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Commercial Real Estate: Firehose or Water torture?

|Includes: LXP, National Retail Properties, Inc. (NNN)

I work with private high net-worth individuals buying and selling commercial real estate. Commercial real estate transaction volume is down roughly 90% compared to the peak in 2007 according to Real Capital Analytics. The lack of transactions makes price discovery extremely challenging.
The recent IMF report from October 2009 states that in the "RTC days, late 80's early 90's" commercial real estate values in the US fell 27% from peak to trough. Surprisingly commercial real estate values have already fallen 40% from their recent peak. This huge drop explains in part the reluctance or simple inability of local and regional banks to sustain the write downs and get these assets off the books.
What I have discovered in talking with my investing clients is that the vast majority are expecting a huge wave of distressed assets at firesale prices. Their expectation is of high quality performing assets that for some reason are in default.  However an RTC-like clearinghouse does not seem to be on the horizon, so the ultimate decision lies with each individual bank or mortgage holder, all with different motivations. Again, many of them simply can not take the write down if they wish to stay in business.

My solution to breaking the logjam is to allow interest rates to go up:

With interest rates being held down there is very little incentive for capital suppliers to recycle their capital. Once interest rates do go up, mortgage holders have incentive to allow more pre-pays/defeasance and liquidate distressed assets that have low nominal rate notes. As market interest rates rise there is a natural discount to the note that will more closely match the collateral impairment. They have no reason not to kick the can down the road and see what happens and that is why we are hearing the term "pretend and extend" on these property loans.

This is why commercial real estate is in for a long painful road if the path continues as is. It will be water torture of the worst type.

Play it safe with a net leased REIT: Having done some REIT equity research, specifically on National Retail Properties, NNN of which I do not own any shares. A safe play would be seeking out like type net-leased REITs that have low leverage and have paid down or re-upped their credit facilties. They are currently trading at implied cap rates of 7-8%. Their dividend yields are close to double digit as well. They are characterized by long term leases with tenants. These are vastly different than other retail REITs that have your malls and grocery anchored shopping centers with near term lease roll over, actual mortgage debt (See General Growth bankruptcy)