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Shape of the Road to Recovery – "L", "U", "V" or "W"? Note from the editor By Eric Rosedale
The state of the health of the global real estate industry is a matter of much debate and speculation following an unprecedented period of turmoil trigged by the sub-prime crisis in the US more than two years ago. Investors are asking whether we are now facing an "L", "U", "V" or "W" shaped recovery. There is no consensus view, and every pundit has a theory. In the private equity sphere, we are seeing a growing divide between funds targeting developed and emerging markets, with the weight of available capital still favoring larger, more transparent markets with less perceived country risk. Ironically, this is leading to what some observers already see as an "overheating" of sub-markets such as the London office sector where pricing is being buoyed by a rush of foreign investors in the belief that we are at or near a bottom of the UK recessionary cycle.
The trend away from "risky" markets is leaving room for more local - to - local deal making, as local players don't have to answer to wary investment committees, often take a longer term view and don't require a large country risk premium.
Ultimately, it will be the banks that will set the price benchmarks going forward. Outside of the US, banks have been in no rush to pressure troubled borrowers. This is largely because they still don't have REO programs in place and need to deal with more pressing balance sheet and strategic issues in their "home" markets. This situation is unlikely to last much longer if the commercial real estate industry in markets outside of the US begins to experience the same sort of occupational difficulties that are beginning to drive US banks to "take back the keys" from defaulting borrowers.
If the US real estate market is a sign of things to come, then more markets are likely to follow a "U" or "W" (double dip) shaped recovery, within a second wave of price reductions to come. By way of comparison, prices in the US have reportedly dropped 35% below their peak in October of 2007 and rents have fallen by more than 16% - far deeper than what has been experienced in most European markets.
Russia is an interesting illustration of what has happened in an emerging market where real estate transaction volumes fell off a cliff after years of robust growth. Even with a recovery in commodities prices and a glimmer of hope that the US economy will begin to lead a global recovery, it's far too soon to break out the vodka and caviar to celebrate the beginning of a "V" shaped recovery. Structural problems in the Russian economy, persistent high unemployment and a large backlog of short term corporate debt that needs to be re-financed is making any recovery to come look more like a "U" than a "V" and hopefully not an "L".
While private equity combined with abundant debt fuelled real estate markets like Russia, the private equity industry suffered its worst year on record in 2008 and some real estate funds are in deep trouble. More conservative funds have moved large emerging markets such as Russia and China (and smaller markets with structural fiscal deficits such as Ukraine and Turkey) off their lists of regional targets. In Russia, India and China committed investors will wait to see some benchmarks on price corrections, and the general consensus is that there is still a significant gap in pricing expectations, with not enough of a risk premium to whet their appetites. This is another indication that we may be in for a "U" shaped recovery in many emerging markets.
On the distressed side of the coin, not much is happening in outside of the US - yet. Unlike the US where waves of distressed real estate are beginning to come on the market, other markets are still in denial. For example, European commercial property owners are facing a debt "time-bomb" with many sectors expected to be in negative equity for many years to come and a massive CMBS re-financing requirement to deal with. This is largely unchartered territory, where restructuring, foreclosure and banking laws and regulations will be tested in developed and emerging markets alike.
Other observers believe that emerging real estate markets have the potential to recover faster and further than developed markets, especially compared to those developed markets with large fiscal deficits, more highly indebted consumers and deeper supply and demand problems in their commercial real estate markets. This optimism for a "V" shaped recovery is especially evident in China where there is still relatively high GDP growth; favorable demographics for virtually all sectors of real estate and huge foreign reserves available to stimulate the economy.
The amount of cash allocated to real estate waiting on the sidelines has been difficult to measure. In the private equity sphere, there has been a degree of successful fund raising targeting distressed assets and debt with more to come, especially as equity markets recover which should ease the impact of the denominator effect. Ultimately, savvy investors with a long term commitment to their markets of choice will be glad to see that much of their competition has disappeared. This will be a painful reality for banks and other sellers that are forced to put product on the market, but it's an essential first step on the road to recovery, whether it be in the shape of an "L", "U", a "V" or a "W".
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