2011 looks bright for private, institutional investors Featured

4:08am EDT January 5, 2011

Smart Business spoke with John M. Leonard, first vice president and

regional manager of the Atlanta office of Marcus & Millichap Real Estate

Investment Services, about what real estate investors can

expect for 2011.

What must occur in the U.S. economy to spur a

strong recovery in the commercial real estate market?

Fears of another recession, global debt levels,

uncertainty regarding taxes and regulation are confidence-killers among U.S.

companies that must drive a fundamentals-based recovery to heal the consumer

sector. The recovery may be lacking momentum, but evidence suggests contraction

is unlikely, barring an unexpected shock. Companies have wrung maximum

productivity and need more help, leading to improved, if below-average, job

growth in 2011. Election results should contribute to reducing uncertainty and

move the political agenda more to the center, with likely compromises on key

issues. The impact of the Fed’s bond purchases may be questionable, but the

message of readiness to shore up near-term conditions is clear.

What sector will be most sought-after by investors?

In other words, which sector do you anticipate staging the strongest recovery?

Well-located U.S. multifamily assets will be the most

sought-after among investors. But industrial and the once-troubled retail

sector are also staging an impressive comeback, since property fundamentals in

the retail sector seem to have bottomed. The apartment recovery rallied above

expectations in 2010 thanks to the release of pent-up renter demand, lower

tenant rollover and job growth. Occupancies in other property sectors are at or

close to a bottom, and gradual recovery will begin in 2011, led by industrial

and retail, then office properties. Concentration of sales in the upper end of

the market reflects an intense flight to safety. In 2011, investors will likely

move down the quality spectrum as premium property returns dip and the cap

rate/ interest rate gap, along with locking in cheap debt ahead of rent growth,

provide a safety net. Financing will ease further, but tight underwriting is

here to stay, even as the commercial mortgage-backed securities market expands

and banks become more willing to lend.

Will levels of distress in the U.S. CRE market

continue to rise?

Lender response to distressed real estate has played

out quite differently from the 1991 to 1994 period. In the current cycle,

lenders have minimized fire sales, especially for quality assets, thus limiting

large-scale opportunistic buying and frustrating many vulture and opportunity

funds. In 2009 and year to date through the third quarter, more than 80 percent

of the distressed property sales were under $5 million. In the third quarter of

2010, new additions of troubled assets totaled $13.7 billion, a 61 percent

decline from the same period last year, and were offset by $11.3 billion in

workouts and restructured loans, minimizing the net increase in outstanding

distressed assets to the smallest in two years.

Approximately $281 billion of commercial real estate

properties were classified as distressed assets in the most recent cycle; of

those, one-third have been restructured or liquidated. About half of those

resolved culminated in restructured or extended loan terms, with the remainder

completed through new financing or sale. The balance of known outstanding

distress is estimated at $158 billion, while the inventory of lender REO has

reached approximately $34.3 billion. Opportunities

exist in different forms of distressed acquisitions, ranging from note sales to

sourcing fresh equity to restructuring deals;

however, it requires far more work,

sophistication and networking to identify and

take advantage of distressed situations.

Currently, more than 20 percent of

outstanding commercial

debt is held in tranched commercial mortgage-backed securities (CMBS), adding a

level of complexity to the ownership of

underperforming assets. This dilemma has

resulted in limited offerings and,

consequently, the broader commercial real

estate market resetting at a slower pace. A ‘suspended animation’ effect has fostered gradual price rediscovery,

especially when compared to the 1991 to 1994

period, which was marked by massive and highly discounted disposition of

commercial property by the U.S. government

vis-À-vis the Resolution Trust Corporation.

Core, quality assets fetch a true premium in today’s

market, while lesser-quality and more illiquid properties in secondary or

tertiary markets remain hindered by risk-averse buyers and lenders. Sales

velocity, although substantially improved since its mid-2009 bottom, has been

and will stay sluggish for a while as a result. Generally, lenders remain less

inclined to sell under-performing debt and assets, delaying the deleveraging

process. The redistribution of noncore, distressed and revalued commercial real

estate will eventually occur, but over a two- to three-year period as loan

maturities roll, lenders gain financial strength and space fundamentals


What types of transactions will close in 2011?

Notwithstanding the institutional and REIT acquisition

volume resurgence in 2010, 93 percent of transactions in the four major property

types were below $20 million, and 87 percent were below $10 million, reflecting

the importance of private investors in the marketplace. Institutional debt

sources share common criteria, including a preference for low-risk,

high-quality assets and larger transactions with strong sponsors. This mandate

leaves the majority of the transaction bell-curve, that being sales of $5

million to $20 million in the B-minus to C-quality range, with limited

financing options. That is not to imply deals in these categories cannot get

done, but the process and qualifications remain far more exhaustive and driven

by the strength of buyer and lender relationships.

Risk aversion will persist for the foreseeable future.

The sparks needed for broad-based easing in financing conditions include

several consecutive quarters of solid job growth and sustained improvement in

corporate capital expenditures. Current conditions suggest this will not

materialize until mid-2011, resulting in more seller financing, loan

assumptions and fresh equity injections to restructure existing deals.

Well-capitalized buyers will have an array of opportunities, but they must be

willing to move down the quality spectrum and assume more risk for the most

competitive valuations, as stable assets in strong markets will not trade at


What message would you like to deliver to all types

of real estate investors in 2011? 

In 2011, investors should take stock of two

fundamental points: the worst is over, and capital markets have improved faster

than expected. Higher returns require the appropriate degree of risk-taking,

and approaching 2011 with the same tenor of wariness present a year ago will

likely lead to lost opportunities. Many investors failed to pull the trigger

over the past 12 months, expecting an RTC-style, deeply discounted property

market or prolonged deterioration of the U.S. economy. The odds of either

occurrence have further diminished. The low-hanging fruit may be gone, but

attractive investment opportunities exist that may not be available a year from

now. That is not to say investors should throw out caution. Economic and market

risks remain and must be assessed; however, this year’s improved data points

and lenders’ ongoing strategy to prevent fire sales on quality assets highlight

the need to reset expectations and adjust strategies.

John M. Leonard is a first

vice president and regional manager of the Atlanta office of Marcus & Millichap Real Estate

Investment Services. Contact him at john.leonard@marcusmillichap.com

or (678) 808-2700.