COVER STORY, MARCH 2009

PROPERTY VALUATIONS ARE BECOMING MORE VALUABLE
By Joseph D. Pasquarella

Pasquarella

What a difference a year makes. It is abundantly clear that the commercial real estate party is over and more sober times are ahead. The frothy debt markets of the recent past, which resulted in too much money made available at too low a cost, produced real estate price surges unrelated to the underlying economics of property. The pendulum has now swung in the opposite direction with debt capital significantly more constrained and disciplined, but the basic principles of investment, development and valuation have not changed.  

Much has been written recently about the dearth of debt capital, wide spreads and pricing risk. However, gross generalizations of commercial real estate as an investment class, to include market conditions such as spikes in cap rates and falling prices, are,  not justified in many instances. Properties vary from type to type, from class to class and from submarket to submarket. To make broad suppositions or characterizations of real estate in general is wrought with error. Even more challenging are the  mistaken comparisons between the current state of the real estate sector and the 1990 to 1991 real estate market.  Current valuation studies are not finding this to be the case.

In 1990 to 1991, the profile of the commercial real estate market was entirely different than it is today.  First, the market was extremely overbuilt, with new inventories coming to market in the face of a recessionary economy. This is very different than what we face today. Owing largely to more disciplined market participants and tighter valuation standards and bank guidelines, the current situation is not a crisis of overbuilding, but one related to sharp declines in demand drivers and lack of confidence in a financial system that has significantly cut off lending, the drivetrain of real estate investment.

Nonetheless, there are pockets that remain sound. Philadelphia, for example, has a central business district (CBD) office vacancy rate of less than 10 percent, even in the wake of the 57-story, 1.2 million-square-foot Comcast building completion. With minimal new construction, the market is not at risk of being overbuilt for at least a 2-year timeline. The CBD apartment vacancy is less than 5 percent, and rents continue to grow in spite of the shadow cast by the significant amount of condos that are filtering into the rental market now that residential sales have all but completely stalled. While some ever-increasing turbulent seas remain for retail, the regional fundamentals are just as strong as other markets around the country. To the experienced captain, rough seas are no reason to stop sailing. The scarcity of land in Northeast cities and high construction costs bode well for real estate investments over the long run throughout the Northeast. 

Markets such as New York will likely feel the fall out of the financial sector more so than Philadelphia, which lost most of its money center banks in the 1990s. Today, the Philadelphia area has a strong presence in the field of healthcare, pharmaceuticals, biotechnology, oil and chemicals, telecommunications, computer technology and food manufacturing. The presence of leading educational institutions in the area has also made Philadelphia a top communications and technology center. The education and healthcare sectors, which are largely recession proof, are the leading employment sectors in both size and growth in Greater Philadelphia. The presence of numerous surrounding colleges and universities has also aided the city’s development into one of the top life sciences centers in the nation along with Boston and San Francisco.

These market indicators point to much opportunity for investment by traditional real estate investors who are committed to viewing this asset class as a long-term investment vehicle. There are just as many opportunities investing in down markets as in bull markets. In fact, well-capitalized, “all cash” real estate investors and developers perceive the current market as one with better opportunities for more profitable real estate investments compared to the past 2 years when the market was cluttered with unsophisticated, high-leveraged newcomers. The novices saw real estate as a short-term flipping game or a means to generate fee income, rather than investing with a longer term perspective or a value-add strategic plan.

In hindsight, it appears abundantly clear the market over the last few years had become overheated by these non-traditional real estate players at the expense of those who view real estate for exactly what it is -— a long-to-intermediate capital investment made in real property for a specific holding period, usually 5 to 10 years, or for development opportunities presented by a property that is underperforming or to be developed from the ground up. Either way, there is a discrete investment purpose and strategy behind the acquisition besides getting into the game by borrowing 90 to 110 percent of cost where the loan amount is largely driven by artificially engineered low interest rate loans at low debt coverage ratios.

While the capital markets landscape has changed markedly, opportunities for traditional, well-heeled, sophisticated investors, particularly all-cash or low-leveraged buyers with access to traditional lending sources, very much exist today. During the next 2 years, we anticipate re-pricing of real estate towards mean cap rates of the past 30 year period or so. Once economic fundamentals stabilize, and transactions from the all cash sector begin to occur, more leverage will be infused into the market permitting more investors to participate. As more investors enter the marketplace, stability will return. 

While REITs’ share prices have adjusted downward, the potential for future growth is excellent, given the less cluttered field of buyers and deals that make more economic sense. Look for a return to traditional mortgage capital based on more rigorous and comprehensive underwriting and valuations. The future remains bright for real estate investment activity to be made by strong real estate investment firms with access to good market reconnaissance and with strong track records in the field.

Joseph D. Pasquarella, MAI, CRE, FRICS, is the managing director of Integra Realty Resources - Philadelphia

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