlights the dramatic drop in new loan origination.
Leasing fundamentals in the Washington-Baltimore area have weakened but thanks to the insulating presence of an expanding Federal government and tremendous land constraints our region should see comparatively less weakening in demand for space.
Investors expecting “fire sale” pricing in our region are being disappointed so far. Buyers depending on large amounts of leverage are on the sidelines. This leaves institutional investors and other low leverage buyers purchasing high quality real estate at more attractive capitalization rates than they could in 2007 thanks to the less competitive environment. Older, less-well-located real estate is seeing the biggest spike in capitalization rates.
As more high leverage loans become due in 2009, and owners fail to refinance, more forced selling will occur. Owners with attractive assumable financing in place, or those willing to consider seller-held financing, have the opportunity to sell and achieve pricing not too far off of 2007 highs. Expect seller-held financing to expand considerably in 2009, particularly to facilitate the sale of less than institutional quality real estate.
While it is a dangerous game to call a “bottom” the real estate market, we believe that we are in a sort of a “buyer’s market” seen only once or twice in a lifetime. The savviest investors will focus on buying now in markets that show dramatic historic rent growth and have weathered previous downturns relatively well. Industrial, multifamily and downtown Washington DC office buildings should fare better than retail and suburban office product.
AMB just recently announced that they will lay off 22 percent of their work force. First Industrial laid off something like a third of their salaried work force. Anecdotally, I’m seeing both commissioned brokers and salaried professionals being laid off left and right - it’s ugly out there.
