Industries Commercial Real Estate

Who’s doing deals in 2011?

REITS and other cash-flush buyers are in the market while banks stay on the sidelines

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Constructing a two-building, Class-A office complex in Sterling seemed like a good idea back in 2008, but things didn’t turn out so well. Demand from tenants never materialized, and the buildings — Loudoun County’s only LEED gold office space — sat empty for two years.

Finally the owner —  institutional investor Dexus Dulles Town Crossing LLC — decided to get out. It put the properties up for sale, and in early November Maryland-based First Potomac Realty Trust bought the 219,980-square-foot project for $22.5 million, or about $102 per square foot.

“The attractiveness for us was to be able to buy these buildings at a substantial discount to what it would cost to build them,” says Nick Smith, executive vice president and chief investment officer for First Potomac in Bethesda. He estimates a savings of about 40 percent. “We’re buying them at enough of a discount that we can offer some very affordable leasing rates to tenants.” 

Plus, the complex in the Atlantic Corporate Park offers the attractive amenity of being within walking distance to a hotel and shopping. Potomac’s deal illustrates a key trend in commercial real estate these days. Well-funded buyers, often REITs like First Potomac, are snapping up distressed properties, or stepping in with money to take over new projects that ran out of cash. In fact, for those with money, and the courage to spend it, today’s market is ripe with opportunity. 

Andy Little, a principal with John B. Levy & Co., a real estate investment banker in Richmond, says institutional investors left the sidelines in the third quarter and started spending. “They got off of defense and got on to offense, and that’s a great sign,” he says.

Many banks, though, still are shedding bad loans. Last year banks got rid of about $30 billion in debt, Little says. While bigger banks are likely to increase their lending in the next three to six months, he predicts smaller banks will have a tougher road. “When I say smaller banks, I mean banks in the community. The lenders who were doing construction loans [or] unanchored retail. Those smaller banks are still heavily concentrated in real estate loans, and that’s going to take a while to clear … In 2007 if you went to 10 community banks [for a loan], you probably got 10 quotes. Now there are probably three that are in a position to lend.”

Pension funds, both foreign and domestic, also are doing deals in core markets like Washington, D.C. Vornado Realty Trust recently sold a partial stake in two prime D.C. offices to the Canada Pension Plan Investment Board. The fund invested $91 million and assumed 45 percent of an existing loan secured by the buildings, which are valued at more than $500 million. 

First Potomac definitely has been on a buying spree. In 2010, it spent $393 million on a dozen properties, mostly in the Washington, D.C., region, split between downtown and suburbs in Virginia and Maryland. The purchases were divided between distressed properties selling at lower prices and higher-end properties with a stable revenue stream. For instance, in contrast to the empty buildings in Sterling, First Potomac bought a fully leased 96,700-square-foot office building in the Battlefield Corporate Center in Chesapeake for $8 million.

“We’re trying to take a balanced approach to what we perceive to be opportunities in the marketplace,’ says Smith. For every two or three financially stable buildings Potomac purchases, it buys an empty one.

Properties in D.C. have tended to be in better financial shape; whereas in Northern Virginia and Maryland there are projects — mostly in business parks —  that are struggling, in part because there is too much inventory in some places. Yet, they offer the potential for revenue growth as the market rebounds.

“We can generate some great returns off of deals like that,” notes Smith.  “We could offer rates that are anywhere between 10 percent and 25 percent” lower than the original owner could, he says. “That puts us at a huge advantage.”

First Potomac raised $170 million in November through a follow-on second offering of 10 million shares of common stock, Smith says. “We have the capital on hand to make these investments.”

Chris Macke, senior real estate strategist with CoStar, a Washington-based commercial information and analytics provider, terms the market as somewhat volatile because many other buyers are doing the same thing as First Potomac — buying high-end properties in strong markets and looking for deals at the other end of the spectrum. REITs have been doing particularly well in raising investor cash largely because they offer a better return.  “If you’re an investor and looking for something safe, you start off with 10-year [Treasury bonds]. Back in October, you could get about 2.5 percent. A REIT can get about 6 percent,” Macke says.

Another funding source that fell off the cliff in the real estate collapse two years ago is commercial mortgage-backed securities, or CMBS. Little says the newer version of that funding approach is doing well. “We’re actually seeing a lot of deals getting done,” he says. Under the old version of CMBS, lenders charged higher rates than banks and life insurance companies for smaller loans on properties that Little called “ugly, old and out of favor” with traditional lenders.

Today’s version of CMBS has lenders pursuing stronger properties in the best markets. “The bond buyers are out there, and there’s a depth to those buyers, and that makes the market more stable,” he says. Some industry watchers look for the issuance of CMBS securities to increase to $25 billion this year, which is more than last year, but a pittance compared to $234 billion in 2007, when the securities market peaked.

For the near term, trends are looking better, observes Little. The weakest link is still the banks. He predicts the bigger banks “will come of the woods first” and start increasing their lending. “The funny thing is, once that switch gets turned, it’ll be almost universal,” he says. “As soon as you get a couple of banks stepping in and saying, ‘We are ready to lend,’ word travels very quickly.”

Investor financing for well-located projects is beginning to come through. For instance, Developer Hines/Archstone plans to move forward with CityCenterDC, a long-delayed, $950 million, urban project that is supposed to break ground in April. The announcement came after preliminary financing was put together in October.
Meanwhile in Loudoun County, Boston-based New Boston Fund Inc. is investing in a 178,200-square-foot, office/industrial complex that will serve as a regional headquarters for Rockwell Collins, a major player in the communications and aviation electronics industry. 

With the market seeing activity on both ends of the spectrum — from speculative to build-to-suit — there seems to be something for everyone willing to invest.

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