The Year Ahead In Commercial Real Estate

The Year Ahead in Commercial Real Estate 
As we look forward to a new year, I am pleased to share my thoughts on the very memorable 12
months past, and to offer my outlook for the commercial real estate market in 2012. Before I do, I
would be remiss if I did not thank the Sperry Van Ness clients, Advisors, staff, and fellow brokers
for their contributions in driving us forward in spite of the unpredictable times. I know that I speak
for all SVN Advisors and staff when I wish you a prosperous New Year.
A Year of Fits and Starts for Commercial Real Estate
During a year of extraordinary economic and political uncertainties, commercial real estate held
its position as a crucial safe haven for investors in 2011. Investment into the sector reached a
peak in the second quarter, supported by CMBS conduit originators and more active life company
and bank lenders. Even as economic and employment trends fell short, leasing activity for wellpositioned assets strengthened. During this period, investment into segments of the market that
had lagged during 2010, including commercial properties in secondary and tertiary markets and
value-add opportunities, showed signs of firming, as well.
In spite of the rising momentum, commercial real estate investors revealed they were not entirely
immune to the obstacles facing the wider recovery in business confidence. As I suggested in my
New Year’s message one year ago, this has been a period of fits and starts. Over the summer,
renewed disruptions of capital and credit that were largely unrelated to the property sector threw
the conduit into disarray and slowed the pace of transaction activity more broadly. For many
borrowers, lending sources pulled back once again, with the result that a larger share of pending
sales has struggled to reach closing.
While sales volume in the third and fourth quarters will not
match the spring’s flurry of trades, the shifts in the market must
be understood in the context of a turbulent economic and
political environment. Where investors have retrenched, it is
often under the force of external pressures. It nonetheless
remains clear from the current diversity of investors and lenders
that commercial real estate is high on the investment hierarchy.
In fact, many of the last twelve months’ most notable and most
visible deals only came to fruition as the year drew to a close.
The fundraising activities of the major REITs support this
assessment, as well. US REITs raised $37.5 billion in equity in
2011, a new record that easily surpasses the previous high of
$32.7 billion set in 1997. They raised another $13.8 billion in
unsecured debt.
A Persistent Imbalance
In the final tally, investment sales in 2011 will easily surpass the $120 billion benchmark set in
2010 and will roughly triple the record lows set in 2009. As a wider range of buyers and sellers
have reengaged, pricing in the most actively traded markets has exhibited the sharpest
improvements. In the extreme, some highly coveted trophy properties have prompted aggressive
bidding by domestic and cross-border buyers and have ultimately sold at higher prices than
during the market peak in 2006 and 2007.
While the most visible investments affirm institutional investors’ confidence in the sector, they
offer only one perspective on the market. As I pointed out at this time last year, the headline
statistics do not fully convey the unevenness of the recovery or the diversity of its investors. The
market for assets that do not dominate their respective cities’ skylines is necessarily recovering
along its own trajectory. In the current market, that has meant a balance of tailwinds and
headwinds that has weighed in favor of the latter.
Core investors whose scope may be limited to a subset of metropolitan areas have argued that
rising prices and falling cap rates will inevitably spill over into other segments of the market. In
one respect, this is correct. Yields on mid-cap investments are higher than for any trophy
property. But that assessment also overlooks the uniqueness of the market for small- and midcap commercial properties and the very different makeup of the investor and lender base.
Understanding these differences is crucial to assessments of what the next year will hold for
commercial real estate.
The Economy, Jobs, and the Political Deadlock
As in previous cycles, the recovery in small- and mid-cap
property investment is proving more sensitive to underlying
drivers of cash flow than the market for the largest properties.
This inevitably means that a strong economic recovery will be
one of the requisites for more robust investment. While
companies have seen their profits rebound, surpassing their
previous peaks from 2007, an environment of extraordinary
economic and political uncertainty has constrained decisionmaking and investment in new tools and people.
In the first days of 2012,
the employment outlook
looks brighter. For
commercial real estate – and for millions of families across
the country that have struggled with unemployment – this is
the critical missing link to a more balanced recovery.
Although the data on job creation in 2011 only shows a
modest improvement over the prior year, leading indicators
of firm hiring have turned more positive. Job openings have
been trending up consistently over the last year. More
recently, first-time applications for unemployment insurance
have fallen back to their lowest levels since early 2009.
Further, employment gains in temporary help services have
picked-up over the past 5 months, which lends well to
permanent job creation. Even though single-family housing
shows no definitive signs of an inflexion, other metrics
indicate that marginally stronger growth in 2012 will support a healthier pace of private sector job
creation.
Regrettably, an environment of political dysfunction qualifies the outlook, both at home and in
Europe. In fact, the latter presents one of the most credible threats to global growth. In the United
States, the uncertainties presented by unusually intrusive policymaking may resolve over the next
year, given the need for all parties to clarify their political positions and objectives as Election Day
approaches. Needless to say, a business environment where the rules of the game are more
predictable is more conducive to growth and job creation.

Investment Sales and Financing
As much as it depends on a stronger economic trajectory, the outlook for small- and mid-cap
investment also relies on buyers’ access to financing. In financing their investments, large REITs
may offer shares or issue unsecured bonds; trophy investments have also been supported by
favorable lending terms from life companies and large international banks. These scenarios are
not reflective of the market for smaller assets where the sources of risk and its mitigating factors
can be very different. Given the historically dominant role of regional banks and CMBS lenders in
facilitating this segment of the market, these lenders figure prominently in the assessment of what
the next year will hold.
Although the CMBS market has struggled to reassert itself since last summer’s interruption, plans
for new issuance in the first quarter of 2012 indicate a gradual increase in conduit origination
activity. Surprising as it may seem, stability in global bond markets is an important condition for
well-functioning CMBS markets, since the spreads on the latter’s bond yields are influenced by
corporate bond market trends, as well. In the first half of 2011, more than half the CMBS loans
securitized had origination balances of less the $10 million. It remains the case that a more active
CMBS market is required for the small and mid-cap segments to flourish, in particular, as a large
number of seasoned CMBS loans mature over the coming year.
Outside of the apartment sector, where
generally improving fundamentals and the
contributions of Fannie Mae and Freddie Mac
are facilitating both sales and new
development, commercial property investors
are dependent on bank financing given an
absence of other debt sources. For the last
several years, that has presented a problem.
Banks have been preoccupied with the
management of their distress portfolios and
have hesitated to extend new credit, even in
the best of cases. The most recent data
show those priorities changing. Banks’ default rates on their commercial and apartment loans
have fallen consistently over the last year. Coinciding with the stronger performance of the legacy
balance sheets, many banks are accelerating the liquidation of bad loans and real estate-owned.
A growing minority are lending again, increasing their exposure in segments of the market where
an absence of competition and low interest rates are affording opportunities to extend credit.
Improvements in bank lending and CMBS issuance will have a disproportionately positive impact
on the mid-cap market. Access to historically low-cost credit in 2012 and the likelihood of higher
interest rates in 2013 signal an unmatched window of opportunity for acquisitions over the next 12
months.
Conclusions
The economic and jobs outlook is improving. With so many of the underpinnings of a stronger
recovery in place, we can afford a degree of optimism. Politics and the possibility of external
shocks, primarily from Europe, still qualify that optimism.
While prices in the largest markets have recaptured a significant share of their lost value, other
assets have lagged the headline measures. Combined with historically low borrowing costs, there
is tremendous upside potential for borrowers with access to financing who can identify wellpositioned assets.
While the process has been frustratingly slow, more banks are moving distress off their balance
sheets. This process has the potential to accelerate in 2012, given banks’ stronger positions
generally, an evolving regulatory environment, and the potential for distress from maturing CMBS.
That will create some pressures on the market, but it should also deepen the pool of distressed
assets and notes for sale.
Attention will necessarily turn to the small and mid-cap market as the economy improves and
financing options broaden. Given our experience in this arena, we are anticipating a high volume
of advisory work to identify and market investment opportunities before consensus firms. Timing
will be the crucial differentiator in this market – the intersection of low-cost financing and firstmover advantage demands that we act deliberately