Chairman's Letter
January 11, 2010
My New Year’s Resolution for Capri Capital Partners is to do a better job of reaching out to our clients to understand your investment needs and to share our own views of opportunities in commercial real estate and more broadly key developments in financial markets. While you will certainly be hearing more directly from my colleagues here at Capri, I have committed to send out a quarterly letter that hopefully you will find useful in helping to navigate in today’s challenging investment environment.
As we head into the first weeks of 2010, it is a very different investment environment than we found ourselves in at the same time last year. Calm has returned to markets as the coordinated massive monetary easing by central banks and fiscal spending measures by governments around the world has worked to stabilize global growth and return liquidity to financial markets. Indeed as we enter the new year equity markets are well-off their lows and in some emerging market economies at or near new highs, credit spreads have normalized in many asset classes and global growth forecasts are being revised upward.
At Capri, we don’t want to minimize the headwinds still facing the economy, as we saw in last week’s disappointing employment report showing another net loss of jobs and the unemployment rate remaining at ten percent. In this environment consumers will no doubt need an extended period of time to repair their damaged balance sheets. Moreover, banks remain reluctant lenders as they too struggle to repair balance sheets and deal with legacy commercial real estate portfolios on which they will likely need to take further write-downs.
While these factors will certainly serve to damper the pace of economic recovery, our baseline view at Capri is that US growth troughed in the first half of 2009 and we look for slow but steady growth in 2010. Global growth is also headed for a rebound. The IMF is now forecasting global GDP of three percent, following a decline of one percent in 2009. We also expect that inflationary forces will remain muted given the extent of underused capacity of both labor and manufacturing in the economy today. This will allow the Federal Reserve to keep its promise of keeping interest rates low for an extended period of time.
The recent repayments of TARP capital by Bank of America, Citibank and Wells Fargo indicate that we are now past the worst for financial institutions, where job losses have been particularly harsh. Capital spending and manufacturing also look ready to turn up following the sharp cutbacks in production that occurred in 2009 and the current low level of business inventories. With corporate cash balances at record highs it should not be surprising to see some of this money flow back into real assets as the economy begins to recover.
What does that mean for the outlook for commercial real estate markets in the US? While the operating environment is certain to remain difficult, we believe that the market is closer to a bottom than most might realize. We would not be surprised to see some price recovery return to major markets in the second half of 2010, as the unemployment rate stabilizes. With commercial real estate prices down 40-50 percent from their recent peak, we expect private buyers to be drawn back to the market, especially for quality properties, at today’s discounted prices. Given the recovery we have seen in global equity and credit markets in 2009, commercial real estate valuations should begin to look attractive on a relative basis to other asset classes. Although transaction volume still remains low, private investors have made up nearly 50 percent of commercial property buyers in 2009, which is up from just over 33 percent in 2006-2007, when institutional investors and private equity funds were the largest purchasers. We also look for foreign investors to return to the US real estate markets taking advantage of their increased purchasing power given our battered currency.
Without a doubt one of the biggest obstacles to a broader recovery in commercial real estate markets is the mountain of debt that needs to be refinanced over the next three years – which we estimate could be as high as $1.4 trillion. Traditional lenders at commercial banks and life insurance companies have been capital constrained and liquidity has yet to return to the CMBS market, despite an extension of the Federal Reserve’s TALF program.
We believe that this will prove to be an investment opportunity rather than a mini-financial crisis. Certainly many recent vintage loans from 2004-2008 continue under pressure and more losses will surely need to be taken. However banks and life insurance companies have strengthened their balance sheets and we expect many loans to ultimately be modified and extended. Similarly for the CMBS markets, the recent IRS ruling allowing special servicers and borrowers to begin early workout discussions is certainly a plus as well.
Ultimately we believe that a wall of cash has been built up by financial institutions will need to be put to work and will find commercial real estate investments attractive on a risk/reward basis. US banks in particular are sitting on huge amounts of cash. JPMorgan’s research shows that banks have added more than $800 billion in deposits since 2008. With commercial loan demand weak and with low returns available in their securities portfolios, with five year Treasuries yielding just over two percent, banks will slowly be forced back into the lending business. Similarly for pension funds, yield levels on HG Corporate debt are no longer attractive to meet their return benchmarks. With net issuance in HG corporate debt expected to be negative in 2010 yield levels may not increase much even if Treasury rates back-up somewhat. The Federal Reserve is doing its job – there is a pain to earning zero for an extended period of time and cash needs to be put to work.
In terms of property types we would expect multifamily to benefit as the unemployment rate starts to come down. While buying homes has become more affordable, strict lending criteria will exclude many newly employed from purchase options and pricing power should return to rental properties. Office rents should also stabilize and with a limited amount of new office properties hitting the market we would expect this sector would show improvement as well. Retail may be in for a longer workout period given muted consumer spending and the amount of supply that came into the market in recent years. Lodging and hotel properties have experienced the most pain, with hotel RevPAR down 40 percent from the peak; although a pick-up in business and leisure travel may lag the economic recovery.
Thus as we head into 2010 we think we have passed through the worst of the storm for battered commercial real estate prices. However the pace of recovery is likely to be slow at first as investors remain cautious and many want to see improvement in their legacy portfolios before committing new capital. This should provide attractive investment opportunities for investors with new cash to put to work, as we are seeing investment opportunities that we have not seen in many years.
Finally let me take this opportunity to wish you a Happy New Year and strong financial returns in 2010. I will be traveling to the Middle East in the first quarter and will report back to you my observations from that trip in my next letter.
Quintin E. Primo III
Chairman & Chief Executive Officer
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