Deloitte: Globalization and Diversification Spur Commercial Real Estate; Residential Market Appears Years Away From Recovery

Commercial real estate benefits from increased capital, transactions; improved fundamentals in these uncertain times

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Oct 24, 2011, 10:14 ET

NEW YORK, Oct. 24, 2011 /PRNewswire/ -- Global commercial real estate (CRE) is gradually improving despite mounting concerns over sovereign debt, the pace of future economic expansion and a weak housing recovery, according to Deloitte's "Real Estate Outlook: Top Ten Issues in 2012" report released today.

"Commercial real estate continues along a bumpy path to recovery, with strengths outnumbering weaknesses. Foreign investment, absorption and lending have provided a solid foundation for the upward momentum and deal flow we've seen over the past 12 months," said Bob O'Brien, vice chairman and real estate sector leader, Deloitte LLP. "However, concerns remain. The residential market is challenged and the overall economy faces uncertainty. Until the majority of the challenges are abated, the industry should proceed with caution and a measured optimism."

Key findings of the report include:

Issue 1 – Globalization of CRE: Global CRE is benefitting from a partial rebound in manufacturing activity, increased business spending and higher capital flows, resulting in an increase in transaction volumes for seven consecutive quarters. In the U.S., foreign investments are helping revive the transaction market. While a favorable assessment of risk versus reward may continue to add momentum to U.S. CRE, emerging markets will remain attractive due to favorable growth and demographic trends.

Issue 2 – Macroeconomic Fundamentals: The U.S. economic recovery appears to be stalling following the U.S. sovereign debt rating downgrade by Standard & Poor's, the Eurozone crisis and the Japanese earthquake. In 2011, GDP growth will likely be 2.5 percent which is lower than the prior estimate of 2.9 percent. This economic uncertainty has resulted in lower consumer confidence and business expectations. Consequently, unemployment may remain high and housing demand could remain muted.

Issue 3 – CRE Fundamentals: CRE space is being leased or bought at a rate faster than new units are being completed, reducing vacancies. Construction activity remains at record lows due to tight underwriting conditions and contracted demand. The small improvement in employment is resulting in a better-than-expected uptick in leasing and sales. Key markets to watch include:
- New York, Los Angeles and Washington D.C. are among the strongest markets for apartments.
- In the major office markets, New York and San Francisco are strongest with low vacancies allowing landlords to drive rental rates upward.
- Improvement in retail real estate fundamentals has moderated due to increased cautiousness by retailers. Retailers, unsure about consumer spending, have shelved expansion plans. Key markets such as New York, Chicago, Boston and Dallas are unlikely to return to prior peak levels until 2016.

Issue 4 – CRE Lending: Increased investor demand drove a CRE lending recovery resulting in higher loan sales and financing options. Lenders' balance sheets are stronger due to loan modifications and extensions, and fewer write-offs spurred by the "amend and extend" strategy. However, this strategy is gradually losing steam as lenders focus on permanent resolution of troubled loans amid a pick-up in CRE investment activity.

Issue 5 – Commercial Mortgage Backed Securities (CMBS): The CMBS market recovery is stalled due to credit market volatility and Standard & Poors' recent cancellation of ratings of two new issuances. In addition, CMBS spreads have widened considerably in recent months and added to issuer reluctance. A healthy, functioning CMBS market is essential to refinancing significant amounts of mortgage debt coming due over the next few years.

Issue 6 – REITs: REITs are well-positioned due to the improvement in property fundamentals and market dynamics along with access to capital. However, unlike pre-recession economies, growth prospects of REITs are now heavily dependent on mergers and acquisitions and rental income due to limited development activity. In the long term, REITs will benefit from global expansion as emerging markets adopt this structure.

Issue 7 – Private Equity: The real estate private equity market is still recovering despite an increase in investment activity. Property values and economic and market volatility remain concerns. The North American real estate market and distressed opportunities are yet to recover fully. This could result in strong investor interest.

Issue 8 – CRE Deal Flow: Driven by REIT acquisition activity and an increase in distressed deals, CRE transactions continue to recover. Distressed property transactions continue to rise due to improved financing conditions and favorable pricing convergence. Distressed inventory fell for the sixth consecutive quarter to its lowest level since the third quarter of 2008. Despite this, with nearly $182.6 billion in troubled assets, transaction opportunities still exist.

Issue 9 – Residential Real Estate Market: Housing remains depressed, inhibited by elevated supply, weaker single-family home sales and falling home prices. In order for a recovery to begin, home inventory – including foreclosures – will need to be cleared. For home prices to move upward, supply will have to fall to a market clearing level or to the point at which demand equals supply. Improvement in employment is essential to spark home sales and reduce mortgage delinquencies and foreclosures.

Issue 10 – Residential Mortgage Market: While mortgage debt levels continue to drop, new non-agency mortgage securitization issuances remain at record lows. Delinquencies hover at historic highs despite several loan modification efforts by banks and government. Despite stabilization of the situation, the market is yet to demonstrate growth, which has resulted in considerable speculation about its near- and long-term viability and impact on the U.S. economy.

A copy of the report is available on Deloitte's Web site at: www.deloitte.com/us/realestate/2012CREOutlook .

As used in this document, "Deloitte" means Deloitte LLP and its subsidiaries. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.