US real estate risks remain ‘very, very high’

The investment mood in the US real estate market may have undergone a “discernible change” in the past few weeks, but the risks of investing remain “very, very high”.

Our message is not to do nothing, but we sound a note of caution that we all need to resist our industry’s optimistic nature to see improvement where there may be none. Advisory firm Hodes Weill & Associates

Despite a spate of high-profile – and high priced – deals in the past month alone, advisory firm Hodes Weill & Associates has warned in its latest market commentary that the risks of investing in real estate remain high as the “overall market has not really corrected”.

Already this week, the Canada Pension Plan Investment Board acquired a 45 percent interest in Manhattan’s 1221 Avenue of the Americas office from SL Green for roughly $576 million, as well as buy a 45 percent interest in SL Green's recently-purchased office building, at 600 Lexington Avenue, for roughly $87 million.

However, Hodes Weill said net operating income, particularly for the US office sector, remained “poised for several more years of decline”, while vacancy rates would stay high coupled against weak tenant demand.

That, combined with a “troubling” outlook for US job growth, and private sector spending still “slow to kick in”, the firm questioned that the “renewed wave of investment and optimism defie[d] the cold fact that most existing US portfolios held privately remain over-leveraged, under-capitalised and illiquid”.

This renewed wave of investment and optimism defies the cold fact that most existing US portfolios held privately remain over-leveraged, under-capitalised and illiquid. Hodes Weill & Associates

However, fund managers with capital to invest were stepping up their investing, perhaps in some cases “out of the sheer boredom of not doing deals for a few years”.

“Our message is not to do nothing, but we sound a note of caution that we all need to resist our industry’s optimistic nature to see improvement where there may be none,” the commentary said.

The firm, founded by David Hodes and Doug Weill last July, also warned there was a large bid-ask spread in relation to recapitalisation deals, saying capital infusions that took equity-like risks should seek equity-like control, as well as equity-like returns.

Establishing current equity values today though was a “challenging exercise”, the commentary said, with fund managers wanting to base NAVs on “older business plans and use questionable market comparables as supporting data. New capital will seek to participate at a 2010 cost basis.”

As a result, the industry was currently undergoing a “complicated process of manager/portfolio transitions. This is a major challenge for the industry and a structural weakness of the private fund vehicle that needs to be addressed before the private fund market can begin to grow again”.