Real Estate Develops A Split Personality

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Real Estate Develops
A Split Personality

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By Christine Haughney
From The Wall Street Journal Online

Real estate in 2005 was a tale of two markets: Residential sales showed early glimpses of a slowdown, while commercial sales roared ahead as buyers set records with the prices they paid -- and the amount of money they borrowed.

The cool-down is expected to spread to all parts of the real-estate market in the coming year, although some acknowledge that such predictions haven't come true in the past. "I wake up every year and say 'it can't be this good again,' " says Steve Kantor, global head of real estate for Credit Suisse First Boston. "I find it hard to believe the robustness of the markets."

The residential real-estate market had reasons to wane after a five-year boom in sales volume and prices. Mortgage rates overall edged lower early in the year and then rose steadily. The average 30-year fixed-rate mortgage hit a low for the year of 5.53% in June, down from 5.77% in January, according to housing-finance concern Freddie Mac. But rates reached 5.91% by the end of September and by Dec. 29, had risen to 6.22%.

As rates pick up, the record number of homes up for sale means they are likely to spend more time sitting on the market. The backlog of unsold homes is at a nine-year high, and the number of unsold newly built homes has jumped 20% in the past year to 503,000 as of November, according to a Merrill Lynch & Co. report.

The number of existing single-family homes sold in the U.S. rose 4.7% in 2005 to about 7.1 million, from 6.78 million in 2004, according to the National Association of Realtors. Analysts predict sales could fall 3.7% this year, to 6.84 million.

"It's signaling the onset of softer pricing environment and a reversion to a buyer's market from a seller's market," says David Rosenberg, Merrill Lynch's North American economist. He says these conditions mirror the technology industry in 2000 before its fall, although he adds any decline in home prices will be far more gradual than the market declines that most recently hit the stock market or technology sector.

"Housing is a slow-moving asset," Mr. Rosenberg says. "This isn't going to be the same as Nasdaq falling 70 points a day."

Concerns about a possible slowdown in the housing market have trickled into related areas like real-estate mutual funds. Investors poured in $3.4 billion of new cash during the first eight months of the year, according to Arcata, Calif., research firm AMG Data Services, a sign these funds were in for a record year. But as the market changed course, investors pulled out some of their money. For the year through Dec. 28, just under $2 billion of net new money went into real-estate mutual funds, down from a high of $6.9 billion in 2004.

Publicly traded real estate has been the darling of investors in recent years, but recent performance has faltered. Real-estate investment trusts, which generally pay at least 90% of their taxable income as dividends, delivered total returns (stock-price appreciation plus dividends) of 12.3% in 2005, down from 32% in 2004 and 37% in 2003. Total returns in 2006 are expected to remain lower at about 13% this year, according to Charlottesville, Va., research firm SNL Financial.

Still, SNL Financial real-estate group director Keven Lindemann notes that REITS remain an attractive investment compared with other choices: The broad Standard & Poor's 500-stock index returned 4.9% last year, including dividends, 10.9% in 2004 and 28.7% in 2003.

"History would suggest that REITS can't return 30%-plus a year over an extended period of time," Mr. Lindemann says. But "they're still outperforming most other sectors in the investment world."

REITS, which typically own large-scale properties such as office buildings and apartment complexes, also are being targeted by buyout firms that want to take them private because of their perceived untapped value. "The private market is saying that [despite] that high share price we know this is worth even more," Mr. Lindemann says.

Meanwhile, many Wall Street banks still are eager to finance such large commercial projects as skyscrapers and luxury condominiums. Most banks that make loans, then package them as commercial mortgage-backed securities and sell them off as bonds had a successful year in terms of issuance. Banks issued $159.2 billion in commercial mortgage-backed securities in 2005, up 47% from $83.9 billion in 2004.

Banks already predict that it may be tough to do better in 2006. To preserve the momentum, some are talking about branching into what could be considered riskier and less conventional deals. "Last year, we were active in land deals, construction loans and condo conversions. Depending on credit quality, we hope to do more of the same in 2006," says Mr. Kantor, of Credit Suisse First Boston.

Investors still seem eager to buy any commercial real estate they can find. About $220 billion in U.S. commercial real estate changed hands in 2005, up from $186 billion in 2004, according to research firm Real Capital Analytics Inc. in New York. The bidders winning these deals often are private buyers who put out large sums for a property, contributing to a run-up in prices.

The average price for an apartment complex rose 15% to $102,745 a unit, from $89,213 in 2004. The average office building sold for $193 a square foot in 2005, up from $166 in 2004, according to Real Capital. In September, a group of Hong Kong investors, with Donald Trump as a minority stakeholder, used proceeds from the sale of an apartment complex on Manhattan's Upper West Side to buy the Bank of America Center in San Francisco for $1.05 billion. The previous owner paid $879 million in 2004.

Many think buyers of commercial office buildings are making safe bets because the fundamentals underpinning the market are improving: Job creation has picked up and fewer new office buildings have come onto the market. According to data collected by real-estate brokerage firm Grubb & Ellis Inc., vacancy rates for the top 50 markets fell to 14.5% from 16.8% in 2004. The company expects vacancy rates to shrink even further, to 12.8% in 2006.

"On the leasing side things look pretty good," says Robert Bach, Grubb & Ellis' national director of market analysis. "Rental rates are ratcheting up."