SpecialResearch
R E P O R T
Long-Term Real Estate Investment Outlook Favorable Despite
Capital Markets Tightening September 2007
apital markets have settled and lender spreads
C have eased moderately since the recent
disruption that stemmed from residential
subprime mortgages. Nevertheless, investors face a
liquidity squeeze and exaggerated re-pricing of risk,
despite healthy commercial real estate fundamentals.
The Downside of Excess Liquidity, Low-Cost Debt
and Distribution of Risk. The cycle of increased
liquidity began in the aftermath of the dot-com bust and
the 9/11 tragedies. The availability of low-cost capital
propped up the global economy, increasing investment
activity and fueling price appreciation, particularly in
housing. Global liquidity and the need for higher yields
produced a higher tolerance for risk among investors,
which would eventually require realignment.
In addition, over the past 20 years, the concentration
of balance-sheet debt held by banks has been reduced
substantially through the securitization of mortgages.
Loans are placed into pools and sold off as Mortgage-
Backed Securities (MBS) to investors. This distribution
of risk has been a positive force for the financial
system; however, it has also obscured the identity and
exposure of investors, particularly in subprime
mortgages. This uncertainty caused investors to pull
out of the MBS market over the past several weeks, as
several funds announced problems with subprime
mortgage holdings, and concerns spilled over to
commercial securities (CMBS).
Some Adjustment in CMBS Market Was Expected,
but the Re-Pricing of Risk Is Exaggerated. AAA
CMBS spreads initially rose from 30 to 66 basis points
over swaps, but have since narrowed to around 53
basis points. Conduit lender spreads increased from
110 basis points over the 10-year Treasury yield to 220
basis points between late July and mid-August, but
have since come down to the 180 to 200 basis point
range. Spreads are still volatile and continue to
change almost daily. Loan-to-value (LTV) and debt
service coverage (DSC) requirements have tightened
substantially.
Conduit Lenders Hit Hardest, Alternative Sources
Stepping Up. As conduits substantially reduced
© Marcus & Millichap 2007
lending, commercial banks, life insurers, credit unions
and agencies increased activity. Interest-only (IO) loans
have all but disappeared and higher-risk transactions
are receiving the most scrutiny. Property quality, actual
performance and location are driving lenders’ decisions.
Commercial Mortgage Delinquency Rate
Remains Near Historic Lows
10% THEN:
CRE Overbuilt
Delinquency Rate (ACLI)
8% Deliquency Skyrockets
6%
NOW:
4%
CRE Supply/Demand Healthy
Delinquency < 1%
Credit Concerns Rooted in
Subprime Residential
2%
0%
*
89
91
93
95
97
99
01
03
05
07
*Through 1Q
Sources: Marcus & Millichap Research Services, ACLI
Capital Markets Challenging Transaction Volume,
Pricing - Generally Balanced Supply/Demand and
Rent Growth Bode Well for Commercial Real Estate
Values. Unlike the liquidity crunch in 1990/91,
property fundamentals are healthy. Although
moderate increases in CMBS delinquencies are
expected, they are currently near historical lows. CMBS
60-day delinquency is at 0.21 percent, the lowest rate
reported since 1999. Life insurers are reporting
delinquency of 0.1 percent, compared to 3.6 percent in
1990 and 7.3 percent in 1992.
The Fed’s Staged Support Effective. The Fed’s infusion
of cash and a reduction in the discount rate helped settle
the market over the past few weeks. The next major
move is expected to be a Fed funds rate cut, which
would lend more direct support to the consumer sector.
Economy Strong Enough to Withstand the Drag from
Housing, Credit Squeeze, but Growth Will Moderate.
The most likely scenario calls for a slowing of growth,
not a recession. The greatest risk to our outlook is an
extension of the credit crunch due to further financial
market disruptions. Additionally, if the negative
psychology in the housing market intensifies, consumer
spending could be adversely affected.
Special Research Report Marcus & Millichap Research Services

SUMMARY OF RECENT EVENTS

Single-Family Home Prices
To understand the current climate in the capital markets,
it is important to first examine the events that led up to $225
the current situation.

Median Home Price (ths)

Build-Up to the Credit Market Disruption $175
 Fed Rate Cuts Spark Growth. To avoid a prolonged
economic downturn, the Fed began cutting the Fed
$125
funds rate in early 2001 and continued to do so well
into 2003, reaching a low 1 percent.
 Housing Boom Begins. Low interest rates set in motion $75
91 92 97 02

93
94
95
96

98
99
00
01

03
04
05
2Q06
07
the greatest housing boom in history. An abundance of
inexpensive debt and looser underwriting standards Sources: Marcus & Millichap Research Services, NAR
made it easier for home buyers to qualify for mortgages.
The median home price rose 40 percent from 2001 to 2006.
 Flexible Financing. Buyers looked to adjustable-rate
mortgages (ARMs). Lenders were more than willing to
offer non-conforming loans as steady price appreciation
and healthy demand from the secondary mortgage
Home Mortgage Originations by Loan Share
market temporarily insulated them from losses.
FHA/VA Home Equity Alt-A Subprime Prime
 Subprime Lending Soars. Between 2001 and 2006,
originations of subprime and Alt-A loans soared from 100%
Share of Total Volume

11 percent of the total residential market to 34 percent.

75%
Credit Market Shift Began in 2004
 Tightening Cycle Began. In early 2004, the Fed began 50%
bumping up rates in 25 basis point increments to stave
off inflation. The tightening cycle continued through 25%
June 2006, bringing the Fed funds rate to 5.25 percent.
0%
 ARMs Reset, Delinquencies Rise. As interest rates rose 2001 2002 2003 2004 2005 2006
and ARMs reset, a growing share of homeowners Sources: Marcus & Millichap Research Services, JCHS (Harvard)

found monthly payments unaffordable.

 A Bifurcated Market. By mid-2007, 15.75 percent of
subprime ARMs were past due, up 550 basis points from
one year earlier. By contrast, delinquencies for prime
fixed-rate and adjustable-rate residential mortgages
were at 2.2 percent and 3.7 percent, respectively.
Mounting Subprime Concerns Spark Selloff
 Subprime Losses Surface. Primary lenders have Residential Subprime ARM
increasingly sold loans on the secondary market as Delinquency Soars
mortgage-backed securities to funds and individual 16%
investors. Funds with high exposure to subprime
mortgages began to report losses earlier this year. 14%
Delinquency Rate

 Ratings Slashed. Moody’s and S&P slashed ratings on

securities backed by subprime loans in May 2007. Many 12%
previously investment-grade securities were reduced to
below-investment-grade. The previous month, ratings 10%
agencies warned of lax commercial underwriting
standards, raising the issue of credit in some CMBS pools. 8%
00 01 02 03 04 05 06 2Q07
 Panic Spread to CMBS Market. Demand for CMBS
Sources: Marcus & Millichap Research Services, Economy.com
dropped off, creating a liquidity problem. If there is no
demand on the secondary market, lenders cannot sell
loans to replenish funds and originate new loans.

Page 2 © Marcus & Millichap 2007

 Special Research Report Marcus & Millichap Research Services

ECONOMIC TRENDS
Growing Share of Subprime ARMs
Due to Reset The housing downturn has not yet bottomed, but a sys-
temic crash is unlikely. The pace of existing home sales
% of Subprime ARMs w/ 1st Reset

56% of Outstanding Subprime ARMs

40% Due for First Reset in 2007/08 recently declined to the lowest level recorded since late
2002. Sales declined 9 percent over the past year, while list-
30% ings increased 16 percent, resulting in a surge in available
inventory to 9.6 months. Nationally, prices have softened
20% slightly, with the median existing home price down 1 per-
cent from last year; however, further price adjustments are
10%
expected in varying degrees by market. Strong employ-
0%
ment and demographic drivers should help overcome the
2005 2006 2007 2008 2009 current overhang within the next 18 to 24 months.
Sources: Marcus & Millichap Research Services, LoanPerformance
Potential losses in the subprime residential mortgage
market are limited, but the psychological risk is signifi-
cant. According to Moody’s, there is $1.3 trillion of out-
standing mortgage debt considered to be at risk. This
includes loans from riskier programs originated since late
2004 at 90 percent or greater LTVs. Moody’s predicts that
U.S. Capital Markets Outstanding one-third will default. Based on expectations for reduc-
$49.5 Trillion* tions in housing values, they forecast that defaults could
Corporate ultimately result in more than $100 billion in actual losses.
This is a large figure, but it represents less than 1 percent
Money Market
of the total U.S. mortgage market.
Asset-Backed
Equity
The economy is relatively strong outside housing-
Mortgage-
related industries. Gross domestic product (GDP) growth
Related picked up in the second quarter of 2007, increasing at an
annualized rate of 4.0 percent, up from 0.6 percent in the
Municipal first quarter. However, second half figures are expected to
Federal Agency Treasury come in weaker. For the year, we anticipate GDP to rise by
*1Q07
Sources: Marcus & Millichap Research Services, SIFMA approximately 2.0 percent, followed by growth of 2.5 to 3.0
percent in 2008.

Healthy corporate sector to support moderate job growth.

Payrolls are forecast to rise by 1.0 percent or 1.4 million
positions this year, compared to 1.7 percent in 2006. A
modest acceleration in growth is anticipated in 2008. Over
the next several months, more financial service jobs will be
eliminated as mortgage companies shut their doors, and
Strong Employment Conditions Helping to
Offset Housing Downturn the construction industry will continue to feel the effects of
the slowing housing market. Gains are forecast to be con-
Nonfarm Employment (millions)

140 5/03-7/07
+ 8.3 Million centrated in the education and health services, leisure and
2/01-5/03 hospitality, professional services and trade sectors.
135 -2.7 Million

Low unemployment is expected to keep upward pressure

130 on wages. Over the next year, wage growth will help off-
set some of the impact of reduced cash-out refinancing on
125 consumer spending. During the first half of 2007, home-
owners cashed out less than $150 billion in equity, down 20
120 percent from the same period in 2006, and significant
97 98 99 00 01 02 03 04 05 06 07* reductions are expected. The slowdown in cash-out refi
*Through July
Sources: Marcus & Millichap Research Services, BLS
activity has impacted retail sales growth. On a year-over-
year basis, retail sales were up 3.2 percent as of July, com-
pared to 4.7 percent over the previous 12-month period.

© Marcus & Millichap 2007 Page 3

Special Research Report Marcus & Millichap Research Services

CAPITAL MARKETS OVERVIEW

Lender Break Even Rates Skyrocketed
Conduit lenders accounted for approximately 45 per- but Have Eased Moderately
cent of commercial lending over the past 12 months and 250

Break Even Rates (bps)

have been impacted the most by the liquidity crunch.
200
Fortunately, the 10-year Treasury yield has declined 60
basis points from its mid-June peak, helping to offset 150
higher lender spreads. It is interesting to note that 100
spreads today are relatively close to historical norms, but
50
the rapid shift in the market is nonetheless proving to be
a challenge for investors. Some conduits have temporar- 0
h
7t

th

th

th

th
d
ily pulled out of the market in anticipation of the return

2n
26

10

16

24
y
ul

g
ly
of additional liquidity. As a result of lender uncertainty,

g
J

Au

Au

Au

Au
Ju
some borrower applications are being returned and con- Sources: Marcus & Millichap Research Services, Marcus & Millichap Capital Corp.
firmed rate locks are being broken.

Alternative sources to conduit lenders are stepping in.

Spreads have increased across the board, though the
CMBS market has been the most affected. Local and
regional banks are taking advantage of this opportunity to
gain market share, and some are offering loans without Commercial Mortgage-Backed Securities
prepayment penalties. Borrowers can also look to life (CMBS) Spreads Increased Dramatically
insurance companies, or to Fannie Mae and Freddie Mac 600 AAA AA A
BBB+ BBB BBB-
for multi-family loans. A variety of solutions are being
CMBS Spreads over Swaps
500
implemented with these lenders to facilitate transactions,
400
including seller carryback, bridge debt, short-term vari-
able debt and assumable financing. 300
200
Lenders are mitigating risk by underwriting new loans 100
based on actual NOIs, raising debt service coverage
0
(DSC) ratios and lowering LTV requirements to the 60 to
06

06

06

07

07

07
-0
70 percent range, compared to 75 to 80 percent a few
g-

t-

c-

r-

n-

g-
b
Oc

Ap
Au

Au
De

Fe

Ju
months ago. In some cases, borrowers are finding that loan
Sources: Marcus & Millichap Research Services, Wachovia
applications previously accepted based on strong DSC of
1.25x or higher are being re-priced with reduced loan pro-
ceeds, as underwritten cash flows no longer meet mini-
mum DSC requirements. Some transactions have fallen out
of contract as a result of leverage gaps, requiring more
buyer equity. Lenders are driven by asset quality, strength
of the local market – as defined by employment and demo-
graphics – and the financial strength of the buyer. Inflation Moving in the Right Direction,
Giving Fed More Flexibility
Financial markets are anticipating the Fed’s next big 10% Fed Funds Rate
move. The Fed’s $38 billion injection in early August was 10-Year Treasury
Interest Rate/Core CPI

the largest infusion since 9/11. In the weeks that followed, 8% Core Inflation
the Fed’s addition of another $24 billion in liquidity and a
50 basis points reduction in the discount rate have helped 6%
to calm financial markets, for now. Investors are widely 4%
anticipating a Fed funds rate cut in September. Credit
cards and home equity lines are tied to the prime rate, 2%
which is influenced by the Fed funds rate. While tight
0% 92
labor market conditions, wage growth and high energy 95 98 01 04 07 *
* Through August
prices remain concerns on the inflation front, further Sources: Marcus & Millichap Research Services, BLS, Federal Reserve
slowing in the housing market, deteriorating consumer
credit, and the possibility of a prolonged economic down-
turn are likely to influence the Fed’s decision.

Page 4 © Marcus & Millichap 2007

 Special Research Report Marcus & Millichap Research Services

REAL ESTATE MARKET FUNDAMENTALS

Commercial Real Estate - New Supply
as a Percent of Existing Inventory While the lending environment has tightened, the sup-
1980-89 1990-99 2000-2006 2007-10* ply/demand balance across commercial real estate sectors
remains relatively healthy. Additionally, higher borrowing
Construction as % of Stock

12%
costs and more stringent underwriting requirements will
8%
make it difficult for developers to move forward with some
(Ann Avg)

planned projects, further supporting space fundamentals.

4% APARTMEN T MARKET
Moderate job growth, higher mortgage rates and tighter
0% lending standards will drive renter demand in the near
Apartment Shopping Office Industrial term. As ARMs adjust and mortgage payments become
Centers
* Forecast unaffordable, many homeowners will return to the rental
Sources: Marcus & Millichap Research Services, Reis, PPR
market. Foreclosure sales are up 90 percent this year and
are forecast to rise further. It is estimated that 2.2 million
loans originated in recent years will end in foreclosure.

Competition for renters has increased in markets where

condo/single-family investors were most active, but new
U.S. Commercial Real Estate apartment development remains moderate and vacancy
Supply/Demand Well Balanced
will remain in a healthy range. New supply is forecast to
20% 2002-2006 2Q 2007 2007*
total 92,000 units this year, up from 2006 but still well
below the average from 1999 to 2004 of 152,000 units. In the
15% near term, increasing supply of vacant homes and the
Vacancy Rate

return of conversion projects to the rental market will put

10% some upward pressure on vacancy, though the net effect of
the conversion trend will remain a positive for apartments.
5%
Longer term, immigration and demographic trends sup-
port a favorable outlook for apartments. Immigration is
0%
Apartment Retail Office Industrial forecast to average 1.2 million new U.S. residents annually
* Forecast through 2015. Over the same period, baby boomers’ chil-
Sources: Marcus & Millichap Research Services, Reis, PPR
dren will enter their prime renting years, with the 20- to
34-year old population expected to grow by 4.8 million.
Effective apartment rents are up 4.6 percent from last year
and have increased 13 percent since bottoming in 2003.
Rent growth of 4 percent is expected in 2007 and 2008.

RETAIL MARKET
Echo Boomers to Drive Apartment Demand Retail outperformed during the last economic downturn,
20-24 25-29 30-34 and therefore did not experience a strong recovery cycle
like apartments and office. Retail sales growth in recent
+5.5 Million
10% years was largely supported by housing and mortgage refi-
Change in Population

nancing. Rapid home price appreciation, low interest rates

5%
and looser underwriting standards allowed homeowners
0% to cash out more than $1 trillion of equity from 2002 to 2006.

-5% Cash-out refinancing will not be a driver, but major

retailers have accounted for slower retail sales growth
-10% when preparing expansion plans. Nationwide, retail con-
90-95 95-00 00-05 05-10* 10-15* struction is up from last year, but development has been
*Forecast
largely tenant driven; build-to-suit, big-box retail accounts
Sources: Marcus & Millichap Research Services, Economy.com for half of the new space entering the market this year. Low
levels of speculative construction should prevent oversup-
ply conditions in most markets.

© Marcus & Millichap 2007 Page 5

Special Research Report Marcus & Millichap Research Services

Retail rents are forecast to rise at a slower pace, as con- Rent Growth Slowing but Still Healthy
sumer spending returns to more normalized levels. Across Commercial Property Types
Despite an anticipated uptick in vacancy in the near term, 2002-2006 2Q 2007 (YOY) 2007*
the retail sector will remain on solid footing with vacancy 12%
remaining around 10 percent. Reduced expansion plans

Annual Change
by major retailers have already been announced, and more
6%
will follow. Many planned projects are likely to fall out of
the pipeline as developers and lenders display more cau-
tion, limiting the rise in vacancy. 0%

O F F IC E M AR K E T
The office market has staged an impressive recovery, -6%
Apartment Office Retail Industrial
with vacancy and concessions currently at the lowest *Forecast
Sources: Marcus & Millichap Research Services, Reis, PPR
levels recorded since 2000. Furthermore, rent growth has
accelerated dramatically. Compared to one year ago,
effective rents are up 11.5 percent, close to gains regis-
tered at the market’s last peak.

Office completions are on pace to reach 70 million

square feet this year, higher than 2006, but only 60 per- U.S. Commercial Real Estate Sales Soared
cent of the average delivered annually from 1999 to 2001. in Recent Years
Vacancy is forecast to rise in select markets in the near $400
term due to financial services job cuts and slower econom- Total Dollar Volume

ic growth, but the market is expected to remain relatively $300

balanced with vacancy of 12.8 percent by year end.
$200
The pace of rent growth will slow in 2008. Barring a major
recession, lease rollovers will provide healthy revenue $100
growth over the next three years. Effective rents have
increased 20 percent since early 2004 and are expected to be $0
2001 2002 2003 2004 2005 2006 1H07
back at previous peak levels by the end of this year.
*Includes apartment, office, retail and industrial, $1+ million
Sources: Marcus & Millichap Research Services, CoStar Group, Inc., RCA
I N D U S T R IAL MA R KE T
Despite more restrained economic expansion, interna-
tional trade volume will continue to drive demand for
industrial space. Major ports continue to set records for
container volume, a trend that is expected to persist as the
dollar’s weakness in relation to foreign currencies sup-
ports international demand for U.S. exports.
Large Properties, Portfolios Account for
Warehouse vacancy has steadily declined since 2004 to Growing Share of Total Dollar Volume
its current level of less than 9 percent, and development
remains below historical averages. Over the next three 95%
years, inventory is forecast to rise by an average of 1.8 per-
$5+ Million Volume
(Share of Total)

cent annually, compared to 2.3 percent per year from 2000

to 2006. With vacancy largely in check, owners will contin- 90%
ue to achieve rent growth, with the strongest gains antici-
pated in coastal port markets. 85%

Cap rates have compressed significantly, but the average

is still between 20 to 80 basis points greater than some 80%
other commercial real estate sectors. Much of the recent 2004 2005 2006 1H07
price appreciation has been centered in high-growth and *Includes apartment, office, retail and industrial
Sources: Marcus & Millichap Research Services, CoStar Group, Inc., RCA
coastal markets, though prices in secondary port markets
will receive more support from spillover traffic as trade
activity remains elevated.
Page 6 © Marcus & Millichap 2007
 Special Research Report Marcus & Millichap Research Services

Broad Cap Rate Compression Cycle Over COMMERCIAL REAL ESTATE INVESTMENT
Spreads Also Widening by Quality, Location Recent shifts in the capital markets have cut into com-
1990-2000 Avg. 2005 2006 1H07 mercial real estate transaction velocity, but sound fun-
12% damentals across major property types will help to sus-
tain investors’ interest. Furthermore, with a healthy
Average Cap Rate

8% supply/demand balance and expectations for continued

rent growth, liquidity is forecast to return to the market
well ahead of the residential sector.
4%
While velocity has slowed, the decline is due almost
0% entirely to changes in the lending environment, as
Apartment Retail Office Industrial buyers remain in the market. The number of deals
Sources: Marcus & Millichap Research Services, NREI falling out of contract spiked in July and August, but the
dollar volume of deals under contract also increased.
This suggests that many closings have been delayed and
not cancelled.

Some risk premium is returning to real estate, with cap

rates expected to rise by an average of 20 to 50 basis
points over the next several months. Higher-quality
Price Appreciation Trends by Property Type assets in strong markets, and those with assumable or
1995-2001
1995-2001 2001-1H07
2001-1H07
100% seller financing, will be affected the least. Marketwide,
100%
while increased borrowing costs and limited price
Price
Median Price

75% appreciation will put upward pressure on cap rates, a

75%
dramatic correction is not expected.
in Median

50%
50% Buyers and lenders have become more discerning,
Change in

causing a greater distinction in cap rate and pricing

Change

25%
25% trends based on quality and location. Lenders have
become more selective, showing a strong preference
0%
0%
OfficeSTNL RetailRetail
toward historically tight markets and top-quality prop-
Office MT Retail Apartments
Apartments
erties that can show current strong occupancy and rent
Sources: Marcus
Sources: Marcus &
& Millichap
Millichap Research
Research Services,
Services, CoStar
CoStar Group,
Group, Inc.
Inc.
growth. Local market factors play a much more critical
role once again, as opposed to the broad-based cap rate
compression from 2001 to 2006.

On average, commercial real estate prices have

increased 60 to 90 percent over the past five years,
resulting in a significant build up of equity. The cur-
rent disruption to capital flows and higher financing
U.S. CMBS Issuance costs will be overshadowed by investors’ opportunities
for attractive cash returns and building long-term value.
$225 Furthermore, the tremendous amount of equity in the
market is helping to offset lenders’ lower LTV require-
Issuance (billions)

$150 ments.

For many investors, mitigating risk has become a pri-

$75 mary objective. As baby boomers near retirement,
demand for lower-risk investments that offer stable
returns will rise substantially. For investors with a higher
$0
risk tolerance, there are still opportunities in the market
05
00

01

02

03

04

06

07

that offer above-average upside potential. Deals that rely

D
YT

heavily on future rent and occupancy growth, however,

Sources: Marcus & Millichap Research Services, Commercial Mortgage Alert
will require borrowers to put more cash down to satisfy
current DSC requirements and will face higher rates.

© Marcus & Millichap 2007 Page 7

 Special Research Report
Real Estate Returns Outperforming Stocks
In Recent Years
1-Year 5-Year 10-Year
300%
225%
Total Return*
150%
75%
0%
S&P 500 Apartment Office Industrial
*Returns represent total compounded returns over each time period
Total returns include both income and capital returns
Sources: Marcus & Millichap Research Services, NCREIF, S&P
With more than 1,300 investment professionals
in offices nationwide, Marcus & Millichap is
the largest commercial real estate brokerage
firm focused exclusively on investment sales,
financing, research and advisory services.
For additional information on local or
national market trends, please visit
www.MarcusMillichap.com or contact the
nearest local office to speak with one of our
investment professionals.
Report prepared and written by:
Erica Linn
National Research Manager
Tel: (602) 952-9669
elinn@marcusmillichap.com
Report edited by:
Hessam Nadji
Managing Director
Tel: (925) 953-1700
hnadji@marcusmillichap.com
Capital markets section written by:
William Hughes
Managing Director
Marcus & Millichap Capital Corporation
Tel: (949) 851-3030
whughes@marcusmillichap.com
www.MarcusMillichap.com
© Marcus & Millichap
The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no repre-
sentation, warranty of guarantee, express or implied may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research
Services, American Council of Life Insurers, Bureau of Economic Analysis, Bureau of Labor Statistics, Citigroup, Commercial Mortgage Alert, Costar Group, Inc., Economy.com,
Fitch Ratings, LoanPerformance, Joint Council for Housing Studies (Harvard), NCREIF, Property & Portfolio Research, Real Capital Analytics, Reis, SIFMA, Standard & Poors,
TWR/Dodge Pipeline, U.S. Federal Research, U.S. Treasury, Wachovia.
Marcus & Millichap Research Services
Properties with seller-backed or assumable, lower-
rate financing will command premium pricing.
Mortgages originated as recently as two months ago
could easily have more favorable rates in place than
those available today. When assuming a loan on a
property with significant equity, borrowers may be
able to obtain secondary financing to help fill the gap.
Cash buyers have an advantage in the market today.
Given the tighter financing environment, low leverage
Retail buyers and cash investors will be better positioned for
buying opportunities. However, healthy property fun-
damentals will prevent major price reductions.
Alternatives to investment real estate are currently
less attractive. Higher risk in the MBS and corporate
debt markets, along with stock market volatility, will
keep commercial real estate higher on investors’ lists of
options. Furthermore, total returns in the U.S. real
estate market have surpassed the stock market by a
wide margin over the past 10 years.
Real estate investors consider more than just current
NOIs when valuing commercial properties. Real
estate offers investors a level of intrinsic value that can-
not be found in the stock or bond markets. When com-
panies fail, stocks become worthless, but when a prop-
erty loses tenants, it still has residual value and retains
upside potential. Even when assets become outdated
or obsolete, investors have the opportunity to reposi-
tion or redevelop to improve or renew income streams.
On average, it has taken five to six months from the
start of a liquidity crises to return to more normal-
ized conditions. In 1998 and 2001, it took between 1.5
to 2.0 months for CMBS spreads to peak, and an addi-
tional four to six months to recover. We are four
months into the current widening cycle if we start
tracking from May 2007.
Low delinquency rates, healthy supply/demand fun-
damentals and minimal risk of overbuilding will help
to return liquidity to the commercial real estate mar-
ket. There is an estimated $40-plus billion overhang of
commercial loans in the CMBS pipeline, which may take
a few months to clear. The rate of recovery depends on
how quickly investors regain confidence in CMBS,
which is difficult to predict given that any one econom-
ic variable could sway the direction of the market.