Top seven challenges and opportunities facing commercial R.E.: Market likely to rebound late 2008

There is no doubt that 2007 was a transition year for U.S. commercial real estate. Triggered by the sub-prime fallout and credit crisis, it appears that the out-sized investment returns of the past several years are likely coming to an end. Looking forward, ING Clarion thinks that 2008 is going to be fraught with challenges as well as opportunities. Below is our list of the top seven challenges that could impact commercial real estate investment in 2008. 1. Recession Looming Challenge: The U.S. economy is currently going through a sharp downturn. We probably won't know whether or not we are in a recession for another several months. Nevertheless, "recession obsession" in the media may negatively impact business confidence and consumer spending, reducing demand for commercial space. Opportunity: An economic slowdown could lead to lower energy and commodity prices, reducing inflation pressure. 2. The Credit Crunch Challenge: The credit crisis has proven to be longer and more severe that initially expected. With no clear solution in sight, the capital markets turmoil could drag on for several more months. Debt financing could remain expensive and cap rates could rise accordingly. Capital inflow is slowing as highly leveraged buyers are forced to the sidelines. Opportunity: With less competition, all-cash and low leverage institutional investors are better positioned to dictate pricing. Many poorly sponsored construction projects could be delayed or even cancelled, which will benefit the current cycle. 3. REIT Pricing * Challenge: After dropping 16% in 2007, U.S. REITs were down again by another 7% during the first two weeks of 2008. Currently, REITs are trading at more than a 25% discount to their NAV, the largest discount since 1990! Opportunity: The market pricing suggests that REITs are possibly under-valued and this would be an excellent arbitrage opportunity for privatization (taking a public REIT private at a discount). 4. Housing Market Downturn Challenge: The ongoing housing market correction is taking a heavy toll on the U.S. economy. Continued home price decline is shrinking household net worth and this negative "wealth effect" will likely suppress consumer spending. Opportunity: The current housing downtown started in July 2006 and home prices had already dropped by 7% as of October 2007. With better economic fundamentals this time around, we anticipate home prices bottoming out before the end of 2008. Now is a good time to plan development and value-added projects. 5. Anemic Job Growth Challenge: Jobs are the lifeblood of our economy. Job growth began to decelerate rapidly during the second half of 2007 and is expected to remain sluggish through most of 2008. In December 2007, the unemployment rate rose to 5%, the highest level since 2005. Opportunity: A weak labor market will expand labor pool, lessen wage pressure, and lower construction costs. 6. Financial Distress Challenge: Investors who financed their portfolios in 2006-2007 using short-term debt will unlikely be able to find cheap rates for refinancing in 2008. Case in point, the Australian retail REIT Centro Properties Group is on the verge of default because it could not refinance or repay its $3.4 billion debt. Opportunity: There could be "bargain assets" during fire sales. Opportunities might also exist in stressed condo, land, CMBS, B-notes, and mezzanine debt. 7. Inflation Challenge: Although the core consumer price index (CPI) is running at less than 2.5% annually, surging commodity and energy prices along with the decline of the U.S. dollar are fuelling inflation pressures. Opportunity: Through rent growth, real estate investment can be a good hedge against inflation. Furthermore, higher inflation will lead to higher replacement costs, justifying higher property valuations going forward. Despite these near-term challenges, we believe that the U.S. economy will likely start to rebound in late 2008 as the housing market bottoms out and the credit crisis winds down. Employment and rent growth are forecast to re-accelerate in 2009 and 2010. David Lynn, PH.D., is a managing director, research and development, at ING Clarion, New York, N.Y.