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Investor Sentiment Softens - Especially In Secondary/Tertiary Markets

October 7, 2011

Given divergent economic conditions and income-property fundamentals across the country, it's tough to precisely gauge prevailing sentiment among the thousands of American commercial real estate investors. However, several recent surveys and sources suggest sentiment has taken something of a turn for the worse over the past couple-three months - particularly with participants in the non-apartment sectors outside major markets.

And as concerns about the national and global economies appears to be the primary culprit, chances are the apparent change of heart isn't simply a temporary phenomenon.

It's probably safe to say market conditions are generally healthier - and trading more active - than was the case a year ago. However in the wake disappointing economic news at home and abroad, the rate of recovery in investment and finance activity appears to be slowing.

While dealmakers out in the field still cite plentiful bargains and attractive financing rates for buyers able to qualify, data-crunchers document diminished momentum.

Investment tracker Real Capital Analytics is projecting third-quarter trades of commercial properties ($2.5 million or more) will end up ahead of the year-earlier pace by perhaps 20 percent - down notably from literally more than 100 percent for the first half. One factor likely underlying the slow-down: office space net absorption in the 79 markets research firm Reis Inc. tracks declined sharply from roughly 3 million square feet in July to 1 million in September.

The latest small-cap trading data compiled by Boxwood Means indicates a clear slow-down in activity in July in the $5 million-and-under space - along with a slight downward trend in valuations at least outside the nation's 20 largest metro areas.

The month's preliminary estimate of $2.8 billion in small-cap sales in fact was more than 25 percent off the trailing three-month average of $3.8 billion. Rents at small-cap retail, industrial and office properties also fell across the board during the month - albeit just slightly in each category.

Meanwhile small-cap valuations have declined a bit on a nationwide basis for four straight months. However in the large markets, valuations have tended to parallel the residential sector with slight average increases in June and July.

A pair of just-closed small-cap trades in Southern California's Inland Empire illustrate the substantial cap rate differential (220 basis points in these cases) that can be seen today between stronger and weaker markets - even within 50-some miles of each other.

In the high-end desert resort town of La Quinta, a 5,479-square-foot U.S. Bank-anchored property sold at a 5.42 cap despite its 20 percent vacancy rate. Further west across the mountains in commuter-oriented Temecula, a fully leased 14,500-square-foot shopping center adjacent to a regional mall sold at a 7.61 cap.

The just-released DLA Piper State of the Market Survey indicates the nearly 300 participating U.S. property pros collectively grew more pessimistic in September after a generally upbeat eight-month period. Jay Epstien, co-chair of the international law firm's Global Real Estate practice, cites "global economic volatility, a polarized political environment and stagnant U.S. job production."

Of course it didn't help that August witnessed the nation's first monthly decline in personal income in two years - with The Bureau of Economic Analysis reporting a slight 0.1 percent decline in that metric, and a similar fall in disposable personal income.

DLA Piper's survey isn't necessarily conclusive about activity volume ahead, as roughly half the respondents believe the recent capital markets turmoil will affect transaction closings during the third and fourth quarters.

Meanwhile the latest survey by brokerage Colliers International indicates four out of every five U.S. property investors expect to augment their holdings over the coming couple quarters. Interestingly, more than three out of every four also feel values have recovered more quickly than market fundamentals warrant.

Perhaps predictably, the far and away top market threat cited (by nearly half the respondents): the domestic economy.

Ranking among the more optimistic bunch is veteran small-balance finance pro Keith Van Arsdale, president/CEO of BMC Capital in Dallas. If there's been any hint of renewed investor reluctance to pull the trigger in recent months, Van Arsdale doubts it indicates of any decrease in equity capital chasing small-cap properties.

Nor is it a matter of debt costs, as rates remain at historically low rates despite a notable departure of conduit lenders from the small-balance space. More likely any slight "pull-back" in transaction volume reflects concerns about local, regional, national and/or global economic indicators, Van Arsdale suggests.

While sluggish consumer spending continues putting downward pressure on retail rents in some markets, there's been no indication small-cap property investors have become more bearish on the category than they were earlier in the year, he adds.

But with small-balance credit markets demonstrating some renewed reluctance, certain wannabe sellers are helping buyers avoid dealing with stingy lenders by working out seller-financing arrangements, says Bill Ukropina, executive vice president at Coldwell Banker Commercial's North County affiliate in Glendale, Cal.

For instance with a $3 million sale, the buyer might contribute $700,000 down and make payments for five years at a borrowing rate in the vicinity of 6 percent. "It's something we're seeing pretty commonly now," Ukropina relates. "The seller gets a nice chunk of cash and regular installments, and the buyer doesn't have to meet all those bank requirements."

Van Arsdale for one also stresses that what happens during any given month or two doesn't necessarily constitute a meaningful trend. "You need to look at activity over three to six months."

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