Welcome to the New Normal

2011 is the first full year of what many economists see as an entrenched period of slow economic growth, high unemployment, and volatility.

January 1, 2011

What does the "New Normal" look like for commercial real estate? It's not 2006, but it's a lot better than 2009. Brokers in major markets are seeing multiple bids on Class A, top-tier properties even if the transaction numbers are still a fraction of those in 2007 or 2008. Lenders are taking calls again—if not yet making many commercial real estate loans. Cap rates for some Class A properties are nearing pre-credit crisis level.

In some ways, "we're not seeing a New Normal as much as a return to the 'Old Normal' before the bubbles of the early 2000s," says Mark Dotzour, chief economist with The Real Estate Center at Texas A&M University in College Station. In the Old Normal, he says, nonrecourse commercial real estate loans were a rarity, and home owners didn't spend the equity in their homes at the mall.

"We need to erase the period from 2004 to 2008; that was built on unrealistic refinancing," agrees Ken Riggs, cre, CEO of Real Estate Research Corp. in Chicago. The commercial real estate market is recovering, he says. "It's just going to play out at a leisurely pace."

A Bump in Job Growth

What will speed up the recovery? Jobs. The good news is that "the pace of new job creation should pick up to about 100,000 jobs a month in the near future," says Jim Costello, principal with CBRE Econometric Advisors in Boston. "We have a lot of highly qualified workers who can be rehired quickly once the recovery gets underway," he says. Costello estimates that the increase will begin in mid-2011 and last a year or so before leveling off. In the longer term, however, he says, job growth will "settle down to about 50,000 a month." That's much slower than the 2003–2007 recovery, but still the fastest growth of any developed economy, he says.

Another positive factor: the record high corporate profits and funds available for investment. As of the second quarter of 2010, U.S. companies saw the internal funds available for investment increase by $61.1 billion, according to the U.S. Bureau of Economic Analysis. The addition of $30 billion in federal funds for small-business lending in fall 2010 could also boost business confidence and thus hiring. Quantitative easing by the Federal Reserve, issuing more money and then buying back Treasury bonds to support the market, is a policy meant to encourage banks to lend and businesses to invest, says Timothy Riddiough, professor of real estate and urban land economics at the University of Wisconsin, Madison.

Why isn't this money translating to more jobs? Most attribute it to fear. "There's still a huge amount of uncertainty because the pace of recovery has been so uneven," says Robert Bach, senior vice president and chief economist for Grubb & Ellis. He anticipates that this slow hiring could keep office space from reaching equilibrium until 2013.

Small businesses are also worried because they don't know how regulations and laws in areas like bank policy and health care will affect them, says Dotzour. "Businesses are fearful, so they hoard cash," he says.

An Uptick in Confidence and Spending

While business confidence lags, consumers seem more resilient, at least at the cash register. Consumer spending has also risen close to 2008 levels, "a pleasant surprise," says Bach. Yet, uncertainty about employment and home values have kept consumer confidence numbers fluctuating. Revolving consumer credit, which includes credit cards, declined 9.6 percent in 2009 and was projected to fall 8.75 percent last year, according to the Federal Reserve, cutting into retail purchasing power. "Cap rates for retail are dropping, and I'm having more tenants asking for rent reductions," says Richard Forsyth, cpm, president of Westerra Realty in Salt Lake City.

Declining retail sales also put pressure on industrial and warehouse properties, but they too may be turning the corner. "We saw a 0.3 percentage point decrease in industrial vacancies during the second quarter of 2010, which is significant in a 1 billion-square-foot national market," Bach says. He credits a recovering manufacturing sector, buoyed by exports to emerging markets and a restocking of business inventories in late 2009 and early 2010. "People and businesses are more comfortable that they're not going to see a repeat of the Depression, which is helping all properties," he says.

Rents have also repriced, but instead of moving up to better space, some tenants are shying away from top-of-the-line space, says David Zimmer, sior, president of Zimmer Real Estate Services/ONCOR International in Kansas City, Mo. "Companies don't want to be perceived as overspending," he says. He adds that he believes this shift away from ostentatiousness to value is all part of the New Normal lifestyle.

Lifestyle choices, demographics, and the fallout from the housing crisis continue to make apartments a top choice for investors. "Demand is good, and supply has been kept in check," says Riggs. "We're seeing a lot more deal activity and offers on multifamily, and cap rates are pretty compressed for Class A and B assets," says Nick Fluellen, ccim, associate vice president of investments at Marcus & Millichap Real Estate Investment Services in Dallas. The aggressive cap rates haven't yet trickled down to C-class product, he says. RERC's preliminary research indicates that in the third quarter of 2010, investors wanted an average going-in cap rate of 6.6 percent for unleveraged apartment properties.

Investors Get off the Fence

A prevailing sense of economic uncertainty is also making commercial real estate more attractive to investors, says Costello. "It's a hard asset and provides some protection to capital, as well as a possible inflation hedge." Most of what investors are buying falls into two diverse pools—Class A core assets in major markets or severely distressed properties.

"Investors are yield-starved, and the combination of safety and yield spreads over 10-year Treasuries makes core commercial real estate very attractive," says Robert White, CRE, president of Real Capital Analytics in New York. The high occupancies, long-term leases, and financially sound tenants in core properties are often netting multiple offers and producing cap rate compression as low as 5 percent, he says. Ironically, the spike in Class A real estate prices might actually provide some fuel for inflation in coastal cities with constrained inventories, Riddiough says.

The quest for the best has increased the deal volume through August 2010 to $54 billion. That's half of the deals done over the same period in 2008 but up 45 percent from 2009's lows, according to Real Capital Analytics. With the volatility and no clear trend in the economy, "occupancy is worth a lot and vacancy is worth little," White says. Another encouraging sign is that buyers aren't just institutions. Small investors are also returning, often through the mechanism of private and nonlisted REITs, Riggs says.

At the other end of the investment spectrum, distressed buyers are still active. "Vultures with patience are being rewarded with more product to choose from and price drops of about 20 percent last year compared to 2007 highs," says White. "We started having more asset managers call us in mid-2010 about disposing of property. Lenders had taken on too many extend-and-pretends and had to move some off their books," says Larry Culbertson, broker and regional director of KW Commercial in Atlanta.

Yet, despite an uptick in REO sales, the volume of distressed properties never reached the levels predicted in 2009. "Commercial real estate values have held up surprisingly well, considering the size of the downturn," says Bach. Regulatory pressure that discourages lenders from foreclosing and selling repriced assets to entrepreneurial investors is "keeping the market from clearing," says Dotzour. "Lenders have learned that they aren't the best owners of commercial real estate and are less eager to seize assets," says Robin Webb, ccim, Orlando-based head of Florida operations for NRT.  (See "Find Creative Ways to Finance" at right.

Debt Eases Gradually

Investor bifurcation is mirrored in the lending arena. "There was a big improvement in debt availability in 2010, but most of it focused on risk-averse assets," says White. Refinancing has also picked up because of the healthy spread between lenders' borrowing costs and today's low interest rates. "Bankers are still in the business of lending, and at some point they are going to have to take more lending risk in order to retain their profitability," says Zimmer.

Yet, regulatory pressure from the FDIC not to let commercial real estate loans exceed 300 percent of the bank's equity has kept most lenders from making new loans. "It's a brick wall," says Dotzour. Uncertainty over the details of financial regulation also makes lenders hesitant. To motivate real estate lending, Dotzour advocates new banking policies that differentiate between levels of risk in commercial properties. "You can't equate the risk of a new retail development with a building that will be leased to doctors to operate their practice," he says.

The Glass Is Half Full

While the New Normal may mean slower growth for several more years, it promises solid, if not soaring, returns for well-managed, conservatively leveraged assets. The dislocations of a slower market also create opportunities, Costello notes. Residential and retail development in urban infill locations offers work at a time when cities are turning to density instead of outward expansion. Well-located big box spaces will need to be leased to the next retail concepts. Poorly positioned ones will need adaptive reuse that is tailored to the needs of the neighborhood. Corporations will seek expert help to keep occupancy costs low to compensate for lower returns.

In the New Normal, "commercial real estate will be the winner on a relative basis because it will provide a much safer investment than the alternatives," concludes Riggs.

Point of Opportunity: Find Creative Ways to Finance

The Situation: Value-oriented retailers are opening stores at a rapid pace, even with the slowdown. Yet, new credit standards requiring 25 to 40 percent down on project costs make it tough for a retailer's chosen developers to finance and build multiple stores at one time.

The Solution: Bring in investor money up front through a structured presale, says Peter Colvin, ccim, national director of single tenant investment for Sperry Van Ness and broker with SVN Silveri Co. in Grand Rapids, Mich. After a builder or developer has found a site and negotiated a lease with a tenant, Colvin brings in cash investors to purchase the land and take over the lease. The original developer gets the contract to build. When the building is completed, usually in about 90 days, the investors start receiving income. The investors also get a better cap rate by purchasing early. Construction adds slightly more risk for investors than buying a finished product, so you need a builder you can trust, says Colvin. Once the transaction is complete, investors can usually refinance the property for up to 70 or 80 percent and get most of their cash back.

Point of Opportunity: Get the Buyer Off the Fence

The Situation: The persistent seller-buyer price disconnect in markets where the average commercial property has lost 20 percent of value makes it challenging for parties to agree on price, according to Real Capital Analytics.

The Solution:  Don't wait for the buyer to make the first offer, says Larry Culbertson, associate broker with KW Commercial in Atlanta. Instead, give the buyer an incentive to move forward by presenting a "reverse proposal" that's economically feasible for both parties. After prequalifying an interested buyer, Culbertson worked with his owner client to prepare a purchase agreement that demonstrated the financial potential of the transaction, including the cost of Small Business Administration financing, a lease-vs.-buy analysis, and reports on maintenance costs and environmental conditions. By demonstrating to the tenant that it could transition from tenant to owner, Culbertson closed the deal in 60 days.

Mariwyn Evans

Mariwyn Evans is a former REALTOR® Magazine writer and editor, covering both residential brokerage and commercial real estate topics.