2011 – 3rd Quarter Update
Greetings,The commercial real estate industry was not immune to the bumpy economic ride experienced by the US in the 3rd Quarter of 2011, primarily due to the European debt concerns and several missteps by the credit rating agencies.
S&P abruptly and mistakenly withdrew its rating on the $1.5B CMBS offering of Goldman Sachs and Citigroup in early August. Later in the quarter, this securitization and several others went off without a hitch, albeit at higher spreads. S&P also downgraded US debt due to the debt ceiling debacle, which caused equity markets to deteriorate and bond markets to soar. Ten-year bond yields approached 1.5%, however CMBS lenders temporarily took themselves out of the market by increasing spreads beyond what the market would bear. More recently, ten-year treasuries yields have increased to over 2.25% and CMBS spreads have narrowed. Even with the turbulent market conditions, real interest rates on 10-year commercial mortgages hovered around 6%, plus or minus 50 basis points. More recently, CMBS lenders started adding “flex language” to term sheets, which allows lenders to change spreads prior to closing, if major market swings occur.
Due to the turmoil in the public markets, commercial banks and life companies are increasingly capturing market share, as evidenced by the very competitive non-recourse, fixed rate, long-term loans we received on our recent acquisitions. (5%, 25-year amortization, 7-year term, 65% LTV). Larger life companies are also offering interest only, 10-year commercial mortgages below 5%. With the issues in the CMBS markets, properties with attractive, assumable fixed rate loans are trading at a premium.
As it relates to predicting interest rates in the future, experts agree to disagree. According to the Economic Outlook of CBRE, the Nation’s largest full service commercial real estate firm, the consensus among investors is that interest rates will stay at or near current levels through 2012. However, according to Moody’s Economy.com, 10-year treasury yields are projected to reach 5.2% by the end of 2012. While experts disagree, what is clear is that when treasury yields increase; general economic certainty and predictability have also likely increased. Investors leave the security of treasuries to pursue riskier investments and swaps yields on CMBS mortgages narrow as risk of defaults decrease. Additionally, as macroeconomic stability and predictability increase, lenders also increase their loan to value ratios, lower debt coverage ratio requirements and lengthen amortization schedules. CBRE correctly states that there is not necessarily a direct correlation between increasing treasury yields and increased borrowing costs on commercial real estate. Certainly this summer we did not see any correlation as treasury yields fell and borrowing costs actually increased.
Similarly, CBRE does not see a direct correlation between rising treasury yields and cap rate increases. “Spreads between the ten-year treasury and cap rates are not constant over time. The variation in the spread is a function of investor interest in the sector relative to other asset classes and their overall perception of risk”, states CBRE’s economist.
According to CBRE, “core assets in top tier markets are currently priced to perfection and institutional investors are now searching for and closing on value-add properties in top tier cities and core assets in secondary markets, both at below replacement costs. Additional cap rate compression will be seen in the next tier markets.” While we predicted this scenario at the end of last year, we now have empirical evidence of its occurrence. CalPers, the world’s largest pension fund, through their retail real estate advisor, Miller Capital Advisory, purchased Midtowne Plaza, a relatively small upscale center for $32M in Little Rock, AR, DRA Advisors, LLC recently purchased out of foreclosure, The Promenade Shops at Centerra, a 700,000 square foot lifestyle center in Loveland, CO and North American Development Group purchased Caruth Plaza, a value-add play in Dallas, TX.
We believe that this trend will continue as private and institutional real estate investors become increasingly impatient with yields on large un-deployed cash reserves and retail markets continue to be supplied constrained as retailers continue to expand and developers are unwilling/unable to break ground on new projects.
CBRE’s director of acquisition states that “a lot of great buying opportunities occurred in 2009 and 2010, but excellent opportunities still exist, given the gradual improvement in real estate fundamentals. Since the day of reckoning for a large percentage of distressed assets has been pushed out several years due to TARP, a steady supply of distressed assets will ensure nimble, hands-on investor’s pipelines are full for years to come.”
Retailers survived the credit crunch in late 2008 and early 2009 by slashing inventories. With tighter inventory management, expanding retailers opening new stores were able to shrink their footprint and maintain a majority of their revenue. The benefit of Morris Capital Partners is we are able to find creative solutions to reposition this older retail space originally developed for a larger footprint environment.
A classic example showing our ability to not only locate, but reposition these assets is attached. (See Bradford Plaza-Results at Work Case Study) In summary, we were able to identify an available asset in Stillwater, OK, a very supply constrained retail market. At the time, the 98,000 square foot, well located, grocery anchored center was only 50% leased due to the 2007 bankruptcy of its lead tenant, Goody’s. Additionally, one of the remaining anchor tenants, Old Navy, while profitable, desired to downsize. We were successful in downsizing, relocating and renewing Old Navy, backfilling the former Old Navy space with TJ Maxx and leasing the former Goody’s space to Jo-Ann’s and ULTA Cosmetics. In less than one year, we were able to purchase and reposition this distressed asset into a potential core institutional investment.
Most retailers continue to increase their top and bottom line, are accelerating hiring and are optimistic about the near-term future. According to the US Census Bureau, retail and food services sales for September increased 1.1% from the previous month and increased 7.9% from the same period a year ago. Excluding the auto sector, sales rose .6% from August. Apparel sales rose 1.3%, the largest increase in seven months and sales of home furnishing were also strong, up 1.1%.
A report released last Tuesday by Krono’s Retail Labor Index, hiring levels reached the highest mark in the retail industry in nearly three years. A report released last Wednesday by GE Capital found that 58% of retail CFOs believes their revenues will increase in 2011. Also, 43% expect to increase capital expenditures in 2011, up from only 38% who expected to increase capital expenditures in the first quarter.
Benefits Opportunities Solutions
Results at Work: Bradford Plaza, Stillwater, OK In late 2010, Morris Capital Partners identified an opportunity in Stillwater, Oklahoma, a very supply constrained market. The property was in receivership and was being marketed by Cushman & Wakefield. Due to our longstanding relationship with not only the broker, but the receiver, we were able to win a competitive bid process with 15 competitors by using our strong equity relationship to go firm in 2 days and be in a position to close within 5 days.
Benefits were identified quickly as follows:
- Supply constrained market
- Strong retailer sales and health ratios
- Acquisition costs significantly below replacement costs
- Retailer void analysis identified numerous tenant prospects
- Strong community support
Opportunities were also assessed as follows:
- Large anchor vacancies
- Several tenants paying alternative minimum rent due to co-tenancy violations
- Several tenant’s leases had expired and were on month-to-month leases.
- Old Navy wanted to downsize
Solutions were effectively implemented using CAR as follows:
- Convert existing leases with Old Navy, Hibbett’s and Cato from alternative minimum rent to base rent.
- Add new tenants identified from the preliminary void analysis including Tj Maxx, Jo-Ann’s Crafts and Fabrics and ULTA Cosmetics.
- Relocate existing tenants, like Old Navy and Party Galaxy to more appropriate locations allowing space for new tenants.