A CONTRARIAN VIEW?
PAUL DOUGHERTY ON THE
NEW INVESTMENT CLIMATE
Sponsor Update: Perkins+Will is running on all cylinders in Maryland doing the NIH Porter Neuroscience facility and the New Clinical Building at Johns Hopkins Hospital; and in DC finishing up smashing interiors for Holliday Fenoglio Fowler and the NFL Players Association—and just completed the new headquarters for the US Green Building Council.
In this installment of our mid-year commercial real estate forecast series, Bisnow on Business’ Doug Anderson sat down with Perseus Realty Capital and Perseus Realty Partners' President Paul Dougherty to discuss the real estate investment outlook.
- Real estate has seen a strong six year run, driven by equity and debt markets awash in cash. Once viewed as an alternative asset class, it’s now viewed by pension funds as mainstream, like bonds and equities. Following 9-11, and due to lackluster returns in the equity and bond markets, most pension funds significantly increased their exposure to real estate. Some doubled their historical allocations of 4-5%. Among all factors, this has been the major contributor to the frothy market. Mega-private equity funds have been the biggest recipients of pension fund dollars. And Wall Street has been the enabler, coming up with creative debt structures to fund private equity’s insatiable acquisition appetite.
- During this most recent cycle, the DC market has been one of the most desirable and active markets in the country and arguably has received the most attention of any of the domestic markets. Going forward, most pension funds believe domestic markets are fully valued, and are turning their focus to international and emerging markets.
- The question is whether this era of liquidity will end abruptly, or taper off in a slow but inevitable correction. It would be hard to argue against the belief that this six year run is close to an end, as underwriting has begun to tighten and money is becoming more expensive. This is happening due to a confluence of factors, including the recent run-up in Treasuries, combined with stricter debt service coverage tests and higher subornation levels by the rating agencies. Buyers are finding it harder to purchase buildings and leverage them up to high levels. More equity translates into lower returns. And at some point, this will ultimately affect cap rates and values, which is probably long overdue.
- It is safe to say that the era of cap rate compression is over, and the ability to use financial engineering to manufacture returns is nearing an end as well. As a result, it is becoming increasingly difficult for the opportunistic buyer that relies on high leverage to find deals and compete with the all-cash pension fund buyers that can close in three weeks.
- With the impending release of new underwriting standards by Moody’s this month, many lenders have experienced significant difficulties securitizing loans sitting on their books. Coming on the heels of the recent fall-out from the residential sub-prime morass, B note buyers have become very picky, kicking many questionable and aggressively underwritten loans out of pools. Buyers of other classes of bonds have taken a wait-and-see attitude and are sitting on the sidelines. This has caused several lenders to stop quoting deals until the dust settles. While it will take a quarter or two for many of the securitized lenders to move these loans through the system, the psychological damage will last longer.
- The focus going forward will be a flight to quality: More conservatively underwritten loans and pools with more stabilized assets.The ability to underwrite blue sky scenarios of significant increases in future cash flows is now gone, as well as higher-leveraged loans with 10 years of interest-only periods. The next six to 12 months should be very interesting.
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