The Clarus Blog

It was only a matter of time before deteriorating market fundamentals began to affect every asset class, and it’s a rare property that hasn’t been hurt by falling rents or occupancy.

National apartment and retail vacancy is now at record highs (going back to the 1980s), and office vacancy is approaching the highs of 1992. Hotels have had a disastrous year (revenue per available room is down over 18%); malls are still wretched investments (and will likely remain so after what is expected to be a poor holiday shopping season); and industrial properties have been hurt by continuing convulsions in the manufacturing sector, shipping and storage sectors. Even real estate such as parking lots, storage sheds, and farmland has been undercut by the recession.

There have been a bevy of studies and polls recently that discuss the savings and spending habits of Americans, and the results are not pretty. Via MartketWatch:

A MetLife study released last week found that 50% of Americans said they have only a one-month cushion — roughly two paychecks — or less before they would be unable to fully meet their financial obligations if they were to lose their jobs. More disturbing is that 28% said they could not make ends meet for longer than two weeks without their jobs.

And it’s not just low-income earners who would find themselves financially challenged. Twenty-nine percent of those making $100,000 or more a year said they would have trouble paying the bills after more than a month of unemployment.

While we still see possibilities for strong returns in select domestic real estate markets, we also believe that battle-worn investors will turn to foreign markets to increase diversification and returns. In a normal environment (which is what we’re slowly returning to), domestic returns average 15 to 20 percent (on the high end), but foreign real estate investments average 30 to 40 percent (also on the high end). While international investments are often perceived as riskier (less information can make investors wary, which is why most investors only invest locally despite the obvious dangers of such a strategy), it’s hard to argue that the U.S. is or will quickly return to the pillar of stability we’ve imagined it was for the last decade.

The world’s largest investors are already turning to other markets, with most of them targeting Asia (from NuWire Investor):

Struggling property markets in Asia are starting to attract strong interest from investors, with Japan and China among the most popular.

Funds and private investors are seeking well priced investments and are looking to buy now and in the near future as they expect the region will recover more quickly than markets in the U.K. and U.S.

Property fund manager LaSalle Investment Management, which raised a $3 billion fund in August, expects Hong Kong and Singapore to recover first from the global financial turmoil while others predict China will be first to see recovery.

“We are seeing a decline in values throughout the region. There are properties that are being sold at much lower prices than the market’s perception of their values,” said regional director David Edwards.

From our analysis, based on the economic, market and social conditions that matter most to real estate investing, Vietnam is one of the most attractive mid-term real estate investment opportunities, with strong returns projected through 2025. We’re not alone in our analysis (from Nhan Dan):

Indochina Capital and VinaCapital Group, two of Vietnam’s biggest investment managers, are raising funds to invest in the nation’s property market as the credit crunch hurts local developers, according to a Bloomberg article dated November 19.

Indochina Capital plans to increase the size of its property fund to between US$400 million and US$500 million when it closes in the first half of next year, from the US$155 million it raised in July, said Rick Mayo-Smith, co-chairman of Vietnam’s third-biggest investment firm.

VinaCapital, Vietnam’s biggest fund manager, is in talks with investors to start its second real-estate fund early next year, said Chief Executive Officer Don Lam. The firm’s second real-estate fund will aim at private- equity investments and won’t be listed, Lam said. The new fund will likely produce an internal rate of return of about 35%, he said.

Much of real estate investing is timing. Highly cyclical in nature, it’s important to catch and ride the upswing of the cycle. The current spate of Asian investors, who are investing on the downswing, are speculating pretty wildly that Asia will recover first and that it will recover quickly. Given the nature of the downturn and the often opaque data that comes from Asia (does anyone really believe China’s GDP numbers?), it seems increasingly unlikely that world real estate markets will quickly adapt to both a new financial order as well as the United States’ diminished place in world financial and economic importance.

Last night several of my acquaintances (whose names and professions will graciously go unidentified) asked me if the economy would enter a recession soon, and I nearly choked to death on my pastry. If we’re going to enter a recession? We’ve been in a recession for almost a year!

I spent the next hour talking about employment, income, retail sales, production and the jerry-built way the government measures GDP, after which everyone was appropriately depressed and gloomy.

Rather than depress everyone all over again, I’ll let Liz Ann Sonders talk about it. Sonders is the chief investment strategist at Charles Schwab, and while I don’t always agree with her analysis, she’s spot-on in terms of the recession.

Liz Ann Sonders tells it like it is

While internet pundits and investment gurus are beginning to acknowledge we’re in recession (duh), the effects are already visible in quite a few cities. Office space is going empty, jobs are being lost, and retail is has been simultaneously blindsided by Thor’s hammer, Zeus’s thunderbolt, and Recession’s pummeling fists of fury. Yet the effects of this recession on the apartment market are going to be much different than the last recession.

In the last recession the apartment market posted strong gains but didn’t perform as well as several other commercial asset classes. Why?

In the last recession home ownership was like a Nike ad: everyone was doing it. Interest rates headed lower and had plenty of room to drop. Credit was easier to come buy. Lending practices were loosening up. Bush was pushing the Clinton-era policies regarding home ownership (i.e., everybody needs a house). Heck, home buyers didn’t even need to verify income to buy a house. Who needs an apartment when houses are being given away for no money down?

In the last recession real estate was comparatively unaffected. The recession was mostly limited to one broad sector (technology) and was more akin to tulip mania than total systemic collapse. Home prices were appreciating. Banks were sound. People still believed in decoupling. Jobs first lost in Silicon valley were later gained in the mortgage and real estate industry. The nation wasn’t fighting two wars. The global economy was booming. Now, everything is in decline: energy, stocks, most real estate, China, commodities, magazine subscriptions, etc. Our wars are now 7 and 5 years old. Credit has disappeared like Houdini.

In the last recession apartment developers happily overdeveloped. In fact, it wasn’t until about 2006-2007 that national supply and demand finally found common ground and reconciled their differences. With multifamily permits down again this year (due to the credit crunch), most markets lack new product. Some markets have seen almost no new product in several years despite strong increases in occupancy. (Note that some places are still overbuilt and that the apartment market is incredibly localized.)

In the last recession demographics hinted at more homeowners, not more renters. That’s reversed now. Baby boomers are selling (and will continue to sell) homes. Echo boomers are renting (and continuing to rent) in record numbers. When the job market recovers, household formation will favor apartments, not homes.

In the last recession gas didn’t cost $3.50 per gallon. People didn’t take mass transit. City governments weren’t as concerned with urban density (and its cost-saving perks).

In short, the last recession was completely different than this one, and while most real estate will continue to suffer, it’s likely that the national apartment market will remain strong despite increases in vacancy due ot job losses. Most factors that weaken the apartment market–cheap credit, cheap gas, limited demand, excess supply–have disappeared.

As always, research will indicate which markets are suitable for investment, but on a macro-economic level, look for the recession to increase the bottom line for most apartments.

-Jens Larson

Source:

Marsh, Bill. “For Most Cities, Recession Has Arrived. The New York Times. 4 October 2008. http://www.nytimes.com/2008/10/05/weekinreview/05marsh.html?_r=1&oref=slogin

In the U.S., times are tough for commercial developers, over-leveraged investors and almost anyone who owns a mall. When Lehman Brothers failed, the mass media finally began to pay attention to these and other problems in the commercial real estate (CRE) market. Of course, the media rarely takes time to make distinctions, and we end up with accurate but alarming information like this:

Source: The Wall Street Journal

As we noted in a past posting, commercial property fares better than residential in almost all housing busts, but more importantly, certain types of commercial property fare better than others.

If we trace annual returns from 1991, a period that includes two recessions, it’s clear that the apartment market has handily outperformed other asset classes. Indeed, apartments typically perform well above other assets in recessionary periods. During the early ’90s and during 2001, for example, apartments posted annual IRRs that were a full 5.4 percent higher than the other asset classes.

Source: National Council of Real Estate Investment Fiduciaries

More importantly, the apartment market outperforms other asset classes with greater consistency. In the selected time period, apartments led returns six years, finished second six times, finished third five times, but finished last just once–in 2007, when prices in other asset groups were experiencing the unsustainable growth that is now leading to the CRE industry’s woes:

Source: National Council of Real Estate Investment Fiduciaries

Retail, unsurprisingly, is the under-performer of the group, and this won’t change until the economy recovers. Office space is either boom or bust, and with the boom years behind us and with businesses failing left and right, it’s not to difficult too predict the next years will be bust. Industrial space, even though the U.S. has been losing manufacturing and industrial jobs to overseas competitors, provides solid returns even if it never really excels.

Only apartments perform consistently well with little volatility.

Details will always matter, of course. Would I like to own high-end luxury apartments in New York City right now? No way. With the financial industry tanking, no one can afford to rent them. But ask me the same question about another market and I’ll probably give you a different answer. I’d consider office space if my tenant was the government or a stable company. Even retail might intrigue me in the right situation.

The paranoia that finds its way into print will likely tempt investors to sit on the sidelines during the most important buying opportunity since the last recession, but as always, sound research will identify opportunities for strong returns.

Sources:

Frangos, Alex, “Commercial-Property Players Find Their Pressures Growing,” The Wall Street Journal, 24 Sept 2008, http://online.wsj.com/article/SB122221997903469917.html

The National Council of Real Estate Investment Fiduciaries, http://www.ncreif.com/

-Jens Larson