Is the Commercial Real Estate Downturn Over?

| About: Vanguard Real (VNQ)
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The National Council of Real Estate Investment Fiduciaries, or NCREIF, reported this week that commercial property returns had jumped sharply in the fourth quarter of 2010. The NCREIF Property Index (NPI), which measures unlevered returns on core property investments by its data contributing members, jumped up by 4.62% in total return, including a 3.02% quarterly burst in capital appreciation along with 1.60% in income return. That follows on quarterly total returns of 3.86% in 2010q3 and 3.31% in 2010q2; the NPI also showed positive total return of 0.76% in 2010q1, but property values were still going down at that time, with the negative capital appreciation outweighed by positive income returns.

Does that mean the worst of the commercial real estate market crisis is behind us? Yes and no. I believe it's true that real estate operating fundamentals (rent growth and vacancy rates) have already passed their low points and are starting to get better -- not for all property types in all geographic areas, but nationwide on average. But that doesn't mean that we don't have lots of bad CRE news ahead of us.

Part of the problem is that the NPI just isn't a very good source of information on what's happening to property values when the market is in turmoil. The NPI is computed from appraised values, and appraisals are notoriously unreliable during periods when (1) market conditions are not very close to "normal," or (2) there aren't a lot of transactions on which to base the appraisals. Both have been true for the last two-plus years, so appraisals shouldn't be accorded very much weight.

Indexes based on the actual prices at which properties changed hands are much more reliable, especially in periods of market turmoil--and they tell a very different story from the NPI. The Moody's/REAL Commercial Property Price Index, for example, showed positive returns in September, October, and November--but still remains 1.3% below where it was at the end of 2009, contrary to the roaring growth reported by the NPI.

Even more interesting, MIT's Center for Real Estate publishes a quarterly Transaction Based Index that's computed from the same set of data as the NPI -- but using actual prices on transacted properties, rather than appraised values on all 6,000+ properties in the NCREIF data set. The TBI showed strong growth during the first and second quarters of 2010, but big declines in the third quarter of 7.3% in capital appreciation and 6.2% in total return.

What should investors make of all this? First, as I mentioned, I think the worst really is behind us in terms of operating fundamentals. Second, values really have been increasing for a large portion of the commercial property stock in the country. Green Street Advisors, for example, estimates that the values of properties owned by publicly traded equity REITs have increased by more than 30% from their low -- but are still 20% below their pre-downturn peak.

Going forward, though, we're still likely to see a lot of defaults, foreclosures, and distressed sales in the commercial real estate market. There are two reasons for that. First, even though property values have increased in part of the market -- especially (though not exclusively) the REIT-owned segment -- we're still likely to see downward movement in indexes that are based (unlike the NPI) on actual transaction values. Second, part of the downward pressure on transaction-measured values will come from distressed sales, which are generally motivated by debt maturities -- and debt maturities won't even reach their peak until something like 2012.

The upshot is the investors are likely to see a curious mix of news over the next few years: optimism and positive reports (widely trumpeted) from investors that aren't in trouble, along with spectacularly negative reports (not at all widely trumpeted!) from investors and investment managers that haven't been able to roll over their debts and have to sell assets to get cash. I've written on this before; what investors in publicly traded REITs need to keep in mind is that REITs are the ones who stand to take greatest advantage of the continued problems among private real estate investment managers.

As is often true, what's bad news for the private-side real estate market is good news for public-side REIT investors.

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

Additional disclosure: I am long Vanguard REIT Fund and ING Global Real Estate Fund.

Disclaimer: The opinions expressed in this post are my own and do not necessarily reflect those of the National Association of Real Estate Investment Trusts ((NAREIT)). Neither I nor NAREIT are acting as an investment advisor, investment fiduciary, broker, dealer or other market participant, nor is any offer or solicitation to buy or sell any security investment being made. This information is solely educational in nature and not intended to serve as the primary basis for any investment decision.