could something go right in 2011?

(This is a reprint from Wrightwood Capital's regular column, The Credit [r.e.]View)

Given the uncertainty in the economy, the significant loss of value in commercial real estate markets, regulatory change, ongoing deleveraging of portfolios and the threat of exogenous economic shocks brewing in Europe, Asia and elsewhere, it takes very little imagination to predict what could go wrong next year.  To borrow, and perhaps abuse, Nassim Taleb’s brilliant metaphor for improbability and uncertainty, there are “black swans” lurking in every corner of our global marketplace.  But could something unexpected go right as well?  Are there any “white swans” in our future?

Most of the experts, articles and surveys that try to predict commercial real estate next year indicate a fragile world especially vulnerable to the power of black swan events.  Most predict that 2011 will look much like 2010:  slow improvements, perhaps a little more transaction volume and continued healing.  The National Association of REALTORS® sees only slight improvements in store, “Commercial real estate markets are flattening out, with modestly improving fundamentals expected in 2011.”  ULI, in their 2011 report, Emerging Trends in Real Estate 2011, points to a year of “tempered improvement” while participants in their study “expect halting advances in digging out from the recent avalanche of ill-considered commercial property investments and problem loans…larger economic forces that could stunt any upturn make the course more treacherous.”  According to Preqin’s special report, What Now for Private Equity Real Estate?, “There are some signs the market may be improving, but in turbulent conditions, predicting when this will happen is a difficult proposition…Recent performance is not showing any signs of a quick reversal of fortunes, and real estate has lagged behind other asset classes which have seen a rebound in performance.”

But what about the unexpected? As John Kenneth Galbraith once said, “The enemy of the conventional wisdom is not ideas but the march of events.”  Most of what goes wrong in this economy is unexpected.  Few expected the events of 9/11 before it happened.  Although most people were worried about asset prices in 2007, very few stopped investing.  Much of what could go right is unexpected by conventional wisdom as well.  In 1993, no one thought the 1990’s would be known for explosive growth federal budget surpluses and computers in every pocket. 

Most are familiar with potential problems in the world and many hours have been spent hypothesizing and worrying about what could go wrong.  North Korea could erupt into conflict.  There could be a major terrorist attack on U.S. soil.  Another European country could default.  The economy could spiral into inflation or deflation.  New regulations could make it impossible to invest.  Large financials could collapse.  OPEC could flex their muscle.  Those are just the more obvious threats.  Many other unforeseen things could easily go wrong.

But could something also go right in 2011?

Wrightwood Capital’s resident skeptic, David Friedman, (Managing Director, Fund Management), surprised me the other day with the question: “Is it possible that commercial real estate could be set up for a great 2011?”  He pointed out a few data points that counter conventional wisdom’s flat view of the future.  “First off – have you been following the P/E ratios for public real estate brokers compared to the S&P Index?  They are steadily growing despite the slow year in 2010.  CB Richard Ellis is sitting at 41 times earnings, and Jones Lang LaSalle is at 27.5 times earnings – while the S&P is only at 22.  Perhaps this represents some kind of irrational enthusiasm for real estate, but it has been trending up for some time.  Does this mean that investors believe there will be more transactions next year?”

Another indicator of positive surprises in store is the possible or even likely re-entry of the Commercial Mortgage Backed Securities (CMBS) market in 2011.  After three years of not much more than $20 billion of issuance (down from over $330 billion in 2007), major issuers are planning for over $45 billion next year.  Although that amount is still less than the amount issued in 2005, it has a significant multiplier effect on available debt in the U.S. commercial real estate market, and perhaps on transactions.  According to David, “It becomes even more interesting if you start to compare the historical ratios of core real estate transacted each year to CMBS issued.  From 2002 to 2007, the ratio of CMBS dollars to deals transacted was around 55%.  For the last three years, that ratio plummeted to the 10% range.” 

2010 is on track to stay in the 10% range.  Real Capital Analytics is predicting that transactions closed this year will exceed $100 Billion while Preqin estimates that new CMBS issuance will be in the range of $10 billion.  As David points out, “If the ratio between CMBS and closed transactions in 2011 stays even close to 2010, $45 billion of new CMBS may translate to quite a year for anyone in the transaction business.”

Another driver for pleasant positive surprises comes from the banks that were bailed out by TARP and have given the money back to the federal government.  According to David, “It won’t just be CMBS coming back next year.  These banks will be back in business.”

Given these positive indicators for new debt coming into the market, David asked, “Is debt availability the lubricant needed for a meaningful increase in transaction volume?  There has been plenty of equity capital sitting on sidelines (according to Preqin, there is over $174 billion of uncalled capital available to invest within real estate private equity funds), but there is a significant gap between debt and equity on all but the most stabilized properties coming to market these last few years.  With more low cost debt, the gap may be easier for buyers to bridge.”

There are certainly many things, known and unknown, to fear in 2011.  As Michael Palin famously screeched in a 1970 Monty Python sketch, “Nobody expects the Spanish Inquisition!”  Conversely, right now, everyone expects but may be surprised by the good.  No matter what happens, these are certainly challenging and exciting times to work in commercial real estate. 

Have a safe, prosperous and peaceful New Year.