As financial institutions are still trying to weather the storm from Subprime Mortgage Crisis, real estate investors should anticipate great challenges in 2008. The instability in the financial markets has had a domino effect in the investment market for commercial real estate assets. It first began with an impact on the lenders which moved right through to buyers and sellers.
While no one can project how long this unsettling period will last, most investors believe that 2008 will see fewer transactions, tighter underwriting guidelines, longer marketing periods, lower property values, and higher overall cap rates. This is quite the reverse of what the industry was experiencing over the past few years during the recent cap rate compression. For buyers and sellers, the main challenge will be coming to terms with the current price correction. It is going to take time for sellers to tolerate the greater risk on the part of buyers and lenders. Lenders are requiring significantly more equity in order to complete purchase transactions and are no longer lending on speculative income. Along the same lines, fewer buyers are eager to acquire assets with a large value-add component to their investments. While buyers welcome the price correction, sellers are typically slower to accept that the market has peaked and that their property values may have diminished. Although some sellers have lowered asking prices on their assets, there are a lot less buyers due to the recent turmoil in the credit markets. A good percentage of the high leveraged buyers that previously dominated the investment arena have now been sidelined. The less affected investors, such as life companies and pension funds, are also hesitant to put capital to work due to the uncertainty surrounding the depth of the correction.
While it is still too early to determine the extent to which property values will correct, corrections should vary between property types and locations. For now, it appears there will be a flight to quality similar to that of traders increasing their investment allocations in Treasury Bonds during a correction in the equity markets. This flight to quality in real estate assets should result in greater investments in stabilized, quality assets that should see the least adjustments in cap rates and sale prices.
The CMBS markets seizing up in August of 2007 played the greatest role in the current, underlying credit crunch. Leveraged investors are no longer able to receive the aggressive debt terms provided to them just a few months ago. This has had a negative affect on the pricing these investors are able to offer for the assets that best fit their investment strategy. Just to elaborate on the significant affect of the decline in the CMBS markets, it is important to note that half of the deals done in the first half of 2007 were financed with CMBS conduit and bridge loans that were liberally originated by Wall Street sources. Since value-added transactions were primarily financed with short-term bridge loans, which are very scarce at this point, prices for value-added deals have been more affected than core, stabilized assets. Tenancy-in-common (“TIC”) syndicates and other 1031-exchange buyers, who were some of the most aggressive bidders, were among the groups of buyers most dependent of CMBS conduit lenders due to their complicated ownership structures. They will probably face the greatest difficulty in obtaining financing and winning deals in the current environment.
The credit crunch shall have a greater impact on some investors than others. The highly leveraged, private equity buyers who were the most active in the first half of 2007 should see the greatest impact from the current credit crunch as lenders are requiring greater amounts of equity to fund acquisitions. In addition, TICs and other 1031-exchange buyers who proliferated rapidly over the past few years and channeled a great amount of capital from low-cap markets to high yielding secondary and tertiary markets shall now face greater hurdles obtaining debt. As a result, institutional and foreign buyers, who are less sensitive to the cost and availability of debt, will look to take advantage of their lower cost of capital and increase their market share of future investments in real estate assets in 2008.
Myers St. George
Investments and Acquisitions
Macon Commercial Office