U.S. commercial real estate generating momentum for long-term recovery: Deloitte

Following sharp declines and painful deleveraging in the wake of financial and economic turmoil, commercial real estate (CRE) in the United States is showing signs that the deterioration of industry transactions and fundamentals has started to plateau, and early stages of recovery may be imminent, according to Deloitte’s “Commercial Real Estate Outlook: Top 10 Issues in 2011 – Generating Momentum for Recovery.”

“Uncertainty is the most significant issue for commercial real estate in the post-recession environment, as market participants – owners and operators, lenders, investors, developers, and tenants – look for a signal that economic and industry fundamentals have hit bottom and started a sustainable recovery,” said Bob O’Brien, vice chairman and real estate sector leader, Deloitte LLP.  “While this signal remains elusive, positive developments like increased deal flow, improved real estate capital markets, stabilizing office, apartment, industrial and hotel fundamentals, and the REIT rebound offer hopeful signs of recovery.”

The report reveals the following Top 10 issues facing CRE today:

  1. Prevailing uncertainty as downturn defies expectations.  The current cycle is not following historic tendencies because it was fueled more by overleveraging than overbuilding, creating a unique dynamic involving flexible lenders, stubborn owners, and expectant investors.  CRE fundamentals and capital markets metrics indicate that the worst may be over, with sharp declines showing signs of leveling off.
  2. Impact of “amend and extend.”  This downturn has been characterized by a new willingness by banks to extend the terms of loans unlikely to return full value on principal and interest accrued, which could help keep delinquencies and defaults in check until the economy recovers.  However, it also puts a floor under the market, making it difficult to know when the bottom has been reached.
  3. High maturities remain a challenge.  The high level of maturing debt over the next several years remains a significant barrier to recovery.  In addition to commercial mortgage-backed securities (CMBS), loan delinquencies and CRE loan defaults, there is also an increase in strategic defaults as more CRE borrowers make a pragmatic business decision to exit profit-draining investments in order to divert funds to performing projects or shareholders.
  4. Transactions reviving modestly, driven by distress.  Transactions have emerged as a bright spot with year-over-year improvement in both the number and value of transactions driven by public investors and foreign investors.  While distressed opportunities have spurred deals, they have also resulted in wide bid/ask spreads – a significant barrier to the resumption of robust deal flow.
  5. Trajectory of economic fundamentals remains uncertain.  Modest gross domestic product (GDP) growth, combined with subdued consumer spending, volatile employment and weak performance of the housing sector indicates a robust short term recovery is unlikely.  While the economy does not appear to be an imminent threat to the CRE market, it appears that it won’t be a potent catalyst either.
  6. CRE fundamentals moderating, but recovery may be slow.  There are early signs of improvement in fundamentals such as occupancy and rental rates in certain property types and geographies, and indications that declines in pricing, occupancy, and rent growth in other property types and geographies are moderating in advance of a rebound. However, prospects for a majority of indicators reflect low and slow growth.
    • Office fundamentals have deteriorated significantly over the past two years with the economic downturn and high unemployment, but there are some signs that a slow recovery may begin as early as 2011.
    • The retail space continues to face substantial demand-side challenges, namely a decline in retail sales following high unemployment, low consumer confidence levels, and reduced discretionary spending.
    • The apartment sector is benefiting from a modest increase in demand complemented by low supply, as tight underwriting standards continue to favor renting and impact home-buying decisions.  
    • The industrial sector is experiencing a modest increase in leasing activity across many markets as manufacturers replenish depleted inventory levels in line with demand.
    • Demand for lodging continues to recover due to improved business and leisure travel.  
  7. REIT rebound continues.  The recent real estate investment trust (REIT) rally has been driven, in part, by investors’ realization that REITs took on far less debt and have generally done an impressive job positioning their balance sheets to take advantage of developing CRE opportunities. REITs have outperformed competing asset classes recently, making the category more attractive to investors looking for a way to invest in any potential rebound in CRE and for a hedge against stock market volatility.
  8. Capital Markets – New lending stabilizing, but remains subdued.  The stabilization of bank lending and the renewal of CMBS are critical developments for the industry, but the modest level of issuance will do little to help many CRE borrowers obtain needed financing, and issuance is expected to be focused primarily on high-quality, stabilized assets. Deleveraging continues, and despite the potential emergence of alternatives such as covered bonds and seller financing, new CRE debt origination is expected to remain subdued until the high level of maturities is reduced to a more sustainable level.
  9. Regulations directly and indirectly impact CRE. Recently enacted healthcare legislation will likely provide a boost to commercial real estate demand, but financial regulations could make it more challenging for commercial real estate firms to access necessary capital in both the near and longer terms.
  10. Positive signs for global CRE.  Foreign acquisitions are a key component to recovery for the U.S. CRE market, which will benefit from pent – up demand from foreign investors seeking to diversify. As the global market begins to recover, the Asia Pacific region is expected to be a catalyst for growth, both as a destination and a source of investment into the U.S. market, while more traditional investors from Australia and Germany reduced allocations due to trouble in their home markets.
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