Curb Your Enthusiasm?

Joe Sandner III has been around the Alabama commercial real estate business for 35 years and has seen his share of ups and downs and bursts and bubbles. He says he doesn’t put much stock in the talk going around about a bubble in the commercial real estate business.

“In Alabama?” Sandner says. “I don’t think so. Across the country you can make an argument that there may be some markets that may be heating up, but I am not aware of any specifics I would want to point to.”

And, Sandner says, “There has been more investment, more properties to handle in the past two years than I can remember in a long time.”

Sandner, based in Birmingham, is CEO of Alabama operations for Colliers International, a publically traded international commercial real estate services company specializing in all facets of commercial real estate. The Alabama office manages five million square feet of office space in north Alabama.

“Now, you know any economy that goes south real fast, people can look back and say, ‘Oh, it must have been a bubble.’

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“In Alabama I think there are still good fundamentals, and I think they will be here for a while. You still see retail and apartments and office buildings trading below replacement costs, and, to me, that is a pretty good thing, ” Sandner says.

A lot of the talk about a commercial real estate bubble can be linked to reports in the national business press over the past six months or so. The reports have been based on warnings from the Federal Reserve Bank and the Office of the Comptroller of Currency about an increase in risky real estate lending.

But there are as many definitions of a bubble as there are classes of commercial real estate assets. 

Carl Hudson, director of the Atlanta Fed’s Center for Real Estate Analytics, says, “Bubbles are inherently difficult to spot before they burst.”

“A bubble is really more about a poorly formed expectation, an unrealistic expectation in terms of asset purchases, an overly optimistic growth forecast, ” says Clarence Pouncey, executive vice president and chief operating officer of ServisFirst Bancshares Inc. “When a purchaser is overly optimistic in terms of the overall return an asset class is going to provide them, that is creating a bubble expectation.”

Whatever the definition, a lot of people involved with the commercial real estate market say if there is a bubble forming, it is forming in big city markets like Seattle, Oakland, Austin, Boston, San Francisco and Miami. And, of course, bubble talk is usually linked to the financial crisis of 2007.

“One thing to contrast now with the past, ” Hudson says, “they use cap rates frequently to talk about what is the net operating income from a property versus the price that was paid for it, so the lower that cap rate means the higher the price relative to the income it is generating. If you look between 2003 and 2007, the difference between a cap rate and a 10-year Treasury rate started getting pretty narrow, so, looking back, that was kind of frothy relative to 10-year Treasury (note). People were pricing these products to where they were not offering a great deal, a great premium over the 10-year period, and if we look now, the spreads are about where they were in 2002-2003, before there was this great narrowing.”

“That one thing I look at, ” says Hudson, “is how worried should I be. Are people pricing for risk, and, since they are maintaining the spread above Treasury, one might conclude that that is consistent with pricing for risk, which is not part of a bubble.”

Brian Bailey, senior financial policy analyst with the Federal Reserve Bank of Atlanta, agrees with Hudson.

“In 2006-2007, those spreads were between 100 to 200 basis points for the main property groups, but it has widened out to 350 or greater, ” he says.

“I am asked occasionally to contrast 2016 with what we saw in 2006. There is greater oversight right now in the banks, which I think has an impact on their lending, certainly on their lending attitude, as we have seen in the senior loan officers’ survey. They are becoming more hesitant to loan in commercial real estate, but my information says that the loans are still getting done. The outcome of that is we are getting into an environment where people are cautious and putting the brakes on a little bit on the process, which invariably means it is harder to get to a point where there is a significant amount of oversupply.”

The loan officer survey to which Bailey refers — the July 2016 Senior Loan Officer Opinion Survey on Bank Lending Practice — has added to the talk of a lurking bubble. The survey indicated that banks tightened their standards on commercial and industrial loans and commercial real estate loans over the second quarter of 2016. The survey results also indicated that the demands for commercial real estate loans went up during the second quarter.

“The Fed surveys senior loan officers at most banks, trying to get a feel for what is happening in specific Metropolitan Statistical Areas (MSAs) from a lending perspective, and we do participate and there are questions relating to underwriting and relating to risk analysis, ” says ServisFirst’s Pouncey.

 “We have not changed our loan policy, we have not changed our underwriting standards. The regulatory bodies came out with something described as HVCRE — that’s High Volatility Commercial Real Estate — so there is some guidance that came in early 2015. What that really says is that the developer has to have 15 percent equity contributed to the project prior to the bank providing their funding, and if a developer has at least 15 percent contributed equity to the project, then it is not classified as a high volatility commercial real estate. Banks that do have HVCER assets have to allocate increased capital.”

“I think most of the lenders are disciplined, ” says Sandner. “They are not as disciplined maybe as they were seven or eight years ago, but at that point everybody was dealing with the shock of what had happened before. But I find that most lenders are more aggressive than they were eight years ago, but they are not as aggressive as I have seen them at other times in my career.”

There are three other areas that often come up when people talk about a CRE bubble:  fundamentals, disrupters and foreign investment.

“Fundamentals in my mind, ” says the Atlanta Fed’s Bailey, “is supply and demand. We are talking about vacancies, and we are talking about rents, those kinds of issues.”

Disrupters are what the word implies — issues that disrupt the process, for example technology.

Bailey says shopping malls and suburban offices are the two sectors impacted the most by the current technology disrupter.

“You look at shopping malls, obviously retail, and you think about e-commerce growing at 13 to 14 percent, compared to the brick-and-mortar retailers where sales are up somewhere in the low single digits, 1-3 percent. So there are disruptors that are occurring that are impacting the sales of retail establishments, which then have impact on the vacancy rate.”

Another disrupter, Bailey says, is workers using technology to work from home, “teleworking.” “Workers have become more mobile, and employers have become much more efficient in their use of office space. There is a movement going right now. We may not need as much office space per worker as we have in the past.” 

And then there is foreign investment.

 “We have had some concern about foreign capital coming in, in the search for yield. Commercial properties might be an attractive alternative. An important point is that this foreign capital doesn’t view all metropolitan areas the same. If you look at foreign capital moving into the West Coast or the East Coast, New York or San Francisco, for example, those are the 24-hour cities that are pretty well known internationally. They may get some foreign capital that is really looking for a long-term play, and so they may really bid up those prices and view those as more of a store of wealth. Once you start moving to secondary and tertiary markets — and I would say that Birmingham and Tuscaloosa and Mobile would be tertiary — they are not going to pay for properties in cities that they don’t really have a good feel for.”

Sandner says he feels confident about the state of the commercial real estate business in Alabama.

“There is real estate that can be acquired under good fundamentals today that should stand the test of time. Most of the time, I think, when you have problems, you have people who have over-leveraged real estate or don’t have the money to weather a downturn. Real estate is a phenomenal investment, but it is illiquid, and if you have a hiccup it can cause a problem for that particular borrower and, thereby, the lender, and you have a lot of people having hiccups, and money is being lent to folks under terms that otherwise don’t make good sense. Maybe that is the definition of a bubble. But I don’t see that happening. 

 “I think that you need to watch where you are going. I think that is fair. But I don’t believe we are in a bubble. I just think you need to be careful so you don’t get caught without a chair when the music stops.”

Bill Gerdes and Cary Norton are freelance contributors to Business Alabama. Gerdes is based in Hoover and Norton in Birmingham.


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