Indianapolis-area experts see bright spots amid ongoing real estate weakness

Industry experts in commercial real estate and construction offered insight during an IBJ Power Breakfast Oct. 8 at the Westin Indianapolis.

The panelists:

Bill Ehret, CEO, Summit Realty Group

Jeff Henry, managing principal, Cassidy Turley

Michael Huber, deputy mayor for economic development

Jeff Luebker, managing director, CB Richard Ellis

John Thompson, president, Thompson Thrift Construction

George Tikijian, principal, Tikijian Associates

The panel was moderated by Cory Schouten, IBJ’s real estate reporter.

The following are edited excerpts:

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Reflection: Think back to this time last year where you thought the market was headed and tell us if you were on target. And even if you were way off, give us your quick version on what to expect in 2011, leasing, lending, values, whatever.

EHRET: We’re where we thought we’d be today. It was a flat market going into it, we’ve gone through a very, very difficult period, and it’s probably going to be much the same in 2011.

HENRY: We predicted that all the areas would be slow, there would be some growth but it would be slow growth. We thought there would be more activity in distressed assets than there has been to date, but we still think that that will pick up.

HUBER: We rely on these folks to tell us what’s happening in the market. Similar story we would tell. I think the thing that is very different, though, about where we stand today is, we were able to get the water and the wastewater transaction through the council. We’ve got $55 million out in the neighborhoods right now rebuilding the city’s infrastructure and another $100 million coming up soon and potentially another $300 million if the transaction is approved by the IURC, so we hope that local stimulus to the construction industry will also help the real estate industry with risk-taking, the ability to fill the gap on critical deals.

LUEBKER: Our perspective at the beginning of the year was kind of tempered growth, if any, and I think we’re there. We’re not trending in any significant way. I would say that a lot of the interesting and significant activity is coming from our public sector, the city of Indianapolis and the state.

THOMPSON: I would agree that we’re probably about where we all thought we would be from when we sat here a year ago. I would add, though, that the one thing that’s a bright spot is, most of us have learned how to adapt, how to stay profitable, and I think we all are seeing some bright spots now that maybe we didn’t quite think we’d be seeing this quickly.

TIKIJIAN: Things are a little bit better than we anticipated. While the economy has been slower, that’s probably helped the apartment industry because it’s caused the Fed to push interest rates down, and in an investment world, very low interest rates cures a lot of ills. So we had a lot of capital that’s come into the market that has become more aggressive at what they’re willing to pay because there is a strong desire to get money out at higher yields. So property values have actually improved, and then the stagnant single-family market has helped the apartment market. Occupancies have increased probably more than we expected. Rents have actually increased a bit.

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Funding: We’ve talked about how reliant the industry has been on stimulus, whether federal or local. What’s the outlook for privately funded projects?

THOMPSON: Well, we’re starting to see some opportunities to gain conventional financing, so we feel very strongly that if the projects are right, you’ll be able to go and get the financing for them. These are mainly multifamily opportunities. I don’t think that you’re going to see any large retail opportunities able to get any kind of significant financing in the very near future, so I think you have to have a market or a segment of the market that is going to experience growth.

EHRET: Just earlier this week, the Society of Industrial and Office Realtors did a nationwide survey about a lot of different topics, and one of them was the development activity in your region or your area. There were 357-some respondents and 99 percent of the respondents nationwide said that there would be virtually no development activity or limited development activity. We’ve got a lot of stuff to burn off, but that’s kind of the climate we’re in.

TIKIJIAN: As deals get recapitalized there’s going to be plenty of retrofitting and rehab but construction jobs available for all segments. As retail uses get changed and retooled there’s going to be construction jobs for that. It could be awhile before there’s much in the way of new construction in any segment.

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Recovery: The Wall Street Journal reported on signs of recovery in the office market, citing the smallest quarterly drop in average rents since 2008 and the sale of Boston’s John Hancock Tower. What, if any, signs suggest the local market could be ready to rebound?

EHRET: We’re in for a long slug here relative to both the CBD and suburban office market. There are a couple of nice transactions out there that will help, but whereas before our vacancy rate increases were attributable to inventory, massive inventory being added, today it’s definitely an employment issue and you have to have employees in office buildings and people are doing more with less and until that turns around—which again is going to be a good year, year and a half down the road—we’re just going to limp along with our vacancy issues in the office market.

HENRY: Yeah, it’s going to continue to be slow, but if you’re looking for a positive sign, our statistics at the end of the third quarter had positive absorption in the office market for the first time in a long time, about 100,000 square feet of positive absorption, and that’s about a quarter behind what we’re seeing nationally. For the first time in two years at the end of the second quarter nationally, there was positive absorption throughout the U.S.

HUBER: The only thing I’d add to that is the deal flow or at least those companies who inquire with the city and with Develop Indy about incentives and infrastructure support and those things. We’re seeing a lot more in the IT and the health care sector and certainly the growth in companies like ExactTarget and Angie’s List is really, really exciting. They’re also very much in the urban core. I think Indianapolis is actually positioned really well in the recovery because of the regulatory and tax environment, so we’re optimistic.

EHRET: The growth in general is health care. As Mike mentioned, for-profit education, which is a little bubble out there, by the way, it’s something for those that have those tenants need to pay a lot of attention to given the recent press.

LUEBKER: Health care is going to be probably our primary leading area of growth for two reasons: the aging population, particularly the baby boomers, is creating a significant demand on the health care delivery system. Another is going to be the new health care reform. Health care reform will bring upward of 40 million people into that health care system who are not there today. That new influx of demand is going to put significant opportunities for supply into the system, so both around the country and in our local market.

THOMPSON: From a construction perspective, the only activity in the office market we are seeing is the health care [sector].

HENRY: Even though medical is kind of a leader right now, for people out there when they hear statistics of vacancy rates and absorptions, we do not count medical space in those statistics. So, they don’t get the benefit of the growth in medical.

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Commercial markets: Without a stronger showing from the housing market and lower unemployment, does the commercial real estate market have a shot to come back strong, and presuming an answer here, how do we get those improvements?

HUBER: The mayor did what a lot of newly elected officials do, first come in and take an inventory of assets.

As we were going through this process toward the end of 2008, we needed a massive infrastructure campaign because in a down economy that’s the perfect time to invest in public infrastructure, long-term projects that you know you’ve got to do anyway. At the time our thinking was really geared toward the construction industry. I think we’ve made a lot of strides.

We’re trying to be strategic and not just fix broken streets and sidewalks, which we’re doing a lot of, but trying to engage certainly the construction community and the real estate community to try to make very targeted investments. The second thing that we’re doing is on projects like the North of South that was recently announced, we’re trying to work with our biggest employers, people with the most creative ideas, to see if the government can help underwrite a little bit of the risk, can provide some kind of a key gap-filler.

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Opportunities: George, multifamily has held up relatively well. In your most recent market overview, you talk about how times of economic adversity often present the greatest opportunities. Are there still great opportunities today? And please give us some examples so we can all go make money.

TIKIJIAN: Well, there are opportunities. There is pretty much a continuous pipeline of distressed properties, maybe not as much as many people expected in this short time frame, since low interest rates have helped bail some folks out or maybe delayed others.

I think for the next four or five years, we’re going to see a continuous stream of troubled assets and opportunities to buy properties. There’s also the opportunity that this spread between cap rates and interest rates are pretty wide now, so you can buy a property. And if it’s financeable, if it’s stabilized and financeable, a 4- to 4.5-percent interest rate, there’s a spread there, you can actually make money. So there are opportunities for good operators, for sure.

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“New Heartland”: Where do you guys see the growth in Indianapolis and the Midwest?

HUBER: One of the most exciting things happening in the region is what the city and the Speedway Redevelopment Commission and the IndyCar Series are doing to bring the IndyCar back to Indianapolis. And so when we talked to Dallara before the deal was done, Dallara essentially said, “This is a great location for us strategically because you’ve got a manufacturing work force, a skilled manufacturing work force looking for jobs.”

Now, that’s just an anecdote, but we are absolutely targeting all of the suppliers of the IndyCar to also see if we can build in central Indiana as they bring the IndyCar back to Speedway and Indianapolis. We keep hearing from the suppliers, “We’ve got the work force in Indianapolis.”

The second thing that I’d add that I was really encouraged by—I believe it was in May the Brookings Institute issued its most recent report on America’s cities. Indianapolis’ profile was grouped with cities like Charlotte, N.C., and Portland, Ore. We were called the “New Heartland.”

Some of the criteria were diversity growth, growth in college graduates, and growth in some of these new sectors, and they pointed out in that report life sciences and IT and also advanced manufacturing.

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Retail: John, you guys just built a retail strip center near Washington Square Mall. I haven’t seen a whole lot of new retail coming out of the ground. I’m interested in how you landed tenants for that, how you got financing, and just talk about when you can start building spec projects, and do tenants still have the upper hand?

THOMPSON: We’ve been very fortunate to be able to do some small retail developments over the past year and we’re seeing some more opportunities that are very similar on the horizon. If we’re going to do something of that nature, it either has to be a single-tenant project that we already have a tenant in hand. If it’s a multi-tenant building, we need to be 75-percent-plus leased. We’re going to have to go to a local bank, we’re not going to be able to get a national bank like we used to be able to attract to do a deal like that, and we’re probably going to look at 75 to 80 percent [loan-to-value], so nothing magic there. You just have to be able to go out and get the right tenants, which we’ve had some good relationships that are still out doing deals. Put together a good product with a good piece of real estate and just have the financial backing to do it.

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Downtown: Obviously, there’s a lot of paving going on downtown, which is nice to see. What do you guys think of what the mayor’s doing so far, and what other ideas do you have to accomplish the same?

LUEBKER: I think what the mayor and his administration is doing is great. Our city has a tremendous history of specific projects between public and private developers—the Simon headquarters, the JW Marriott, the Circle Centre mall, Conrad—and this is a continuation of that partnership, which again for our community I think is unique and sets us apart from other cities.

THOMPSON: I think what I’m hearing here, and I agree with, is that it’s the jobs that are going to lead this recovery; housing is secondary. Once we create jobs, then people can afford to live in their own home, whether it’s a house or an apartment. What our federal government has done for the last two decades is take some really good renters and turn them in to lousy homeowners, and I think they’re going to be coming back to the rental market.

TIKIJIAN: I would say just continuing to drive job growth, keep regulation to a point where we’re competitive with other markets and keep our costs competitive with other markets, whether it be tax constraints or other costs of doing business here is going to help win more than our fair share of job opportunities.

HENRY: I think we all want to see downtown grow and thrive, and the only way it’s going to do it is when we as a government put money into those projects, because I don’t think you can really name any project downtown that’s been successful that hasn’t had some type of incentives.

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North of South: Michael, you mentioned that your administration will take part or a small piece of the risk of development projects. Now, with North of South, it’s backing an $86 million loan. That seems like quite a bit of risk. Talk about whether it’s worth that risk and, other panelists, I’d like to open it up to you. Do you think it’s worth the risk, and could that money be spent better somewhere else?

HUBER: Of course I’m going to say we think it’s worth it. There are a lot of different ways the city can support a project, can provide a direct subsidy, which we are proposing to support about $9 million in public infrastructure and improvements on the project. But then we tried to figure out how can we get the support and minimize the risk to the city and the best way we could figure out to do that to provide a credit enhancement.

I know that it is unusual for a transaction like this, but it hits so many of the mayor’s priorities in terms of helping three major employers who we felt from an amenities standpoint are probably underserved. It fills in a really nice connection point between the campuses of those three employers and Conseco Fieldhouse. The downtown rental market is very strong, and this is a project that Lilly has a lot invested in and they will definitely support, and we would be willing to look at projects like this again. For everybody in this room, if you walk into a room with one of our biggest employers, we will listen every time.

LUEBKER: It’s one of the last remaining prime development sites downtown. There are others, but this is a prime one in a sector where you have three of the largest employers—Lilly, WellPoint, Farm Bureau—and when you look at that sector of downtown, you see that the amenity base is almost nil. The city is not the only one who’s taking the risk there. The developer is taking risk, so there’s a lot of sharing going on there, but again this is an example of the long history of that public-private partnership. The scale of the risk by the city I think doesn’t compare as much to some of the risks that we’ve taken in other projects like Circle Centre mall and the JW, which are also great, successful projects.

EHRET: At the risk of being controversial, what I asked Mike at the table prior to this was, we’ve got the Market Square Arena site, we haven’t been able to do anything with it and the Bank One parking garage and the operations center for I don’t know how many years, and all of a sudden we’ve got this great project at North of South. We have Pan Am Plaza that’s just deteriorating in front of our very eyes and yet we can’t figure out how to get something done. Now, I realize there’s complications of ownership structure and all of those kinds of things, and it’s a question more than it is a statement as to whether it’s right or wrong.

HUBER: It is a good question. It’s very legitimate, especially in these economic times. You can’t do everything, but there are deals that the city pursues on properties that we own. Market Square Arena is one of those, and we continue to try to make something happen. But there are also deals that other people bring us that we don’t own. They’re private transactions, and if that transaction has a substantial public value, we will try to figure out a way to support it that doesn’t put the taxpayers at risk.

HENRY: It’s a situation where maybe this was the best project that’s been brought to the city over the last five to 10 years which has a chance of succeeding with the various elements that are in it. I’m not sure that all of the things that were brought forward with the Market Square Arena site, we were trying to do too much on that site and really didn’t have a history that would support that we could do that many living units downtown.

LUEBKER: I think that you also have to trust the constituents or the stakeholders in the project. It’s not a singular stakeholder in the form of the city; there are multiple stakeholders involved who are invested in the project, and you have to trust that it’s not just one entity at stake. Should we build a new convention hotel and where should it go, and now before it’s even finished we already see the news that the JW Marriott is almost filled up for the next year. Should we build Circle Centre mall? Should we not? So this is a natural debate, but I think we have all of the pieces in place for a good, smart development which is going to serve the largest employers within the community.

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Defaulters: Why are developers/owners that have defaulted on deals or have nonperforming deals still able to get financing?

HENRY: That’s always been the case. If you look at the history of it, people who were giving back properties in the ‘80s, five years later they were out getting anything financed that they needed to, so I guess it’s just a short memory process.

EHRET: Yeah, “The other deal was a bad deal, this one’s really good.”

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Auctions: Jeff, you mentioned that there have been fewer distressed sales than you would have expected this year. It seems like there are a lot of auctions. Is extend-and-pretend coming to an end?

HENRY: I don’t know if it’s about to end, but we’re seeing a lot more auction activity. We’ve actually been in the auction business for about 15 years ourselves. Auctions give banks and lenders an opportunity to take a look at the market very, very quickly. It’s hard to value properties today so the auction gives you an opportunity to go out to the marketplace and determine two things: how many people are interested in your property, and at what price.

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Valuation: Property values are stable in the multi-family market. What are others seeing? We’re not seeing as much stability in office, are we?

EHRET: Core assets, Class A core assets, are actually seeing some very good pricing and good improvement, and then you have the other end of the scale, which is value opportunity plays, and if you’re in the middle, you’re not seeing a lot of activity.

HENRY: I think it depends on where you’re located. We see a Disney World of activity in Washington, D.C. They are selling high Class A office buildings, and also in New York. Those are the two markets that a lot of money is being spent on Class A office space and they’re buying somewhere in the neighborhood of $400 a square foot, which we never hear of in Indianapolis.

If we ever get half that amount we’re doing well, but you also can see the reason is because Washington, D.C. and New York have the lowest vacancy rate of any of the cities as it relates to office space.

LUEBKER: From our perspective in the capital markets, there’s more of a discrepancy in value than there ever has been between stabilized assets and the underperforming, nonperforming, unstabilized assets, which on the surface sounds logical. But three to five years ago, that discrepancy in value would not have been as great because today many investors are much more risk-averse. There is capital in the market, capital to buy, but, as Bill said, it’s primarily for prime stabilized assets. Those assets which are underperforming are going to have a very hard time.

Even though there is capital, three areas which temper the investment market are low velocity of leasing, lower rents and high investment required by an owner in the form of [tenant improvement].

TIKIJIAN: One of the reasons for the discrepancy is, there is plenty of money.

In the multi-family side there is financing available for stabilized properties at very low interest rates from Fannie Mae, Freddie Mac and HUD. But they’re only going to finance stabilized properties if you can borrow 4 percent.

So for nonstabilized properties where there’s distress historically, investors who are developers or value-added investors would go to the bank, borrow money on the basis of how the property would be improved and its value after the improvements.

Well, the banking industry is still very risk-averse and it’s much harder to go borrow just purely from the bank without having a tremendous balance sheet or very good liquidity.

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Lilly: Jeff, you have the Lilly account and the listing for Feris Campus. Are they done vacating space for a while, and what has to happen for you to backfill that building?

LUEBKER: I’m a glass-is-half full, glass-is-filling-up type of person, so I see the positive side.

That’s a big issue, OK. That’s more than just about office space, so let me take a moment here to first talk about the macro, and that is Lilly. We are watching probably our top corporate citizen being transformed with great leadership in an industry which is going through tremendous challenges. John Lechleiter and his team have been very public about their mission and what they’re doing and where they’re going to focus, and I think that we’re going to be the beneficiaries of that. They’re going to leverage technology, which means more efficient use of space. They’re going to reshape their organization and use their properties differently. So all of those things mean they’re going to be better positioned and have a lot of history to carry them through.

It’s also going to create opportunities with things like Feris. Now, here’s a campus that is very unique not only within our community but really throughout the Midwest and in many cities around the country.

It is a single-entity corporate headquarters facility in a downtown district with all of the amenities that a downtown has to offer. It’s not a multitenant building; it’s a single-user entity. We have a history in this city of realizing that we need product in hand to be able to create economic development and attract business or entities, things such as back in 1984 when we built the Hoosier Dome or the RCA Dome, we didn’t have an NFL team.

Many of the real estate people here realize that we need blocks of space in order to attract business. So with Ferris, we are marketing that property at a national level.

If somebody is going to consider moving their organization to that facility, they’re not going to do it just because of that particular building. They’re going to do it because of the community as a whole, our labor force, our education, our neighborhoods, our community. Hopefully we’ll have some good news to share about that.

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Guidelines: I’ve got a couple of questions here from the audience, first about the controversial student housing project at St. Clair and Capitol. The quick version is a developer got Regional Center approval to build one project and built basically a completely different project. What would be a fair solution to make right the student housing project, and are Regional Center Guidelines an example of overregulation or a strategy for smart growth?

TIKIJIAN: Well, I don’t have the answer for curing it. That’s a regulatory issue. You know, good design and good regulations are important so that neighbors’ properties don’t get adversely affected. There can be over-regulation. There’s got to be a good balance, but certainly Regional Center approval and reasonable design is an important issue for keeping property values up in neighborhoods.

HENRY: Before I answer that, is the developer in the audience? (No answer.) I don’t know. When I look at it from a design standpoint, each day I drive downtown that way and I kind of shake my head and say, “Oh, really?” So I’m not sure where the design and where the difference was, what was approved and what was finally built came about.

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Banks: Another audience question: Comment, please, on where to find money so I can buy more commercial buildings and refinance ones I have.

HENRY: Would all the bankers stand up, and lenders? Take a look, that’s where you find your money.

TIKIJIAN: The banks are starting to make money. As they make money they’re able to write off some of these properties and actually get them out the door and sell them because there’s not this issue of capital issues, undercapitalized for a year or two because of what’s happened. So the more the banks get rid of their problems, and they do need to grow and make money, they are going to be coming back into the market at various stages depending upon how profitable they become. At some point, I think we’ll see some consolidation in banking and that will also help create more healthy banks out there to be more aggressive at lending.

EHRET: I’ll add that I don’t think the banks are just starting to make money, I think they’ve been making money and I think they’ve been making a lot of money with the spreads that are out there. I guess everybody’s heard that all the TARP money’s been paid back. That’s pretty quick if you think about it, so it’s been an opportunity for financial institutions to make good margins. People are financing transactions anywhere from maybe 65 percent loan-to-value but as high as 80 percent loan-to-value. We recently are getting ready to close on one that’ll be 80 percent loan-to-value. The caveat, as again George mentioned, is that the borrower has a pretty strong balance sheet, has a lot of liquidity. They’re not going to be the way we did business in the past where you have a nice idea and a nice project and a few tenants teed up ready to go. You’ve got to have a lot more now.

THOMPSON: If the question is where do you get the money, you don’t go to the regional bank like we all used to. You’ve got to put shoe leather to the road, and if you’ve got a project in Spring Hill, Ohio, you go to a local bank, and you go in there and you show them what you have. You’re not going to get it from some bank out of the Midwest for a project 200 miles away.

TIKIJIAN: There’s also more equity capital in the market. As a result of very, very low alternative investment yields, there’s an increasing number of investors who want to put money to work in real estate, so even with less leverage that’s available in the market today, there are investors willing to bridge that gap with equity.

LUEBKER: If you’re seeking to refinance your property, I think the answer first is, you have to stabilize your asset, look to your revenue stream, look to the credit of your tenants, stabilize the asset in terms of occupancy and revenue, and then go to the bank.

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Pricing: Another question from the audience. Are you seeing sellers who have had properties on the market for more than a year start to drop prices in order to generate opportunities?

TIKIJIAN: Yes.

EHRET: The answer is absolutely.

IBJ: By how much?

EHRET: Again, it’s case by case. We have sellers that aren’t in a position where they have to sell, so they’ll try to wait this thing out and the property will remain on the market for maybe 24 months, maybe as much as 36 months for the market to come back around. But if you have a seller that is ready to just move on and they have that ability and they are pretty strong in their equity position, they will discount up to 50 percent of what we perceive to be the value. Value is all over the place right now, but we recently had one where it was a good 50-percent discount from where we took it to the market and 10 months later we ultimately sold on an all-cash basis.

LUEBKER: It’s really a case-by-case basis depending on the objectives of what the owner’s trying to achieve. There is a restructuring going on right now of the overall kind of investment market, again defining that gap and the opportunities of those properties.

TIKIJIAN: If the owner has a good adviser, it should’ve been priced properly to begin with, so that’s only an issue where you’ve got bad advice.

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Opportunity: What have I not asked you today that you would like to share?

LUEBKER: There is a topic that is a game-changer within the industry and within the economy, and that is the upcoming changes with FASB 13. FASB is the Financial Accounting Standard Board. It establishes the GAAP rules for accounting. It will be changing its standards with regard to how leases are accounted for on a balance sheet. In essence, it’s going to eliminate operating leases and create capital leases, and this will have a significant impact on organizations deciding whether and how they should lease versus buy, and it will impact owners as it relates to those leases and the value, the revenue of leases for owners of institutional or income-producing properties. So that’s a topic we haven’t talked about. It’s coming and particularly large corporate users of real estate who have lease portfolio, it’s first and foremost on their topic for 2011.

HUBER: If the mayor were here, he would want to say that some of the most creative individuals in the city are here. You create jobs, you create economic opportunities. We’ve got potentially a half a billion dollars going out into the neighborhoods over the next three to four years and we want to make sure we’re engaged with this community in terms of how can we leverage that money and turn it into a billion dollars or more. If we simply just go out and pave streets and fix sidewalks without helping you leverage other opportunities, then that’s a huge miss for the city. He would say, make sure that we know we have all of your creative ideas for how to leverage these infrastructure dollars over the next three to four years.

EHRET: We are absolutely blessed to be living in Indianapolis. It is an absolutely great city for all of us to travel around and see the different areas and different communities. And the good news, the silver lining, is that we absolutely have hit the bottom and we are trending up. As I like to say to a lot of my peers, there are more people living on the planet today than there were yesterday and all of those people have to have housing and they have to have food and they have to have places to go to work. But among everything we’ve heard this morning, I hope that it translates into jobs.

TIKIJIAN: I think we are in the process of restructuring. It’s going to take I don’t know how many years, but a number of years, and it’s probably going to entail some slow growth for quite a number of years as we become more competitive globally, because we’re now competing against other countries with lower costs than we’ve had. We should anticipate much slower growth and much lower yields on all things for a number of years going forward and that’s going to bode well for real estate as people lower their expectations and want to put more money into real estate for a diversified portfolio.

HENRY: I believe we’re well-positioned when things do turn around and start upward, and they are starting upward at this particular point in time. And when you compare ourselves to other cities in the Midwest, we’re in a much better position. When you look at the industrial market, we’re well-positioned to come out of it. There’s positive absorption, there’s not construction going on right now, their vacancy rate is at 7 percent compared with 11 or 12 percent nationally.

THOMPSON: I would agree we’re in a position where we’re going to have slow, if not flat, opportunities and growth. The companies that are going to do the best are the ones that can adapt quickly. Now we’ve all had to change a lot more in the last 12 months than probably in the last 12 years in a much shorter time period. With our organization, it’s great people that pull together, and they’ve been able to say, “How can we work harder and smarter?” The companies that have that core value and value in their people are going to succeed, and I think that probably cuts across all segments of our industry here.•