Commercial Real Estate: From 'Best' to 'Worst of Times' in Seven Months Flat

Includes: FRI, GGP, ICF, IYR, PLD, VNQ
by: Jim Delaney

The most recent Existing Home Sales figures (+5.1% in February) have given some reason to feel optimistic about the residential real estate picture but yesterday’s foreclosure auction of the John Hancock Tower, the tallest building in New England, for about half of its last sale value three years ago, might bring back the somber hues and this time, instead of painting with brushes, they could be using rollers.

Commercial property has taken quite a turn recently. Richard Parkhus, head of commercial mortgage securities research at Deutsche Bank described how “In just seven months, we’ve gone from the best of times to the worst of times.”

While that may be true hind sight is always 20/20 and there’s no telling that today’s “worst of times” might not be the “best of times” when we look back seven months from now. Comparing where we are currently to some of the other “worst of times” might help provide a better perspective. (At this point I feel like I should add one of those warnings that appear before some TV shows: “The following program contains graphic . . . “)

The Real Estate Roundtable estimates that commercial real estate in the U.S. is worth $6.5TN, about three times the size of the market in the early 1990s. The leverage applied is about 50%, as about $3.1TN $6.5TN is financed by debt.

Another way to look at this is in relation to Tier 1 capital. During the 1990s less than 2% of the country’s banks and savings & loans had commercial real estate exposure exceeding 5 times their Tier 1 capital. At the end of 2008 this number was 12% or about 800 financial institutions.

General Growth Properties (NYSE:GGP) could stand as the poster child for the current commercial real estate environment as although they have stopped paying debt service on two of their key properties the lenders have not forced GGP into bankruptcy as they believe there is more to be gained by riding out the storm with a company whose tenants are happy with the way the Malls where they lease are maintained.

The potential for additional GGP’s exists as well as there are $154BN of securitized commercial mortgages coming due between now and 2012 according to Deutsche Bank, of which 2/3rds will not qualify for refinancing due to a decline in property values of anywhere between 35% and 45% from their 2007 peak.

Deutsche estimates that default rates on the $700BN of commercial mortgage backed securites that now exist could hit 30% and the loss rates, a key component of how much lenders recover, could exceed the 10% peak seen in the 1990s.

All of this has not been lost on the REIT market as volatility in some shares has the day traders from the tech boom itching to get back in the game. During the 1st quarter of this there were 4 days where REIT stocks had intra-day swings greater than 10%. That is an improvement from 4Q08 when the number of days was 15 but still well above the figure for the first nine months of 2008 when there was just one.

On March 23rd for example the S&P rose 7% but ProLogis (NYSE:PLD) went up 28%. This past Monday, March 30th the S&P fell 3% and PLD dropped 12%.

In total the Dow Jones Equity All REIT Total Return Index, comprised of 113 stocks, posted a negative return of 32% in the first quarter - better than the -39% realized in 4Q08. The index is down 68% from its February 2007 peak.

The foreclosure sale of the John Hancock Tower has proved that the commercial real estate sector is not immune from the current economic down turn. “The real danger is a repeat of what happened on the residential side: A complete choking up, foreclosure disasters and increased stress on the banking system,” as Jeffrey DeBoer, CEO of the Real Estate Roundtable, so eloquently put it.