Peter Pays Paul

CoStar interviewed Hessam Nadji, managing director of research services for Marcus & Millichap Real Estate Investment Services, asking him his thoughts on the current recession.

Here are some of his thoughts on the length of the current recession:

We think job losses and the recession will end in 2009. We’re expecting that job losses will bottom by the third quarter, perhaps into the fourth quarter. For 2010, if you look historically, we’ve had plenty of instances where sharp declines and severe and sudden recessions have been followed by years of growth spike and better-than-average growth — especially the first year after a recession. But this time around, we still have a significant amount of consumer debt to unwind and we’re still dealing with a lot of headwinds in housing and corporate debt. I don’t think 2010 will bring an economic spike.

Nadji acknowledges that retail is going through some issues and may not recover until 2011 or 2012. He ascribes this to a problem of overbuilding in the retail sector.

On Distressed Property

We also need to know how much distressed inventory is going to appear and move through the market. I believe a lot of buyers with lots of cash are sitting on the sidelines looking for signs of an economic bottoming and waiting to see the scale of distressed property sales. Over the next six months, we’re going to get a better reading on the market because both financial institutions and owners of properties are still having stress and they’re going to have to decide what to do with those assets. I think there will be more motivation to sell at more realistic prices than there was a year ago.

…

One or two high-profile deals are not going to refine the market. Its going to take a little more volume, and a sampling of different asset sales in different places starting to trade, for it to become more of a widespread conviction that it’s time to get back in.

Using Cap Rates in Today’s Market

Nadji that cap rates are not as important as they once were in the realm of commercial real estate.

That’s not to say that no one thinks about cap rates anymore — they certainly use it as a metric — but you have to look at return on cash, number one, and using the new underwriting parameters to clear this market for financing, which requires more equity up front and much more realistic rent growth projections and occupancy projections. That would lead you to look at the return on investment for years year one through three in terms of cash flow, which is right now far more important than just a cap rate, which you can come up with in so many different ways.

RTC 2.0?

Nadji doesn’t believe that the current recession and distress in commercial real estate will lead to a second coming of the RTC.

Rather, the forces are working to minimize foreclosures, and therefore this notion of an RTC 2.0 that will bring quality assets to market at huge discounts may not materialize the same way.

He suggests that there are still quality deals available that have cash, can underwrite to today’s rent and occupancy rates, and are seeking to add value to their projects.

Chris Rodriguez of Retail Chatr has written on Determining Market CAP Rates. It details how CAP Rates have fallen during this recession and where they could go.

Now we are in a recession and retail property prices are moving as fast as the stock market. It is almost impossible to accurately pinpoint a property’s value as there is no common motivation from the buyers in the marketplace. One buyer is yanking money out of stocks to buy something more “secure” while another is in a 1031 exchange having sold at a great price and is now watching as his purchasing power increase daily. Not to generalize too much, but yesterdays 5.00% – 5.50% CAP Rate single tenant properties are (or should be) trading between 6.25% – 7.25% CAP Rates, depending on the lease terms, strength of the tenant and location.

Previously, I wrote about The Money on the Sidelines and the vulture funds waiting to strike.

It appears that a vulture fund in the U.K. has made their first purchase according to the Wall Street Journal article Vulture Fund Circles in U.K.

For nearly a year the veteran British property investment team of Raymond Mould and Patrick Vaughan has sat on their vulture fund, waiting for the right moment to pounce on the growing carnage in commercial real estate.

Now their venture, London & Stamford Property Ltd., is making its first move, buying the prime office building at One Fleet Place in the hard-hit City financial district of London for £74 million ($108.6 million). Given their track record for good market timing, the deal could be a watershed event indicating that the steep decline in British prime property is near its bottom.

Timing the Bottom of the Real Estate Market

Investing in a declining market has been compared to catching a falling knife, you want to catch it as close to the bottom as possible.

Most of the vulture funds have been circling, waiting to make sure that their prey was dead. In this case their prey is the commercial property investors that bought in the last few years with ridiculously low cap rates, high leverage, and inflated rents.

As the WSJ.com article points out this may be a risky move, or it may be a brilliant move depending on where prices go in the next few months. If prices continue to fall, the building may be worth even less in a matter of months.

However, if this is the bottom of the U.K. real estate market, their quickness to act may have allowed them to get a quality building at a great price and before others bid up the price.

Thus the analogy of the falling knife. If you act too soon, you may get cut. If you act to late, you have competition from other buyers and the value begins to go up.

Reaching the Bottom

This pattern is likely to be repeated here in the United States. A few brave vulture funds will decide that we have reached bottom and will make an acquisition or two.

One of two things will happen. If the value of these assets falls, the other vulture funds and investors will stay on the sidelines. If the value holds steady, expect to see a feeding frenzy as competition for assets heats up.

Photo: Circling Vultures by AndyRob