COVER STORY, JANUARY 2012

BUSINESS CONFIDENCE GROWS, SURVEY SHOWS
Brokers, lenders expect deal volume to rise in 2012, while developers ramp up retail construction plans.
Matt Valley and Liz Burlingame

An exclusive online survey conducted by Heartland Real Estate Business of more than 200 commercial real estate professionals across the Midwest indicates that a clear majority of brokers and lenders expect deal volume at their firm to be higher in 2012 than in 2011. Developers most frequently cite single-tenant retail, industrial and grocery/drug-anchored shopping centers as the property types they plan to break ground on this year.

The confidence undoubtedly stems from an improving economy. According to the Bureau of Labor Statistics, the U.S. economy added 1.38 million nonfarm payroll jobs during the first 11 months of 2011.

Michigan, which was hit hard by the recession, added an estimated 63,000 jobs in 2011, up from 38,000 in 2010, according to the University of Michigan. That marks just the second time since 2000 that the state has added more jobs than the year before.

Still, survey respondents are not looking through rose-colored glasses. Their many concerns range from a pricing gap between buyers and sellers for non-trophy assets, to the difficulty owners and developers have obtaining financing, to the uncertainty surrounding the ultimate impact of financial regulation reform on the industry. What follows are some of the survey highlights.

Broker insights

Yes, they are eternal optimists. Still, brokers have good reason for the extra hop in their step as the new year begins, following a 2011 that saw positive absorption of space across property types and an improving investment sales climate.

Nearly three out of four respondents (73 percent) expect total transaction volume by dollar amount in the Midwest at their firm to be higher in 2012 than in 2011. Slightly more than one in five (22 percent) expect deal volume to remain the same, while 5 percent anticipate a decrease.

Among respondents who expect deal volume to increase in 2012, the largest group (37 percent) anticipates a 5 to 10 percent increase. Another 16 percent expects deal volume to climb between 11 and 15 percent. Slightly more than one in four respondents (26 percent) are particularly bullish, forecasting transaction volume to spike more than 20 percent.

What lines of business will account for the anticipated growth spurt? The biggest group of respondents (68 percent) say property sales will be among the biggest drivers of revenue growth at their firm in 2012, followed by leasing activity (63 percent) and distressed asset services (35 percent).

“While we are enjoying pockets of prosperity and normal activity, our receivership and foreclosure activity, followed by distressed sales and liquidation activities, is balancing brokerage opportunities and fee business,” says Kevin Crowley, commercial sales manager with West Des Moines-based Iowa Realty Commercial.

With the economy demonstrating steady improvement, businesses are cautiously re-entering the marketplace and beginning to act on their additional space needs, says Michael Miller, executive vice president in the Omaha office of Colliers International.

From Omaha to Ohio, corporate space users are quietly cutting into the overhang of office space. Prime Therapeutics, a pharmacy benefit manager, recently expanded its corporate headquarters by 24,000 square feet in Bloomington, Minnesota. Located in the 8400 Tower at Normandale Lake Office Park, the company’s total footprint in the park now stands at approximately 180,000 square feet.

“Leasing activity is better than last year, however sales of commercial investment property are very slow,” says Thomas Hellgeth, executive president of Brian Properties Inc. The Arlington Heights, Illinois-based brokerage firm specializes in office, retail, medical and industrial buildings.

“Most buyers are bottom fishermen and will only do a deal after every negotiating technique has been exhausted. This mindset will continue into 2012,” says Hellgeth.

Some 60 percent of brokers say that the apartment sector will experience a high velocity of sales in 2012, followed by medical office (43 percent), retail single-tenant (41 percent), grocery/drug-anchored retail centers (35 percent), and industrial (32 percent).

The apartment sales market benefits from high renter demand, limited new supply, low interest rates and the liquidity that Fannie Mae and Freddie Mac provide. It’s a combination that tends to drive investment sales.

Conversely, which property sectors do they think will experience a low velocity of sales activity in the year ahead? Brokers most frequently cite the retail mall category (57 percent), followed by suburban office (47 percent), downtown office (34 percent), retail lifestyle/power center (32 percent) and hotel (31 percent).

On the question of whether commercial real estate valuations have generally hit bottom in the Midwest, brokers offer a mixed bag of opinions. While 34 percent say “yes,” values have bottomed out, 12 percent say “no.” Another 54 percent indicate that it’s a spotty recovery that varies by property type and location.

“Many owners are reluctant to sell today for one of two reasons,” says Kevin Lynch, managing director with Sperry Van Ness office in Arlington Heights, Illinois, a Chicago suburb. “While they admit that commercial values have fallen 25 to 50 percent, they believe that their assets are the exception. If many owners sell today, they will have to sell for less than, or equal to, what the current loan value is.”

Lynch, who specializes in the industrial and office sectors plus land, says many owners will see their property values remain flat or trend downward for the next 12 to 18 months.

“Cap rates will continue to climb as one travels farther out from central business districts,” explains Lynch. For example, a commercial building in downtown Chicago has a higher value than an identical building in the O’Hare Airport submarket. In turn, the office building in the O’Hare submarket has a higher value than an identical building in the Fox River Valley, located about 45 minutes from downtown. “The cap rate rise for each move outward from a CBD is 50 to 100 basis points,” adds Lynch.

While the local economies of several major Midwest cities are inextricably linked to the fortunes of the auto industry, brokers believe that other industries hold the key to office leasing growth, at least in the short term. More than two-thirds of brokers (68 percent) cite health care as a driver of office leasing growth in 2012, followed by technology (46 percent), biotech (30 percent), energy (27 percent) and education (25 percent).

With tenants and owners alike still grappling with a plethora of issues, talented brokers are in demand. As one grizzled veteran wrote: ”The good news is that the brokers left in the business are knowledgeable, savvy, understand how to be creative and can structure deals (sales and leases) so they get done.”

Developer Favorites

Although a flood of development activity isn’t expected anytime soon, developers feel more confident about dipping their toes in the water. Nearly 60 percent of developers indicate they plan to break ground on projects in the Midwest next year, while 40 percent have no plans to do so.

The largest group of respondents (33 percent) plan to break ground on single-tenant retail projects, followed by industrial (22 percent) and grocery/drug-anchored centers (18 percent). One reason single-tenant properties such as drugstores, banks, fast-food chains and auto parts stores are popular with developers is that lenders and investors alike see them as a safe play, provided the tenant is highly creditworthy.

The survey also measures how active buyers and sellers will be in 2012. More than four in 10 respondents (42 percent) indicate they plan to be a net buyer of commercial real estate properties in 2012, compared to 29 percent who plan to be a net seller. Another 15 percent say they are uncertain, and 13 percent indicate they have no plans to buy or sell properties.

What are they buying? A majority of respondents cite grocery/drug-anchored retail centers (38 percent), followed by retail single-tenant assets (36 percent), retail lifestyle/power centers (20 percent) and industrial (20 percent). Multifamily, office and retail malls were tied at 18 percent.

Rick Drogosz, principal of Mid-America Real Estate Corp., agreed that grocery-anchored centers remain the sweet spot for Midwest investors, along with well-located power centers. “There’s still some concern about the re-tenanting costs associated with that type of product, but overall new power centers are going to demand a premium as well.”

With regard to lease negotiations, 43 percent of owners expect they will have stronger negotiating leverage with retail tenants in 2012 than in 2011. Meanwhile, 36 percent expect to have the same leverage and 15 percent believe their leverage will be weaker than the year before.

Occupancies at shopping centers 100,000 square feet or larger that have an anchor tenant have generally reached the low 90 percentile and are approaching the mid-90s across the Midwest, says Drogosz. That uptick gives owners more bargaining power.

Only 13 percent of respondents believe they will have stronger negotiating leverage with office tenants in 2012 compared to 2011. In fact, 19 percent believe they will have weaker negotiating leverage with office tenants, while 44 percent indicate their leverage will remain the same. Nearly one in four of respondents (24 percent) is uncertain.

In the industrial arena, 17 percent of respondents believe they will have more negotiating leverage with tenants in 2012 compared to the previous year. Nearly four in 10 respondents (38 percent) are uncertain and 33 percent believe their leverage will remain the same. 

Commercial real estate financing remains difficult to obtain as regulators place tight limits on financial institutions, says Mary McCarthy, principal at development firm The Daly Group in Oakbrook, Illinois. 

“The commercial retail market is also affected by high inventory and the inability of non-national tenants to obtain loans to finance new businesses,” explains McCarthy. “Without corporate guarantees backing the franchisees, even single-tenant assets are impossible to finance.”

Lenders raise the bar

Slightly more than two-thirds of lenders and financial intermediaries (68 percent) expect the total dollar amount of commercial and multifamily loans closed at their firms to increase in 2012 in the Midwest. Nearly one-third project deal volume to remain unchanged compared to 2011. No respondents foresee a decrease.

How much will business flourish in the year ahead? Four out of 10 respondents expect the dollar amount of loans closed to spike more than 20 percent in 2012, while 25 percent anticipate volume to increase between 11 and 15 percent. Another 20 percent anticipate a more moderate increase, ranging between 6 and 10 percent.

Dan Rosenberg, director of capital markets for Chicago-based Cohen Financial, says that he expects lending volume at his firm to increase about 25 percent in 2012, the result of an anticipated surge in refinancing and acquisitions activity. The CMBS market holds the key, Rosenberg believes. “It is a very viable source of capital that has been back this year, but has been choppy.”

The consensus of industry experts is that total CMBS issuance will reach $50 billion in 2012, according to Rosenberg, more in line with historical norms before the market became overheated in the 2005-2007 time frame. The largest number of respondents to the HREB survey (37 percent) indicate that total CMBS issuance will range between $40 billion and $49 billion in 2012, followed by 22 percent who believe the final tally will end up somewhere between $50 billion and $59 billion. However, another 22 percent predict less than $30 billion in total CMBS issuance in 2012.

HREB asked respondents to assess the impact of several factors on the debt financing market for commercial real estate in 2012. Some 61 percent of respondents say the health of the U.S. economy will have a high impact on commercial real estate financing, while another 29 percent believe that it will have an extreme impact.

The U.S. GDP grew at a 2 percent annualized rate in the third quarter and has been growing for several quarters, yet one write-in comment suggests that the lending market and the economy remain in a funk.

“If some form of modern Resolution Trust Corp. is created and the abundance of underwater residential and commercial loans are moved through the system, we may have a chance to regain some strength,” wrote the respondent. “If not, it looks like the general malaise will last for a long time.”

Nearly one in three say financial regulation reform will have a high impact on the commercial real estate lending market while 54 percent say it will have a moderate impact.

The apartment sector is the darling of the lending community. When asked which property types provide the most attractive opportunities for lenders in the Midwest, respondents most frequently cite the apartment market (79 percent), followed by seniors housing (50 percent), student housing (43 percent), medical office and grocery/drug-anchored retail (both tied at 39 percent), and industrial (25 percent).

Such strong interest in apartments is raising concerns about a possible bubble emerging in that sector.

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