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September 2, 2010 |
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| November 05, 2007 |
By: Paola Iuspa-Abbott |
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he crumbling housing market, fueled in part by defaulted loans, is having a ripple effect on commercial real estate in South Florida. Lenders are demanding more cash at closings and expecting healthy cash flow on commercial properties, leaving it to deep-pocket pension funds, hedge funds and institutional investors to seal most of the big deals.
Leverage is out, and “cash is king,” said Michael Stein, managing director of Miami-based Aztec Group, which finances and brokers real estate and financial transactions.
Gone are the days when investors would use bridge loans and interest-only 10-year loans for their office, warehouse and shopping center purchases with little money down.
Lenders now want 25 percent to 35 percent equity to finance a deal, brokers say.
The Wall Street credit squeeze that set in over the summer isn’t helping.
New York-based Carlton Advisory Services in September projected U.S. commercial real estate prices may fall as much as 15 percent over the next year. It would be the broadest decline since the 2001 recession as rising borrowing costs force owners to accept less or delay sales. Company data indicate investors in July bought the fewest commercial properties since August 2006.
The demand for cash, compounded by higher borrowing costs, has priced most local investors out of the market, said Miami-based Capital Commercial Group principal Ernesto Casal. He brokered the $38.25 million sale of the 27-acre Doral site of a former Incredible Universe retail property.
Commercial real estate defaults are a scant 0.5 percent of the sector compared with 25 percent in the subprime residential mortgage market, said Holliday Fenoglio Fowler executive managing director Manny de Zarraga.
But lenders are being cautious in financing all deals, said de Zarraga, who brokered the reported $200 million sale of the Phillips Point office complex in downtown West Palm Beach, one of the biggest deals of the past year.
With the housing recession dragging down the South Florida economy, commercial real estate still has its luster. The region, bounded by the Atlantic Ocean to the east and by the Everglades to the west, has limited potential for future development. That, in turn, puts upward pressure on rental prices for office and industrial space.
“The good news is the market fundamentals are still good,” CB Richard Ellis broker Paul Cohen said. In South Florida, it continues to be cheaper to buy a property than build.
REIT stocks in freefall
But not all is well for commercial real estate investors.
Real estate investment trust shares are expected to plummet about 20 percent in the next year, according to University of California economist Kenneth Rosen. He told Bloomberg News REIT stocks are overvalued by 25 percent to 40 percent relative to stocks and bonds.
The Bloomberg REIT index returned 78 percent with dividends in the two years before it peaked Feb. 8 and has dropped to 16.5 percent since then. The freefall came as commercial mortgage rates climbed as much as 2 percentage points above the 10-year Treasury note. The last time Bloomberg’s REIT index declined more than 10 percent in total return was in 1998 when investors switched their attention to Internet stocks.
Warehouse and industrial REITs are performing the best, climbing 11.5 percent this year as imports of raw materials and consumer products increased. Apartment REITs decreased 13 percent, and office stocks declined 12 percent.
But commercial sales in the first half of the year were up 41 percent from the first half of 2006, according to CBRE. Sales of office, retail, industrial and multifamily properties reached $181 billion in the first half of the year, boosted by the $39 billion sale of Equity Office Properties Trust to the private equity firm Blackstone Group in February.
Lagging behind in sales are apartment buildings, which traded at a premium during the condo conversion rage in 2004 and 2005.
Brokers and lenders say the market isn’t distressed, but that could change if owners are unable to pay off mezzanine loans coming due shortly.
Interest on mezzanine loans is considerably higher than senior debt, and compound interest is a large part of the repayable principal. Owners who are nervous about selling are holding on to the properties at least for another year to see if the market settles, according to a CBRE report issued last month titled “The New 3 R’s: Risk, Repricing and Recession.”
Appreciation on prime office, industrial and retail properties held well over the year. Some deals even broke price records.
BentleyForbes, the Los Angeles-based real estate investment firm, paid a record-breaking $492 per square foot for South Florida commercial property when it bought to the 350 and 450 Las Olas office buildings in downtown Fort Lauderdale for $231 million in July.
Price adjustments
But the value of less stellar properties began to moderate in 2007. The re-pricing of commercial properties has begun, brokers say.
Inflated prices on top of increasing operating expenses leave little room for investment return. Climbing property taxes and insurance are cutting into operating margins.
“To get the same cash flow that investors got in the past, sale prices have to come down, which will mean a higher cap rate,” Cohen said.
In 2007, the capitalization rate, also known as cap rate, remained below 6 percent. The cap rate is the ratio between the cash flow generated by an income-producing property and the purchase price. The higher the sale price, the lower the cap rate.
“At the beginning of 2007, cap rates were at a historic low,” Aztec Group’s Stein said.
The cap rate was even lower on deals involving buildings in strategic locations that had the potential for higher rents. They often traded at 50 to 100 basis points lower.
“There has been a rush to quality properties,” said Stephen Bittel, chairman of the Miami Beach-based commercial brokerage Terranova. “Investors are willing to pay up for the best quality in the best place.”
Brokers say they are seeing a recovery in cap rates.
“Now they are increasing drastically,” Casal said.
As the appetite for condo conversions drastically dwindled in 2006, cap rates for apartments in South Florida pushed to 5.6 percent in 2007 from 4.7 percent in 2005.
The largest retail deals of the past year had cap rates of 5.2 percent to 5.5 percent, Bittel said. He was involved in four of the largest retail deals in Miami-Dade and Broward counties, including the $95 million sale of the Flagler Park Plaza shopping center.
“There is some uncertainty on where cap rates are today,” Bittel said. “Nothing big has traded since April.”
Bittel said limited access to capital is making a big difference in the market.
Investors no longer can get financing of 100 percent or more if extra cash was needed for renovations. The interest-only, 10-year loans that became popular in the early 2000s are gone, he said.
“That game is over,” Bittel said.
Things could turn around for private investors if lenders begin loosening stringent lending standards. Bittel hopes that will happen in early 2008.
Big investors dominate
With small private investors left out of the biggest deals, institutional investors increased their presence in South Florida.
“They have the upper hand,” CBRE’s Cohen said. “They have cash, access to capital and lower cost of insurance because they own properties across the country and their insurance is pooled.”
In Miami-Dade, about 15 percent of industrial owners are institutional investors, up from 11 percent in 2004, Cohen said. In Broward and Palm Beach counties, institutional investors own nearly 20 percent of all industrial properties.
“Miami-Dade is catching up,” he said.
The South Florida office sector is doing reasonably well, and industrial space near ports ranks as one of the nation’s best markets. Both sectors are feeding off the growth in trade with Latin America, according to a PricewaterhouseCoopers-Urban Land Institute report on emerging trends in real estate for 2008.
But at the same time, the region faces fundamental issues that could hurt demand: intense growth, depleted water supplies, hurricane threats, costly property insurance rates and rising property taxes.
Among the “buy” recommendations for property subsectors in the top 15 major U.S. markets, South Florida ranks second in prospects for industrial properties, eighth for apartments, ninth for office properties, 11th for hotels and eighth for retail properties, according to the national report by PriceWaterhouseCoopers.
South Florida, like many other regional markets across the nation, faces a slowdown in rent absorption, which will hurt owners’ cash flow and sale prices.
The slowing national economy has in turn slowed demand for commercial real estate from its pace of 2005, according to last month’s CBRE report. “Net absorptions has fallen year over year for two years due to the economic effects of the overbuilt single-family market,” the report said.
The consequences of the housing slowdown are just now beginning to unfold. As home-builders slow construction, employment falls.
At the same time, fewer new homes mean less demand for building materials, furniture and other household products, forcing businesses to shrink or disappear.
South Florida unemployment rates are up from last year. Miami-Dade’s jobless rate was 4.1 percent in September, up from 4 percent a year before. Broward was at 3.8 percent, up from 3.2 percent in 2006. Palm Beach stood at 4.8 percent, up from 3.9 percent in the same period a year ago, according to the Florida Agency for Workforce Innovation.
Bert Bryan, president of CU Business Capital in Miramar, said lenders are looking closely at the tenant makeup of buildings they finance. Buildings with tenants tied to the housing market are seen as a threat after several mortgage office shutdowns bit into rental revenue at some properties. Bryan said he is focusing lending on industrial, hotels and medical facilities.
Some lenders have temporarily withdrawn from South Florida, waiting to see how deep the housing crisis will bite into the region’s economy, said Neil Rollnick, a partner in Adorno & Yoss in Coral Gables and chair of the law firm’s real estate practice group.
“Many lenders have moved to the sidelines and are waiting to see how the economy will move,” he said.
Paola Iuspa-Abbott can be reached at piuspa@alm.com or at (305) 347-6657.
Illustration by Mike Oviedo
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