by Keith Rosenberg, JD MA
The article is a discussion of the state of the US Real Estate Market and how investors should proceed with their investment in Commercial Real Estate.
HafeziCapital is pleased to present the first in a series of newsletters exploring the state of the US real estate market. Approximately once each quarter unless conditions warrant more frequent reports, we will attempt to capture the factors that are impacting the US real estate industry and provide insight into what opportunities are available in that market sector. First we will look at what we believe are the most important economic factors that effect the market. Then we will explore the US real estate market in comparison with other real estate market segments.
The Economy: Is It Better or Isn’t It?
Some of the news is good. Some of the news is not so good. The good news about the US real estate market is that all of the news is not bad and certainly not as bad as it has been. Employment is showing signs of improvement. The unemployment rate declined in December 2011 to 8.5%; 13.1 million unemployed. Long-term unemployment (unemployed for 27 weeks or more) stood at 5.6%. The economy saw an up tick in employment in retail; health care; leisure and hospitality; and a modest gain in manufacturing jobs. The trend continued in January with the unemployment rate dropping to 8.3% with strong jobs growth in manufacturing, construction, hospitality and health care.
The good employment news is offset by the not so good news. Unemployment among African American and Hispanics continues to be high. The unemployment numbers do not count those who are no longer eligible to collect unemployment benefits or are no longer actively seeking employment. If you count those individuals the number of unemployed may be has high as 20 million. The types of jobs that are being created pay lower wages. January unemployment numbers could be significant if seasonal workers leave the workforce. There is no indication that there will be a significant drop in unemployment in 2012.
Inflation is relatively flat at 3.0% for 2011 and consumer confidence was up slightly in December 2011 to 64.5. Consumer spending for the third quarter 2011 was adjusted to 2.0% of GDP; overall it is 3.5% of GDP for 2011 subject to adjustment. The Commerce Department reported on January 27, 2012 that the economy expanded by an annualized rate of 2.8% in 2011 still below the average annual growth rate since the end of World War II.
The National Federation of Retailers (NFR) is looking for a drop in retail sales in 2012. Residential foreclosures have slowed, but we caution that the rate may pick up in 2012. There were 1.9 million homes that entered the foreclosure process in 2011 a drop of 34% over 2010. This is below the peak in 2010. The lower and slower rate may be the result of the “documentation” problems that stopped many foreclosures in 2011. The resolution of the foreclosure “paperwork” problems in 2012 may cause the foreclosure rate to spike.
“Foreclosures were in full delay mode in 2011, resulting in a dramatic drop in foreclosure activity for the year,” said Brandon Moore, chief executive officer of RealtyTrac. “The lack of clarity regarding many of the documentation and legal issues plaguing the foreclosure industry means that we are continuing to see a highly dysfunctional foreclosure process that is inefficiently dealing with delinquent mortgages — particularly in states with a judicial foreclosure process.”
“There were strong signs in the second half of 2011 that lenders are finally beginning to push through some of the delayed foreclosures in select local markets. We expect that trend to continue this year, boosting foreclosure activity for 2012 higher than it was in 2011, though still below the peak of 2010.”
The recent settlement reached between government and lenders over foreclosure practices, i.e., “robo-signing” paves the way for the foreclosures previously on hold to pick up. The business community is uncertain about the future of the economy. Although many large businesses have seen high profits and are sitting on cash, they (and financial institutions) are reluctant to invest. There is concern over where the economy is going: the European debt crisis is far from resolved; there is the presidential election;; and the impact of the health care reform are just a few of the issues that business is confronting. Small businesses are finding it difficult to borrow; and small businesses are the backbone of the U.S economy.
To summarize, we need to be leery of the improvement in the employment numbers clearly employment is not robust. Consumer spending is sluggish; the European debt crisis is unresolved; foreclosures may be on the rise and there is uncertainty about the economy’s future that is stifling investment and the ability to borrow.
The US Real Estate Market: Good or Bad Investment?
We have reviewed the overall US real estate market and have reached some important conclusions. Some of the sectors will be strong; some weak. However, there are opportunities where rates of return will be significant. The most valuable opportunities are apartments, downtown office buildings in 24-hour cities; warehouses that produce cash flow; full service hotels in major markets; limited service hotels (without food and beverages); and community retail centers in stable areas. Regional malls and suburban office space are the least favorable investments. There was only one sale of a large regional mall in the United States in 2011. King of Prussia Mall outside of Philadelphia was the only sale of a mall in excess of $500 million last year.
Owners continue to recalculate return on real estate investments in the single digits. The average cap rate for community centers is 7.4%, which substantially mirrors the entire retail/commercial industry. Rents have probably not bottomed out and range from an average of $13.21 p/s/f in Atlanta (which is a very depressed retail market) to $26.75 p/s/f in more stable areas such as San Francisco. The vacancy rate for retail community centers, 12.9% in 2011 is not expected to go down significantly in 2012. The growth rate of -0.2% in community centers is expected to go into positive territory, 0.7% in 2012.
A Jones Lang LaSalle study shows that rents are stabilizing and the markets are bottoming out in Palm Beach, San Diego, Ft. Lauderdale, Chicago, San Francisco, Los Angeles, Miami and New York City. However, recent information suggests that rent rates rose but modestly in 2011, less than 2.0% above 2010. Rents remain at about where they were in 2007. Landlords expect that 5 year leases coming up for renewal in 2012 will be at the same rental rate or slightly higher than in 2007. This will put a strain on positive cash flow and payment of debt service. Lenders actively addressed the distressed pool of real estate assets in 2011. Banks/Lenders worked out 50% of their non-performing and underperforming loans. In the third quarter 2011, 6% of all retail sales were distressed properties. Notwithstanding those numbers $28.7 billion of distressed properties remain unresolved.
In 2012, we see a commercial real estate (CRE) debt issue that is far from over. According to Deloitte & Touche, $1.7 trillion of CRE debt will come due between now and 2015. Sixty percent of that debt is already underwater. This has occurred because the properties were over-leveraged; the rents were too high and could not be negotiated downward without ruining cash low; and tenants voluntarily or involuntarily vacated. The result is not enough cash flow to carry debt. For example see “New debt concerns torment Washington Real Estate” The Washington Post Capitol Business, February 5, 2012.
We see the market for under-performing and non-performing loans continuing to be strong in 2012. However, the real “bargains” may be harder to find. Banks/Lenders once eager to take deep discounts on loans, have become more reluctant to do so recently. There is also value in REO. All cash purchases with subsequent rent restructuring can be attractive investment vehicles.
For more information about real estate investment opportunities through HafeziCapital, please contact Babak Hafezi or Keith Rosenberg at (703) 752-0200.
The information contained in this newsletter is the property of HafeziCapital, which is solely responsible for its content. The information should not be relied upon to make any decision to invest in real estate. Any investment decision should be based upon evaluating the risks of a specific investment and in consultation with the investor’s professional advisors.
This post is written by Keith Rosenberg, JD who works as a Chief Operating Officer at Hafezi Capital. Mr. Keith Rosenberg turned his attention to business where he successfully guided two companies from 1998 to 2005. In 2005, he became a full time consultant to start ups and small and medium sized businesses specializing in business strategies, organization, acquiring capital and operations.