Metro Phoenix Residential Real Estate to Recover Before Commercial

Posted By Mike Padgett

July 15, 2009

PHOENIX, Ariz. – Hints of a rebound in metro Phoenix’s residential market, multiple bids on lower-end homes, and a delayed return in the commercial market are some of the latest opinions of Kurt Rosene, senior vice president of national development at The Alter Group, a national developer based in Chicago.

Rosene recently took time out from his busy schedule to talk about changes occurring in the metro Phoenix market.

MP: A report from Arizona State University’s W.P. Carey School of Business in June says metro Phoenix’s residential market appears to be nearing a bottom. How is the residential market affecting the commercial real estate market?

Kurt Rosene: “In my informal travels over the last couple of months, and just talking to all kinds of people in commercial and residential real estate and other businesses, even retail businesses, I kind of added up what everybody’s saying. They’re suggesting sometime toward the end February that it appears in almost all sectors that we hit bottom.”

MP: In the total local economy?

Rosene: “In almost the total economy. Like I said, I’ve been talking to quite a few different businesses – manufacturers, retailers, people in real estate. Everybody agrees, consistently, that we’re not going to start soaring out of the depths, that it’s going to be a long painful process in a recovery. But it seems that sometime in the first quarter of this year that a lot of indicators are suggesting that we kind of hit rock bottom.”

MP: And the market today is showing signs that it is up from where it was in February?

“Absolutely. There are some indices that are suggesting or mirroring that attitude. I think we were in such a freefall there that, in some respect, you have to have a bottom and you have to have everybody somewhat agreeing that it’s landed for people to turn the ship around.”

“So that (ASU report) may be good news, and I’m glad that they came out with that. Most of the indications you see in the residential market here locally would suggest that.”

MP: In the commercial real estate market, money has been tight. What trends are you seeing?

“Money’s been tight. For the most part, it remains to be tight. I think from the lenders’ aspect, there’s still no market there. It basically just doesn’t exist. Everybody’s seen in the news how the TARP (Troubled Asset Relief Program) funds are being repaid by the banks. And I think that’s good news.

“Are you familiar with the TED spread? That’s a measure of risk aversion in the credit markets, and everybody’s kind of been looking at that. A lot of people track that. What it is, it’s the difference between the interest rates on three-month Treasury bills basically considered risk-free, and the three-month dollar LIBOR. LIBOR, as you know, is kind of the widely-used index for lending between banks and businesses and mortgage loans.

“That index, which is the acronym TED, the TED spread, has receded below pre-crisis levels. Basically, last fall sometime when the credit crunch hit. Finally, the spread has come together back to where it was before the crisis hit. Which is a very nice indicator.

“That should indicate that money is starting to flow between banks and businesses and even into mortgages. I’m not telling you I see it yet, but that spread has to become narrower for it to happen.”

“So you have banks paying back money borrowed from the government, you have the TED spread starting to shrink a little bit, and then you basically also have, the REITS have been very healthy recently in recapitalization of their debt and equity. Everybody was kind of wondering if a lot of the REITS were going to go away here in the first quarter of this year.

“And I think they’ve raised something like $15 billion recently through almost 50 new equity offerings, public offerings. And the REITs, they’ve kind of followed the stock market, except maybe even more robust. Their share prices overall I think have rallied something like 60 percent from their low in March.

“Now the REITs are definitely are using that recapitalization to buy down debt. I wouldn’t suggest that they’re going out there and they’re going to start development anytime soon. And I guess I’d go to my second part of your question – I don’t see new development occurring in Arizona, substantial new commercial development, for quite some time.

“The trends right now are, (landlord) concessions are still rising, rental rate depression is still going down, you have people in commercial office dropping their rates substantially. And then there are incentives on top of that.

“There’s an overabundance of (commercial real estate) product out there, and it’s going to be painful. I just don’t see much new product coming on line for, I’d say another year or two.

“Now if you want to find silver linings, I think that the price reduction overall in the housing and residential markets here locally are going to help Arizona. As you know, in ’05, ’06, ’07, our standard median home prices were catastrophic the way they were going up so quickly. It was just crazy.

“And a lot of that, I believe, was caused by the fact that our median home price almost doubled. We looked always as a very inexpensive place with a nice quality of living, and we were starting to outprice ourselves (compared) to many other Sun Belt locations.

“So that the fact that the residential market got overbuilt and it’s corrected heavily has hurt a lot of business, but at the same time it may help business because it may start bringing people again here from California and other parts of the country, who can afford homes again.

“And a lot of folks are out there buying homes for less than $100,000 or $150,000. I’ve checked with a bunch of residential Realtors, and they’re saying it’s crazy. If you’re under the $100,000 or $150,000 price range now, you may be getting 10 or 15 offers on a house.

“The same thing was happening to the higher-end homes three years ago, but what that tells you is that there’s a real market for those homes. Now they were adjusted heavily maybe by the lenders or whatever, but there are people buying those. And I think in most of those cases, it’s not speculative buyers – it’s people who are going to move in and live in those homes.

MP: And they’re using their own money, not borrowed funds?

“Exactly. Again, this correction is healthy. It hurts a lot, but it’s healthy in the fact that there’s real money, real equity, the loans have traditional lenderwriting behind them. So you can’t foresee that those will get into trouble because the people are doing it the old-fashioned way.

MP: In the commercial market, because money has been tight, what creative financing tools are you seeing, like hybrid loans or insurance companies involved in financing?

“We’re not seeing a tremendous amount of activity from the insurance companies. The insurance companies, in my opinion, got hit pretty hard because they had a certain amount, you know, almost any institution or insurance company is going to say, ‘You can have X percent of your portfolio’s total value in real estate.’

“When the real estate markets got hit and the valuation went down so much, it skewed their percentages and they were told to either get rid of real estate or that they couldn’t put any more money into real estate.

“So there’s a common philosophy out there that there’s a whole lot of pent-up capital from the insurance companies that’s getting ready to flood back into real estate. I got to be honest with you, Mike – we’re not seeing it.

“If it’s on the sidelines, it’s definitely on the sidelines. I think it’s on the sidelines more because of covenants and restrictions that they’re going to have to let this market work itself out and have valuations come back and make sense.

“There are private equity REITs. There’s a lot of capital out there that’s been raised for, I’d kind of say, your vulture funds. They’re looking at building assets and also looking at land and the devaluation of them, trying to come in and buy at cents on the dollar. That’s not helping the developers so much with capital and loans; it’s potentially just helping the banks work through some of their excess product and underwriting some of the business.

“You know, with the banks paying back this TARP money, I think it’s sending the signal that they’re not willing and ready to write off huge losses off their portfolios, so one of the questions is going to be, ‘The vulture fund money’s out there but if the banks aren’t willing to really dramatically underwrite the values of those buildings, where does that money go to?

“We would suggest, you know, our lending relationships, some of them go back 30 or 40 years with the national lenders, they are telling us they want the loans. They are stepping up on various build-to-suits we’re looking at right now. You will not see it on speculative product. That’s off the charts here for, I’d say, a couple of years. The banks just won’t go near it.

“I think people that have let’s say a 50 percent preleased tenant and want to go get a loan, I think, are going to be very challenged. But if you have a built-to-suit (plan), the banks are going to look at two things – they’re going to look at credit and terms.”

“The deals I’m talking about, a 15-year term and a good-credit tenant, you can still probably live with a 20 to 25 percent equity and leverage up to 75 percent, maybe 80 percent. But if you don’t have good credit, if you don’t have enough term, if you don’t have it fully leased, you’re going to be up maybe over 50 percent equity requirements.

“Now there’s plenty of private capital out there that’s looking to come in and sandwich that and say, ‘Okay, you go get your 50 percent debt from the bank and we’ll come in and we’ll come in and provide up to 30 to 50 percent equity,’ but they’re looking for huge returns on that money. And candidly, it makes the rental rates so high that I haven’t seen any of those pencil out yet.”

“Yeah, you’re looking at equity that wants 18 to the high-20 percent returns on their money. And you factor that in with the cost of building a brand-new building, and you look at the rental rates and the concessions that existing buildings are willing to offer, and you know, at some point, I’ve seen a build-to-suits try to move forward and the client finally just looked and said, ‘I can go down the street to an existing building and do a deal much easier.’”

MP: Any foreign money involved?

“We haven’t seen a lot of it. I’ve heard that there’s some out there. There’s a lot of capital being raised. I would suggest that funds and groups that we’re running into that have in excess of $1 billion haven’t seen a lot of foreign capital yet. In my opinion, before the election, the foreign capital got very concerned about what was going on with the transition from the Bush administration.

“The economic cycle that the United States is experiencing is global. It’s not just here. So most of the foreign capital has issues of its own. And I think if the capital is available, in my opinion, it’s waiting on the sidelines.”

MP: Kurt, I have no more questions. Thank you. Anything else you’d like to say?

“Good luck and have a great summer. A little traveling and stay cool. When the economy heats up, 100 degrees won’t feel so bad.”

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Jul 15th, 2009

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