Commercial Real Estate Sales Drop: Time To Move Out?

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Includes: ITB, PKB, XHB
by: Lee Hoffman

Summary

WSJ reports that commercial real estate sales dropped in the month of February.

Is the end near (or here) for that sector?

Is it demand, supply, or both?

Recent reports (WSJ, Wed. 3/23/16 pg C1) indicate that commercial real estate sales have dropped for the month of February, indicating a reversal of a trend that has been expanding. Lenders who in the past made low LTV (loan to Value) loans are now requiring ever increasing equity, and interest spreads are widening.

So, what is happening in the commercial real estate market? Is the demand down? Are buildings not worth as much, reflecting a weaker economy? Are investors and lenders scared of a market that has been growing since the reversal of 2008?

The answers lie somewhere in the middle. Suffice it to say that to a great degree, the drying up of deals is a result of the lack of distressed and defaulted deals that drove the market since the collapse of the market in 2008. As the distressed market became absorbed at prices that reflected a fraction of their prior value, the amount of "good deals" became smaller and less available. Thus, the attraction to buyers and lenders became less appealing.

Consider this. When the market collapsed in the 2008 debacle, rents dropped, borrowers defaulted, and buildings went into foreclosure. During this time frame, the "special servicer" came into being and collateralized debt obligations were dropping like a rock.

In the conventional arena, loans to commercial borrowers were pooled in Collateralized Debt Obligations or tranches, sold in pieces to institutional investors, and then were serviced by banks until the loan became troubled. Then the Special Servicer took over from the bank.

A Special Servicer was responsible for either remediating the troubled property, or alternatively selling the defaulted note. A good example of a Special Servicer is a company called LNR, which eventually was purchased by Starwood Properties (HOT). A great many of these tranched CMBS loans came due (or ballooned) in 2014-2016. Many defaulted.

In many cases the loans were sold as a defaulted note to anyone wishing to purchase them. Thus, a buyer could purchase a note for 10 cents on the dollar and then sell the collateral subsequent to a foreclosure. In many cases, the defaulted borrower became the purchaser.

The aforementioned activity created a "reset" in rental rates. An office building with 20 dollar a square foot rent that was a profit center when bought for 50 million dollars in 2005, became a defaulted distressed property in 2009 when vacancies drove the rents to 12 dollars. This same building became profitable if purchased as a defaulted note for 8 million dollars. Moreover, even if the property continued to be 20% or even more vacant, the ability to secure lending at the reduced purchase price was a home run for both lender and borrower.

The next dynamic in the new "reset" marketplace was the elimination of new construction. It became difficult to justify the cost of new construction if one could purchase a 50% vacant building for pennies on the dollar.

However, eventually even a marginally recovering economy will absorb some space and the amount of distressed property sitting at the old purchase price has long since disappeared either at the hands of foreclosure, write downs by the owner (if he had enough equity to withstand it), or the trading of the note or property for pennies. When the good deals are done, the buying begins to dry up.

Interestingly, fully leased properties are still a hot commodity and increasingly a rare one. Those properties are now being sold or are trying to be sold close to old valuations. Other than in full highly desirable metropolitan markets, buyers are reluctant to offer pricing anywhere near what the old pricing was. Landlords owning such rented property are reluctant to part with cash flow generating real estate at discount pricing. So, the disconnect between what sellers want and what buyers are willing to pay drives the activity lower. This coupled with the dilemma of what exactly a seller would do with his cash to replicate the return that is generated by a viable rented facility (stocks? bonds?) exacerbates the syndrome of "I will only sell for x", and the reciprocal "I will only buy for y".

To be sure, many sectors are being questioned based on new trends. Certainly office facilities are being questioned as working from home is a viable offset to daily commutes, and brick and mortar retail is being challenged by online purchasing; however, the underlying business is more sound today than it was a few years back. What is not available any longer is the super distressed, bargain basement, screaming buys pennies on the dollar deals that were prevalent just a few years back. To a great degree, the aforementioned is what drove the feeding frenzy in the market in the past.

Thus when the reduction of done deals recently is publicized, it must be viewed within the context of what dynamics were in place to create the activity in the past.

As an investor in real estate, REITs, as well as hybrid or commercial mREITs, it's important to understand the dynamics which drive the numbers and why they may appear to be negative but in fact are merely temporary blips caused by singular market occurrences or dynamics of a market that has re-established itself as a stable market going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.