spring for commercial real estate... Chicago style. April 26, 2011 Springtime in Chicago is not for the faint of heart. Despite the longer days, the promising buds of life on every tree branch and a few breaths of warm air, it is difficult to truly relax. Long-time Chicago residents know from experience that even in late April there is no guarantee of safety from a spring blizzard. Every sharp gust of wind off a still frigid Lake Michigan reminds us that winter’s power extends well into the next season and it will punish those who are unprepared. Just like commercial real estate… The general economy continues to improve slowly, but like the beleagured Chicago populace, most of commercial real estate is unable to believe that warmer times can be relied upon. According to Bruce Cohen, CEO of Wrightwood Capital, “At the end of 2009, we had 5.7% GDP growth; it started to feel like summer – but then in the second quarter of 2010 the economy froze again. We all had to put our coats on again. Here we are a year later, the economy, job growth and the capital markets have slowly, and surely progressed; but it is difficult to trust that summer really will come at some point.” A couple of years of punishing credit markets, dropping values and disappearing tenancy has convinced us to keep our winter coats on – no matter how nice it gets. Bruce continued, “On top of the slow return to health, there are exogenous shocks such as: the changes in the middle east, and the impact on oil prices, the unfortunate disaster in Japan and all the effects on the world’s manufacturing supply chain, and the continued explosive growth in China driving commodity prices. It’s as if we keep getting small tastes of better times ahead, then seeing snowflakes falling from the sky.” Given what we have all been through, it seems reasonable to believe the next couple of years will likely see only slow growth – and perhaps even a few setbacks. At the same time, we know the sun will come back – that summer will arrive at some point. Persistent growth is likely, but it’s hard to trust it right now.
the credit [r.e.]view - April 2011
commercial real estate spring - page 2 of 3
And yet…
to somewhere around 8.8%.
In the February/March issue of Real Estate Forum, the editors included a smart little piece called “From the Forum Vault” that summarized some of their highlights of reporting over the last 65 years. The section titled “..in 1995” sounds oddly familiar:
Commercial real estate, though often thought of as a derivative asset class, one that follows the ups and downs of the general economy and employment growth, may also have some influence on that growth as well. A return of equity and debt capital to the market have driven transactional activity, and that activity is creating jobs. According to Bruce, “The overall economy is heavily influenced by construction jobs – both in residential and commercial real estate. Whenever there is an asset acquisition, even a troubled asset, there is additional spending on improvement of the asset, maintenance and on the exeuction of the business plan. Real Estate is both a derivative of the economy and a driver.”
“Industry experts issued this warning to investors: look past the hype before rushing back into the market…Capital flowed into the sector as stock and bond markets continued to cause uncertainty, resulting in a rebound for real estate. But rents were still flat and vacancies were still high. It seemed that capital, not returns or absorption, is what created investment and enthusiasm. The major question posed was: have the industry and capital sources reached a level of discipline that tempers investment with market fundamentals?” Either they were lucky or smart, but investors in 1995 weren’t betting on current fundamentals – rather, they foresaw demand getting better. Many a real estate fortune was made anticipating the growth of the late nineties. And though history never repeats itself exactly, it’s at least possible that all those institutional and international players are anticipating something good when they bid pricing in core markets into a range of 4% to 6% capitalization rates. Are they thinking about putting their winter coats back in storage too soon, or will they see sunshine soon enough? According to Bruce, “In 1995, what we saw was a simple return of demand – at levels we couldn’t have imagined a hear before. Today, we don’t need that level of demand in order to recover. If job creation continues to improve as it has in the last year, even if it’s slower than we would all like, if it keeps on it’s steady path back to 6% or 7% unemployment, demand for real estate will be right back where we need it.” The first quarter of 2011 showed a steady increase in sales, stabilizing rents and improving employment numbers. According to current Bureau of Labor Statistics estimates, unemployment has continued to drop from its highs last year
According to Real Capital Analytics, January and February 2011 commercial property sales were more than 50% higher than the same months in 2010 at $17.6 Billion. Despite the FDIC’s most recent quarterly report (2010 Volume 4, Number 4) that identified 860 banking institutions on their problem list with assets valued over $379 billion, defaulted loans in the 4th quarter of 2010 actually fell from 4.36% to 4.28% of assets. This is promising, but will working out those troubled bank portfolios have a significant negative impact on the health of the market? Is that where we may experience a spring blizzard? Perhaps the critics of “extend and pretend” were right to argue that we should have had a forced liquidation like the Resolution Trust Corporation (RTC) effected in the 1990’s in order to reset the market. And yet, quite a bit of value was preserved by the banks just by waiting a little longer for markets to improve. Loans that may have sold for half of their original price a couple of years ago have regained at least some of the value lost. Borrowers were given a bit more time to recover and perhaps even retain their assets while banks were able to gain a breather and build up their reserves through deposits (and a few loans from the government). Now that they are on sounder financial footing, they can handle an orderly resolution of assets is possible without falling apart – and without flooding the market with too much discounted product all at once. According to Bruce, “Everything is now clearing. We’re not worried about discounted product flooding the market because everything is trading at a current market value –above where that value might have been at the depths of the recession. The distress associated with those assets now worth less than what others previously invested represents a loss only for those investors – not to the market as a whole.
the credit [r.e.]view - April 2011
And with the abundance of capital flows, there’s little ‘hidden’ value other than the lower basis and economic nadir at which people are investing. We can’t eliminate completely the cold felt by those that came through the worst of the winter, but warmer days are coming for the market as a whole. The clearing of troubled assets doesn’t presage more Winter, it’s just the cooler days of Spring before Summer.” Not taking the RTC approach of the early 1990’s may have actually assisted a deeper and broader potential recovery. Bradley Cohen of Cohen Asset Management (no relation to Bruce Cohen or Wrightwood Capital), during Wrightwood Capital’s second quarter Los Angeles Credit Roundtable pointed out that, “during the days of the RTC, it was difficult for small companies to invest in those large portfolios so quickly – limiting the opportunity to only the largest companies and those with the deepest pockets. Now, thanks to the initial slowness of the recovery and the slow pace of distressed asset resolution, smaller companies are able to take their time, assess different opportunities and make better investment decisions.” Bruce Cohen pointed out, “When markets are going up, there is a false sense of security, when they go down, there’s a false sense of panic. Every investor is asking, ‘is it safe to go out there again?’ The answer depends on their judgements about where the market is going long term, not just what is happening right now. Now is the time to put on a sweater, shrug off the typical Spring chill and make plans for summer.” Welcome to the commercial real estate Spring of 2011… Chicago style.
© copyright 2011 Wrightwood Capital, LLC. All rights reserved.
commercial real estate spring - page 3 of 3
A Commercial Real Estate investor, Wrightwood Capital puts credit discipline at the center of its strategy. Whether investing for its own balance sheet, or on behalf of investors through funds, Wrightwood Capital uses a tested credit process to provide a range of structured debt strategies to real estate owner operators across the US. Wrightwood Capital has made over $5.4 billion of loans and investments since 1997, and currently manages approximately $1.5 billion in assets.
If you want to learn more about investing with Wrightwood Capital or are looking for customized debt solutions, please contact us.
312.324.5900 www.wrightwoodcapital.com