Commercial Real Estate Investors Face Pivotal Q4

REIT earnings season got into full swing last week, but there's a lot more on investors' minds these days that last quarter's earnings. Transaction volume has continued to plunge, and CMBS loans placed in special servicing have continued to rise like a poodle in a jetpack.

This can mean only one thing, and in the words David Hamamoto, CEO of Northstar Realty Finance (NRF), it is that there is a growing backlog of motivated sellers who "will begin to transact later this year and who will establish market pricing as deals are completed." That people will need to sell is not in dispute, but exactly what "market pricing" will be is the $64,000 question.

Globally, commercial real estate sales plummeted more than 70 percent in the first quarter from the end of 2008, according to Real Capital Analytics. In the United States, first quarter sales were not only anemic, they may also be a form of karmic justice to CRE brokers who are now fond of saying that distressed buyers simply 'overleveraged'... Really?

Even apartments, which still enjoy the availability of buyer financing from Fannie Mae (FNM) and Freddie Mac (FRE), saw transaction volume fall 62 percent in 2008, and another 86 percent in the first quarter of 2009 alone. With an average of only 50 apartment sales taking place each month across the entire country, it's simply no wonder that pricing is unclear.

What is clear, however, is that prices are dropping. And as prices drop, "overleveraged" buyers, or those who were basically convinced to overpay for their assets, are unable to refinance their loans. CMBS loans placed in "special servicing", which indicates that the borrower is in some form of distress, were dramatically up and to the right at the end of 2008:

Source: Deutsche Bank

This trend accelerated in the first quarter of 2009. CMBS loans in special servicing jumped another 48 percent (as measured by outstanding loan balance), according to Fitch. "Imminent default" was cited as the reason for 73 percent of the special-servicing transfers. Since the end of 2007, the percentage of CMBS loans in special servicing has grown from 0.54 percent to almost 3 percent or outstanding loans.

Nationally, default and delinquency rates for CMBS rose to 1.76%, or $10.7 billion, in the first quarter, up 62 basis points from the previous quarter and more than triple the rate of delinquencies recorded in Q1 2008 (these figures do not include loans associated with the bankruptcy of General Growth Properties (GGP)). According to REIS Inc., the CMBS default rate could reach 6% by year’s end.

The lack of transaction volume and the increasing levels of distress perfectly illustrate the current market quandary: lenders are unwilling to foreclose on properties that cover debt service, albeit barely, and sellers are unwilling to sell properties at what they believe to be artificially low prices driven by unsustainably low availability of debt capital.

This face-off will not last. Banks must clear their balance sheets at the same time that capitalization rates are rising and NOI is dropping. Rising cap rates mean that a buyer of an office building at a 6 cap in a strong market like Washington D.C. is staring at a 30% decline in value, peak to trough, assuming NOI has remained the same (which is almost certainly not the case). Buyers in tertiary markets are in even worse shape.

However, just as the excess of ready and available credit led to unsustainably high asset values in 2005-2007, so will the dearth of ready and available credit lead to unsustainably low asset values in 2010. Not surprisingly, some investors smell opportunity, and they are betting with real money. Publicly traded REITs raised $10.6 billion in equity in the first quarter, including $6.51 billion in April alone. This is a tidal wave of cash, and the Bloomberg REIT stock index rose by 30%.

Nobody ever rings a bell at the bottom of a market, and $10.6 billion says why bother to listen for it now?

Disclosure: Long NRF at the time of publication

Comments

[zorro6204:]

One slight saving grace this time out is that the debt crisis did unfold over a couple of years, despite the stock markets getting the news a little late. As a result, developers stalled projects, and we're not in the same kind of oversupply situation as the mid-80's for example, where tax policy created rehab credit loss neighborhoods, and "see through" buildings in Seattle and Houston.

In 2002 developers in Seattle were caught fully engaged, resulting in empty holes in the ground, brand new class A office buildings that never saw a tenant before going back to the bank, and famously in Bellevue, partially-built buildings "shrink wrapped", moth-balled in plastic, right in the heart of the city.

Not all cities are created equally, we still have quite a few cranes in the air in Bellevue, but once they are down, we will be crane-free, there is practically nothing on the books. A disaster for contractors, but at least we won't have anything shrink wrapped this time around.

May 14 04:26 AM

[sorgmot:]

The R E boom is dead. Long Live the boom.

Internet killed the boom. Over lending killed the boom.

All the kings men and all the kings horses can not put the boom back together again. In the new world everyone works where she or he lives.

Wages collapse and costs do too.

Mortgage defaults grow and grow and grow in $ terms.

Cities' real estate taxes vanish and they become derelict towns.

Governors everywhere think the unemployed will pay the tax bills.

Neither political party has a clue.

The city model will be Rome in the year 410.

May 14 10:26 AM

[REIT Wrecks:]

Zorro - agreed, we are not overbuilt like the last time, but demand is just evaporating.

I just spoke with the leasing agent for a 700,000 square foot class A building in downtown San Francisco, one block off Montgomery St. Last year, they were getting $62/foot, and now they are booking $30. They have a major tenant that has laid off thousands and is consolidating into another building, leaving them with 375,000 square feet that needs to be leased. By the end of June, they will be 60% vacant. The windows are tinted, but that's "see through" in my book!

They will eventually get that space leased, but going from $60/sf to $30 will obviously have a huge impact on NOI.

May 15 12:28 AM