Thursday, February 21, 2008

Commercial Perspective -- 2008 Real Estate Investment Outlook

Los Angeles Freeways at Night, California

Cap rates that are coming down to earth and a market where cash is king are two highlights of Deutsche Bank Group's "2008 U.S. Real Estate Investment Outlook and Market Perspective". A few key points:

"Overview: During the past few months, most properties traded were at pricing and terms 5% to 10% below those achieved during the first half of 2007....We believe that pricing has adjusted sufficiently that core real estate, purchased in early 2008, can achieve attractive unleveraged annual returns of between 7.5% and 8.0%."

"Effective cap rates increased about 25 to 50 basis points over the past six months as property values decreased."

"The Property Markets: Primary consideration should be given to those metropolitan areas where economic growth should be strongest. The strongest markets have high exposure to international financial and professional services, defense, trade, medical and high-tech industries. Such 'Globally-Linked' markets should achieve particularly strong economic growth...They include... Los Angeles."

"Apartments: Supply constrained markets with low housing affordability will continue to outperform affordable markets, such as ... Los Angeles. In fact, we expect a widening bifurcation in performance between supply constrained and most low barrier-to-entry markets."

"Apartment Transaction Market: The weighted average cap rate was a low 6.13% compared to 6.08% last year. Cap rates in the top tier markets are holding firm, while some decompression is occurring for lesser quality assets in secondary markets."

"Industrial Properties. Gateway markets continue to be the most resilient to the economic slow down with foreign trade and high tech as the key drivers for the sector. Major land-constrained port markets, such as Southern California ... will continue to outperform."

"Industrial Property Transaction Market: Although the first three quarters [of 2007] had been particularly strong, turmoil in the credit markets interrupted potential deals and caused transaction volume to tumble. A flight to quality and fewer deals has allowed average cap rates for warehouse and flex properties to remain low, but a pricing correction is becoming apparent as the risk premium (spread between cap rates and treasuries) is widening for both warehouse and flex properties."

"Implications for Investors: With repricing well under way, opportunities are beginning to emerge for acquisitions ... Given our longer-term positive outlook for real estate fundamentals, acquisitions utilizing realistic assumptions should be attractive. Some sellers are highly motivated, and the pool of buyers is currently thin."

The overheated commercial market of 2006 and 2007 is a distant memory in the new paradigm where traditional metrics such as cap rates and cash-on-cash return determine value. Savvy investors are in a prime position to reap leveraged returns of 12% to 17% in value-added plays. Given the recent turmoil in the credit markets, cash-rich investors will be well-suited to buy good properties at excellent prices, as desperate sellers unload product that had been stagnating on the market.