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Is Commercial Real Estate Bouncing Back?

By Ruchika Tulshyan

TIME

July 12, 2010

Commercial real estate is showing signs of a market bottom, says Mike Kirby, chairman of Green Street Advisors, a Real Estate Investment Trust (REIT) research firm. Kirby tells TIME which parts of the market are turning up and who's doing the buying. You've said commercial property values are up 20% from the lows. Other reports say we're still down 40%. So where are we, really? Our view on property pricing differs from conventional wisdom. Some other indexes, published by Moody's and MIT, show that property prices went down 40% and that they've generally stayed there. But we show they're now down 25% from their peak. The reason for the difference is that their indices track transactions — ours tracks deals that haven't yet closed. It takes an awful long time for their index to capture the essence of the news going on in the market right now. Buyers and sellers of commercial property are striking handshakes at prices that are substantially above where deals are closing, and that's part of what's missing from other indices. (See pictures of retailers that have gone out of business.) Are all regions bouncing back? Manhattan and Washington, D.C., in particular, have had very robust increases in value. Everyplace else, it's been weaker. And that's probably the defining differential. Manhattan took a bigger hit, so it had further to bounce back. Some of the buying activity has been foreign, and they typically flock to those two markets first. We're also seeing some activity in San Francisco and Boston, but not to the extent we've seen in the other two. Where's the foreign money coming from? It's mainly Arab money. They've been the main source so far. The German syndicators [i.e., investment pools] are back in business. They've been toeing around the market. There's also been interest from sovereign wealth funds of all stripes. But particularly it's Middle Eastern money. What about the nagging worry that commercial real estate is the next crisis? This whole premise that commercial real estate is "the next shoe to drop" is overstated. Clearly, we have problems, since there are many mortgages out there that were underwritten using very aggressive assumptions, and those will be difficult to refinance. But the good news is, if you look at our property index, we're back to 2005 pricing. So that means that most properties that were financed in '04 and '05 are not going to be much of a challenge to get refinanced. And, yes, the '06 and '07 deals, which some indices say are still underwater, will also need to be recapitalized. The good news is, there's a very long line of capital sources that have shown up in the last nine months that are ready, willing and able to play that role. (See pictures of Americans in their homes.) But weren't there some really bad deals? Pretty much anything Blackstone sold at the peak out of its equity-office portfolio. Then there was the Archstone deal — the privatization of a blue-chip REIT at a very rich price — that did a huge amount of damage to Lehman Brothers and Tishman Speyer. There's no shortage of headlines saying, "Boy, can you believe how stupid that deal was?" but I think in general everybody's taken a small hit but nobody's bleeding too badly. (Comment on this story.) What types of properties are rebounding? The biggest increases in value are the same sectors that had the biggest decreases in value. Hotels went down the most, offices went down the second most, and those rebounded the most. Apartments got hit the least, and malls didn't get hit too terribly hard, and their rebounds have been smaller. Even with the rebound, hotel and office land investors will continue to feel the pain over the next three to four years, more than apartment land investors. (See 10 big recession surprises.) How is the rental market? You're still seeing problems in terms of vacancy rates and stagnant rental rates. But the important thing is that a recovery is visible. It may take a while to play out — real estate does tend to lag the economy, but there are positive developments. The primary driver for real estate value is the low return requirements everywhere else. So a year ago, corporate-bond yields dropped from 9% to 6%. Real estate returns are now in their mid-sevens. It's the drop in bond-market returns that makes real estate look pretty darn good right now. So it's a good time to invest now? You get a decent return, and you're buying at the bottom of the cycle. Real estate being a historically cyclical animal, you know, it's not going to be a good year next year, or even the year after — the cash flows are going to stink — but eventually, what has gone down comes back up. So we're sitting at a historically low occupancy and rental rates, but barring a double dip, there's only one way to go.

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30,000 SQUARE FOOT WAREHOUSE SOLD. An all cash purchase of a Hialeah warehouse has just sold in West Hialeah for $605,000. It was originally listed for $995,000. There were more than five cash offers for the 1965 warehouse located at 2755 W 8 Ave. The warehouse was used for 35 years as a dyeing factory. The lot size was 40,000 square feet.

Paul Silverstein, Broker-Vice President, Commercial Division with RE/MAX Advance Realty, who represented the seller, had received numerous offers for the property within the first 10 days of placing it on the market. “ Local and international investors are keeping a close eye on the South Florida commercial market and are ready to pounce on any property that is perceived to be under the current market value” he said.  “The offers that came in were from Brazilian, Ecuadorean and Columbian buyers, but it was a local investor that ended up with the property.”

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The Upside of the Downside!

A commercial real estate price index, developed by the Massachusetts Institute of Technology Center for Real Estate (MIT/CRE), posted a staggering 18.1 percent drop in the second quarter. The index, which collects commercial real estate purchase and sales data from leading real estate firms, is now down 22 percent for the year and 39 percent from its peak in Q2 2007. The information was released by MIT/CRE Monday to the dismay of commercial property investors nationwide.

These numbers do not bode well for owners of income producing buildings who may need to refinance soon. Shrinking valuations will make it harder for buildings to qualify for institutional financing in this tight credit environment. Banks have significantly decreased their loan-to-value ratios (LTV) as a result of the credit squeeze and the unpredictable markets. The combination of tighter lending criteria and lower appraisals will result in a large number of buildings that will fail to get refinanced.

This is a half a trillion dollar problem and the government can offer only nominal assistance; the public has no more appetite for bail-outs. The situation is dire indeed; investors are left hoping for a rebound that they know won’t come.

All the bad news, however, is a harbinger of good news. The very best financial professionals know that pessimism is a bullish indicator. A market bottom, by definition, is the moment of maximum pessimism.

The sheer magnitude and the incredible speed of the price declines could be an indication that sellers have capitulated and now believe that getting out is more important than getting their price. It is worth noting that the 18.1 percent drop reported by MIT/CRE is the steepest in the 25 year history of the index and that the peak to trough decline of 39 percent is considerably worse than the 27 percent decrease reported during the last great commercial real estate meltdown in the 1980s. Further, the commercial property collapse has now eclipsed the downturn in residential real estate which is off 30 percent from its highs. The best bad news of all, however, is that the supply side index of prices sellers would be willing to accept plummeted 18.5 percent to a new record low. Who could be blamed for considering that number a white flag of surrender?

Predicting a bottom is a fool’s errand but it would be equally foolish not to watch for signs of recovery. Hidden and overshadowed by all the bad news in the report is the fact that sales actually picked up over the last 3 months. Transaction volume showed a nice increase in the 2^nd quarter, the first such up-tick in nearly 14 months.

I don’t know when the turn around will happen, but I do know that a predominantly bearish sentiment is a bullish indicator and that just because something is counterintuitive doesn’t mean it’s wrong.

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