01/28/2009

Silver Linings Scarce in Office-Sales Market

Coming off a year that saw a sharp drop in office-property sales, market pros expect activity to decline further in 2009, with transactions mostly involving buildings with assumable financing, forced sales or recapitalizations of overleveraged properties. Buyers and sellers have little confidence in the office sector because lenders have retreated to the sidelines, it does not appear that prices have hit bottom and the recession is worsening. That has made it hard to determine valuations, creating a wide gap in the expectations of buyers and sellers. In such an environment, few owners are voluntarily selling.

Last year, the sale of large office properties plunged by 69%, to $42.5 billion from a record high of $137.7 billion in 2007, according to Real Estate Alert's Deal Database, which tracks deals of $25 million or more. CB Richard Ellis dethroned Eastdil Secured as the most active office broker (see article on Page 6).

The sector has been largely stagnant since the credit crunch started emerging in mid-2007. The biggest obstacle to office-property sales is a lack of available financing at affordable rates. "We need capital dedicated to new lending," one Washington broker said.

Added a veteran fund operator: "Without credit or financing, it's impossible to jumpstart the market. We could be locked up for quite a while."

As was the case last year, most sales likely will involve assumable financing in 2009. Trades figure to be dominated by core properties with high occupancy rates and established net-operating incomes, because lenders are no longer putting any faith in projected incomes.

It's possible that some buyers, such as foreign investors and high-yield funds, will step up to pay cash for properties, looking to snap up assets on the cheap from forced sellers, such as open-end funds that need to raise cash quickly to honor redemption requests from their investors. For example, a CB Richard Ellis Investors fund last month acquired three properties from ING Clarion Partners' Lion Properties Fund for $198 million. ING had paid $363.3 million for them in 2005 and 2006, but let the assets go at a steep discount, most likely to meet redemption requests.

Some business for brokers will be generated by owners struggling to refinance overleveraged holdings. Many owners that bought properties in 2006 and 2007, at the peak of the market, won't be able to fully replace their maturing floating-rate mortgages. Additionally, they will have to increase equity in the properties to meet stricter lending guidelines. As a result, they will have to kick in their own equity, or more likely, find equity partners to make up the difference.

High-yield fund operators began raising cash last year for a host of vehicles targeting such recapitalizations. They're talking about garnering double-digit returns by providing so-called rescue financing or equity to cash-strapped property owners and developers, most often in the form of preferred equity or bridge loans.

The catch is that high-yield shops have found it far more difficult to raise capital since the stock and bond markets took another turn for the worse in September. What's more, some fund shops with dry powder are in no rush to invest. With prices still dropping, those fund operators believe they're better off waiting for properties to be foreclosed. And shops with access to capital are waiting for struggling REITs with quality assets to go bankrupt so they can pick up the pieces at steep discounts.

"Recapitalizations are messy," said one equity-raising specialist. "From an investor standpoint, why bother? Don't make your problem my problem. [It's] easier for investors to let properties go to foreclosure, given the convoluted capital structures that were created through financial engineering in recent years."

Meanwhile, some brokers are turning down recapitalization assignments when property owners are being unrealistic about pricing and terms. "I am seeing some attempts at recaps, but they are all under water and don't make sense," a Dallas broker said.

If owners cannot recapitalize, lenders will eventually end up shopping properties. But so far, lenders have been slow to bring product to market, and buyers complain about the large gap in the price expectations of buyers and sellers.

Part of the difficulty of determining valuations stems from the fact that transaction prices ranged widely last year. While office-property values dropped about 20% on average in 2008, according to most estimates, some properties traded at 5-10% discounts and others sold at discounts of 40% or more.

A recent deal in Manhattan might provide some clarity on valuations. A lending syndicate led by Deutsche Bank agreed this month to sell the building at 1540 Broadway to a client of CB Richard Ellis Investors for about $375 million. That was less than half the $830 million price that Macklowe Properties paid for the property in 2007, before surrendering it to the Deutsche syndicate last year. If a few more transactions like that occur, "the bottom will be set," one New York broker said.

Even if low-rate financing suddenly became available, sales would still be held back by awful conditions in the broader financial markets. If businesses continue to close or downsize, vacancy rates would rise. That, in turn, would push down rents, decrease property values and further scare away buyers. While many buyers claim to be interested in distressed properties during the good times, they often change their tune in a sour economy, one market player said.

Asking rents in Midtown Manhattan dropped $4.67/sf, or 5.5%, in the fourth quarter, according to a report from Cushman & Wakefield. In San Francisco's Financial District, new leases for Class-A space averaged $5.59/sf less in the fourth quarter than in the third quarter, down 18.5%. "With no new net demand, where will rents settle? How many zombie tenants are in any given building?" asked one Los Angeles broker, referring to doomed tenants that still occupy space.

Market pros hold out a glimmer of hope that the lending environment might improve in the second half, especially if the federal government's economic stimulus plan stems the rising unemployment rate. Still, there is widespread pessimism about 2009. One high-yield fund operator who was asked what gives him optimism about this year, replied: "It gets us closer to 2010."

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