Market Update
It has been hard to follow any kind of financial news over the last year without references to the coming train wreck that is projected to happen in commercial real estate (“CRE”). Many industry people expected this other shoe to drop by now and are concerned that its delay will only prolong the agony of the current CRE market.
The delay is being perpetuated by the “look the other way” approach some lenders have taken, primarily because of the massive issues they have had to deal with on the residential side. Additionally, sellers have been unwilling, and in some cases unable, to accept the reality of lowered values, hoping they can ride out the storm, contributing to the significant gap between the bid and ask for properties that are on the market.
How bad is the CRE transaction market? According to a recent report by Jones Lang LaSalle, US CRE sales totaled $16 billion in the first half of 2009, down 80% from the same period in 2008 and off 93% from the first half of 2007.
While CRE “green shoots” have been scarce, we have seen some signs that there may be an increase in transactions in the near term. This is not hard data, but based on empirical observations from a number of sources:
- A package of three office buildings in Atlanta recently went under contract to sell at approximately half the price the same owner turned down this time last year.
- Several institutional owners beginning to respond to low offers that they had previously ignored.
- An increase in RFP’s to list income properties at one of the large brokerage houses.
- An office leasing broker says that the subject of his e-mail traffic over the last month has changed from consolidation & sub-leasing to expansion and new deals.
- A caterer in Atlanta is starting to field inquiries from client’s HR departments about recruiting events, which was a segment of their business that has been in hibernation.
Individually these occurrences may not seem significant, however coming in rapid succession over a short period of time they may indicate a trend.
While an uptick in activity is encouraging, the light at the end of the tunnel is still a long way off. Thinking of the situation another way, the system has ingested something that has made it sick. Throwing up is violent and painful, but will get it out of the system quickly. The other alternative is to wait for it to pass on its own while making yourself as comfortable as possible in the meantime, which appears to be what the federal government is choosing to do with CRE.
This approach encourages banks to use extreme accounting gymnastics to avoid a write-down on a CRE loan, commonly referred to as “extend and pretend”. Yet another government initiated issue, this promises to change the landscape of CRE investment for a number of years and is one of the two biggest issues facing CRE today, the other being the lack of available debt. Some of the extend and pretend tools include adjusting the rate, deferral of reserves and amortization as well as projecting (or should I say hoping) that inflation will cause the value to rebound. We are directly aware of several situations of commercial loans being in default for months with banks choosing not to foreclose or even address the issue with the borrower.
Reaction to this is varied as many investors are not willing to put new capital in CRE for fear these anticipated foreclosures will surely put further downward pressure on values, affectionately known as catching a falling sword. Other investors are waiting (and waiting and waiting and waiting…) to buy at what they expect will be deep discounts from the banks. This abundance of uncertainty accompanied by a dearth of comparable sales is brutal on the valuation process for any asset, which further complicates the sale process. All of these factors have combined to seize up the CRE market.
The other ominous hurdle in CRE investing in the near future is the debt issue, which is the result of two fundamental problems, the first being the demise of securitized lending (which represented 25% of CRE lending while banks accounted for 50% and insurance companies the remaining 25%). This segment of debt is gone for now and no one seems to think it will be fully functional for at least several more years, if ever.
The other issue contributing to the debt shortage is the tightening of bank credit, precipitated by the Fed’s mandate that banks reduce their CRE exposure. Couple this allocation reduction with the shrinking of many bank balance sheets and you have a significant amount of dollars no longer available for CRE. These are the same banks that are not getting bad loans off of their books. A really unfortunate consequence here is that many owners will be crushed by not being able to roll over performing loans on properties that either have lost value or whose owner’s financial situation has deteriorated. Bank lending for the first half of 2009 is down to $25 billion from $33 billion at the peak of the market. Coupled with the demise of securitized debt this indicates a reduction in the pool of funds available for CRE by almost 40%.
Where does this leave us? The simple answer is back to the basics – good underwriting, reasonable leverage and efficient operations. In other words it will be less about smoke and mirrors and more about hard work. The other component that has to be dusted off and returned to use is patience.
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