COVER STORY, FEBRUARY 2008

(SUB)PRIMED FOR THE NEW YEAR?
A look at what real estate professionals can do to stay healthy in an unpredictable market.
Scott Lynn

Moving into 2008, there is a tendency to look back upon 2007 with a sense of detachment that can make it feel as if the subprime difficulties and resulting unrest in the capital markets were a thing of the past. There is always a fresh sense of optimism as a new year begins, but in reality, little else has changed between December 31st and January 1st other than the date. Many questions with far-reaching implications for real estate finance remain: How bad have things gotten? Where has this left the industry? Where do we go from here? Perhaps most importantly, what can lenders, developers and brokers do to combat the current situation and stay healthy in an up-and-down market?

As we assess the current status of the capital markets and look ahead to 2008 and beyond, carefully analyzing those questions can not only help us make sense of where we have been, but they also can help us to take stock of where we are, allowing us to strategize effectively so that we can chart a course that will take us where we need to go.

First, the bad news: the markets are far from improving, and, in many ways, things have gotten worse over the last several months. While initially, problems may have started with subprime, there has been a resulting domino effect throughout the broad capital markets. With large-scale trends such as what we are currently experiencing, it has historically taken some time for the acceptance that there really is a significant problem to filter its way through the industry. Events of the last year have shown that this phenomenon is less prevalent than in the past; however, IT innovations and the sheer volume of media outlets and high-speed communications have helped people realize much more quickly where things stand. The pace at which accurate information has traveled and the speed with which that information has been accepted and processed by the market is unprecedented.

The natural pace of events has been somewhat accelerated as a result of these communication advances. In all likelihood, just as quickly as we can begin to say we are officially in the midst of a rough patch, there will be a reason to look for some light at the end of the tunnel. The good news is that there are some sound reasons for optimism.

The period between post-9/11 to summer 2007 was actually a tremendous era of growth for commercial real estate and for capital markets in general. In fact, history will show that it was an era of unprecedented growth in the capital markets that helped drive price and value appreciation for all types of real estate. Obviously, that has changed, and people are now looking at their real estate risks and exposures much more carefully than they were 1 year or even 6 months ago.

Essentially, risk has been repriced. But where did all that money come from in the first place? Much of it came from the stock markets and some from foreign investors. Wall Street contributed its share through securitization and selling off of products that created additional liquidity in the market. Some came from investors who were provided tax incentives to invest in real estate. While some of that influx has proven to be less than substantive, it is not all smoke and mirrors — and it has not all gone away.

The good news is development fundamentals are basically solid. Values could decrease somewhat as equity investors may demand a higher yield, and certainly, many types of development will be tougher to get financed in the near future. Yet, while some sectors have taken a significant hit, the bottom has by no means fallen out of the market. Savvy developers looking for equity capital or favorable terms will need to focus on specific types of projects.

A good development storyline is more important than ever in an uncertain climate, and certain niches will perform more strongly than others. Medical tenants — as well as single-tenant office buildings or office developments with extensive pre-leasing — are safer bets, and development professionals may have to resolve themselves to accept scenarios with reduced leverage.

The key for all parties is not only to set realistic goals and adjust their strategies accordingly, but also to become more flexible and accept that some changes might need to be made to the business model. Many investors or developers are involving themselves in more existing income properties and less ground-up development. Trading lower yields with less risk is a solid bet in what has been a less-than-solid fiscal environment. In addition to changing the kinds of deals, it may make sense to take a fresh look at where to go to place deals. Some are finding that smaller regional banks are offering more favorable terms than some of the bigger banks and national players.

While many in the commercial real estate industry are finding ways to navigate through this downturn, others are not yet done adjusting. Some are just trying to figure out the next step. It is vitally important for owners, developers and investors who rely on debt and equity capital advisors to work with a trusted partner who not only has accurate, up-to-the-minute industry information but also understands how to change strategies to succeed in a still-evolving commercial real estate landscape. Ultimately, the key to success in any challenging environment is to be creative. Those who are flexible, pragmatic and ready to adjust their strategies and business models as needed will ultimately emerge successful.

What does 2008 hold for the industry and the capital markets? Assuredly, we will not go back to where we were, but things will begin to stabilize. As more balanced, reasoned perspectives filter back into the industry and discipline reasserts itself, we will start to see a move back toward normalcy. By mid-2008, we should start to see tangible progress, and things will not feel quite as uncertain as they do now. It is a professional reality that, from time to time, the pendulum of risk and reward will swing too far in one direction, and it is equally certain that the pendulum will inevitably begin to swing back. For those of us who are along for the ride, that arc can be dizzying, but a little professional perspective and thoughtful strategy can help all of us look to the future with genuine optimism.

Scott Lynn is director/principal of Metropolitan Capital Advisors in Dallas.

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