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I feel that it is my duty to write something about the changing Commercial Real estate market. During my real estate career, I have seen far too many people make their real estate decisions based upon poor information resulting in tremendous reversals of fortunes, foreclosures and, sadly, even suicide. On reading this, some may accuse me of being negative. I assure you that I am very optimistic about the long term prospect of this market. Reality and self assessment should not be perceived as negative regardless of the determination. Fortunes are made in markets like these where market inefficiencies create arbitrage and present opportunities that informed investors thrive on.

Before looking at the present and into the future, it is necessary to look back and recap the last cycle starting about eight years ago at the turn of the century. At the beginning of the 21st century, the market was expanding, a republican white house was limiting capital gains taxes, and the dot com bubble created a tight and opportunistic real estate market where the monthly surge of new startup companies provided a strong in flow of tenants and occupiers for real estate. Prior to 9/11, the writing was on the wall and the Dot Com bubble began to deflate due to over-speculation and inflated asset values (sound familiar). However with the terrorist attacks on 9/11, widespread fear expedited the correction process and equity investors began to lose millions in the stock market overnight. We entered a recessionary period and contracting users pushed vacancies up and the real estate market began to cool off in addition to the stock market. It should be noted that diminishing returns in the stock market did present real estate as an attractive alternative asset class. Many thought the real estate market had peaked and the ripple effects of 9/11 would keep asset values down for years to come.

In order to stimulate the economy, the feds dropped interest rates and the cost of borrowing eventually reached a 30 year low. Buyers could afford more real estate and the emergence of leveraging tools allowed them to play in bigger arenas than they previously would have been able. Aggressive lending, cheap costs of capital and a recovering economy signaled the start of a speculative real estate climate that began in the years following 9/11. In 2002, real estate values started to increase as higher leverage and the ability to achieve higher returns with less equity emerged as well as the beginning of compressing cap rates. While rents did increase, the appreciation that began was more a result of cap rates (immediate return requirements) decreasing as investors were willing to take lower immediate returns to obtain South Florida investment product. As a bench mark, in 2002, warehouses in Miami were selling for an average price of $41 PSF. By 2007, the average warehouse sold for $86 PSF. Going into 2003 real estate investment began to receive national attention as newspapers and media outlets wrote front page stories about high rise apartment buildings, condominium conversions, and office towers in sexy locales like Miami, and Las Vegas. Real Estate took the stock market’s place as a “sexy” asset class and attracted massive amounts of capital. With the attention came the previous cycles day traders and novices who made money speculating by flipping condos, converting mid-rise buildings and developing products despite little experience or knowledge of real estate concepts and fundamentals. This emergence of brokers, appraisers, banks, builders, and the media’s attention to this boom helped feed the fire of what would became the beginning of a new asset bubble. Only a short period since the panic of 9/11, real estate began to appreciate at a double digit yearly clip as flippers, converters, novices and institutional capital flooded the market competing for product creating a historical bull market. This rang true especially for markets like Miami and Las Vegas where the inexpensive yet high quality of life became more evident on a national level.

In 2005, Hurricane Katrina swept through Florida and affected the market in the long term by causing a massive increase in insurance premiums. The result was higher operating expenses for landlords, NNN lease structures for tenants exposing them to higher leasing risk, and a flurry of activity from investors who began to see risk that had been hidden during a relatively dormant storm period. Regardless, the market remained hot and cap rate compression continued as cap rates began to hove only slightly above the treasury and risk free rates resulting in an inefficient risk / reward scale. Trouble became apparent in 2006 when the residential market started to show signs of faltering. Fundamental flaws became evident as investors realized that the market was not immune to value corrections and perhaps they had been riding the same wave their neighbor had. Issues in the housing market helped demonstrate what could possible exist in the commercial market mainly: supply and demand issues, inflated asset values, and bad loans on a massive scale. The result was a shakeup of the capital markets as banks, and secondary markets collapsed under the weight of non-performing loans or loans that would soon be in default. As borrowers started to falter, the institutions who were desperate to place money in this new investment vehicle started to loose money. The result of the summer 2007 fallout was that the money supply tightened up and the inability to obtain financing created a smaller buyer pool. This resulted in lower competition for product and therefore lower pricing. The same media that boasted of a hot market and helped create the boom pounced on the emerging bad news signaling a downward spiral to the residential housing market. At this point, home values in Miami have declined about 30%.

How does this affect the commercial market (office, industrial, retail)?
As a result of the lack of residential building, ancillary traders, financiers, real estate service firms, brokers and builders overnight were collapsing and vacating the office and industrial space they previously occupied during the prior five year boom. In Miami-Dade County, 16.7% of all office users were tied to the real estate or mortgage industries. A contracting economy led by the residential crisis hurt consumer confidence and lower spend-able income resulted in lower retail sales which also effected retailers and retail landlords. Cap rates began to increase as increasing financing spreads created higher costs of capital and properties would not underwrite correctly at the previously compressed cap rates. The combination of increased vacancies and increased insurance (resulting in lower operating revenue) and increasing cap rates has resulted in asset value declines of up to 30% in some instances off of 2007’s peak values. Additionally, real estate has moved away from the homogenous and commoditized asset it had become during the flipper times and cap rates and asset values became fractures across property classes, property types and locations.

What can we expect?
Market uncertainty, an upcoming election, and a “wait on the sideline” mentality has created a stagnant environment as businesses are contracting, making few moves and consumers confidence has reached all time lows as inflation, the costs of fuel and job security are all hot topics. The result of contracting business strategy is increasing vacancy. We predict that vacancy rates will continue to increase across all product types for slightly different reasons.

In the office market, even though we do project employment growth, there will be 4M SF of new properties added to the market by 2010. This is a far cry from the oversupply of past cycles, but will affect vacancy and rental rate growth in the sluggish economy as landlords compete for tenants. We believe that this will take vacancy rates into the 15% range and in effect lower rental rates.

In the industrial market, we believe that fundamentals will fair better due to the lack of industrial development because of increasing land and construction costs and constraints creating tight market conditions. Additionally, the expansion of the Panama Canal and the rising fuel prices will likely result in demand for port proximity product like Miami’s industrial market. The contracting economy could bring vacancy rates close to 10% before leveling out and economic expansion creates tight conditions again. Rental rates could decrease by as much as $1 PSF by 2009 in the bulk distribution spaces as the large tenant in an already small tenant market is sought out and aggressively competed for.

Retailers have also backed off of their expansion plans as demographic inflow has slowed (and in some instances been outflow). Mixed use residential projects with ground floor retail components will likely be in trouble as the attempt to centralize Miami will likely take longer than previously anticipated.

We believe that by next year values will decline to their 2004 / 2005 levels – a drop off of 30% from the 2007 peak (still a large increase from 2002 prices). This is largely due to the repricing of risk and the resultant increase in Cap Rates. The cap rate is, in simple terms, is the risk free rate plus the return premiums demanded for taking on real estate risks like liquidity risk, financing risk, location risk, etc… The spread above the risk free rate has recently been so low that investors were not demanding an immediate additional return for taking on these very real risks. Yearly cash flows were not the reason for double digit IRR returns, but investors were dependent on the sell out or reversion to realize the double digit returns they sought. With the market change came a change in the spread demanded and higher cap rate pricing. Additionally with future uncertainty, cash flow has become extremely important once again.

A cap rate determines the value of an investment by dividing the rate into the Net Income. EG: $100,000 income/10% = $1m. If the cap rate goes down then the value goes up. We believe that cap rates will go up, income will go down resulting in a double “whammy” effect that will push asset values down faster than a minor correction.

The problem I see is that investors are making decisions based upon poor information. Many properties are being brought to market with unachievable pricing expectations. If a seller is in a position of needing to sell then misleading him will do him great harm. Buyers are trying to purchase properties that they cannot finance. Tenants are being advised to sign long term leases to lock in rental rates.

What should you do?
If you are a buyer – the next 12 months will be an excellent time to purchase. As they teach you in business school, market timers almost always get hurt. That does not mean not to be conscious of timing general movement, but waiting for the exact bottom usually results in losing money. Many advisors tell stock buyers to buy through the bottom as opposed to trying to time the exact moment. If one can buy property today at $65 / SF and it goes down to $60 / SF before going up again that is okay. If you can underwrite the cash flows and a deal makes sense than it will still make sense even if the implied value is less in the short term. The moral is: underwrite conservatively, but participate in the game as times are opportunistic.

If you are a seller – sell today at a realistic price because next year will be worse OR plan on holding for at least 5 years while we break out of this cycle and revenues increase or cap rate movement trends downwards leading to appreciating values once again.

If you are a tenant – negotiate with your landlord. They may not know it yet but it is a tenants market.

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