The valuation levels at which the commercial real estate market can clear existing inventory and begin turning will be determined by the amount of supply and demand coming into the market and the speed at which it arrives.
It seems that everyone in the commercial real estate (CRE) industry is attempting to retool their operations to launch a fund in anticipation of the much-anticipated CRE bust and resulting flood of distressed supply supposedly just over the horizon. But it often is those individuals pitching their new fund—created to capitalize on distressed deals—who in the next sentence say “there are just no deals out there.” Should this raise a red flag?
How is it possible that no deals exist when CRE values have nearly been halved over the past few years? How can commercial real estate that looked attractive to many in 2007—when record levels of transactions were taking place at values close to double current levels—be too pricey at current values? And most important, why should people expect commercial property values to decrease dramatically from today’s levels when potential demand, in theory, is increasing with every initial and secondary offering by a real estate investment trust (REIT), private equity fund, and distressed CRE investment pool, and when banks are constricting the release of new capital supply into the market as a consequence of the prevailing “extend and pretend” practices?
The relationship between supply and demand in the CRE market must be reestablished. As long as existing assets can be purchased for less than the cost to develop new assets, the development industry and the economy in general will remain subdued. Today, that relationship is distorted on both the supply and the demand side by everything from government policies to divergent expectations by buyers and sellers.
A disconnect exists between buyers and sellers in the form of a bid/ask gap for commercial real estate, and although that gap is tightening, it still remains. This gap must be bridged for the market to clear existing inventory and begin turning. The valuation levels at which this will occur will be determined by the amount of supply and demand coming into the market and the speed at which it arrives.
On the supply side, perhaps the most important factor is distressed assets making their way onto the balance sheets of banks as real estate owned (REO), and the speed at which banks bring these properties to market for sale. On the demand side, initial and secondary offerings by REITs, private equity funds, and new distressed asset funds, combined with the appetite of individual investors, will be the key to evaluating the level of demand.
For an over- or undersupplied market to function, let alone reverse direction, it must first find price levels at which the market can clear. This requires adjustment of values to the levels at which supply balances demand and transactions can take place. These factors, which currently are distorted, must be resolved before a recovery can begin.
One major source of distortion on the supply side is the widely implemented “extend and pretend” mentality at banks around the world. As banks delay foreclosure and sale of the commercial properties that serve as collateral for these problem loans, they are, in effect, withholding supply from the market and contributing to artificially high asset values.
On the demand side, distortions arise from multiple sources: tightly constricted debt markets, underwriting standards undergoing radical adjustments, rapid and huge expansion of the money supply, and equity sitting on the sidelines, possibly because of overly optimistic expectations. Furthermore, possibly unreasonable expectations may be keeping vast amounts of sideline capital from entering the market as investors wait for commercial real estate prices—which have already dropped 40 percent—to decline further. These distortions must be resolved before the market can clear.
According to an April report by the Alexandria, Virginia–based research firm Delta Associates, the total current value of distressed commercial real estate is $187.4 billion, including properties in distress, those in foreclosure, and lender REO. The value of properties known as distressed but not yet foreclosed upon is $47.5 billion, Delta reports. What is not known is how many of those distressed properties will be foreclosed upon to become REO and, thereby, new market supply.
“Over the next four years, around $1.4 trillion in CRE loans will reach maturity. In nearly half of those loans, the buyer owes more than the property is worth,” says Rob Hildt, lending group director at Community Banking Ventures in Irvine, California, who consults and even creates special asset divisions for banks. While the collateral assets in all those loans will not be foreclosed upon, a large portion will be, having a huge impact in terms of value of supply brought to market.
“Banks must face their borrowers and decide whether or not to refinance the loans as they mature,” says Hildt. “If property values continue to remain low with high vacancy rates, bankers may be forced to take back commercial properties at an unprecedented rate.”
In the office market, John Daciolas, senior vice president with Grubb & Ellis, points to the supply of REO office product coming to market as evidence that there will be abnormally high cap rates—so high, in fact, that these transactions “will pose a challenge for both trending and appraisal valuation on a price-per-square-foot basis,” he says. “At present, what seems to be many banks’ mantra of ‘extend and pretend’ is being rigorously tested. This year will be interesting from a pain threshold standpoint.” The key question, he says, is when will the “supply dam break, via internal pressure—self-preservation—or external pressure in the form of, say, government intervention and/or regulation to come?”
The National Association of Real Estate Investment Trusts puts the tally for initial and secondary offerings by REITs at $26.5 billion from the first quarter of 2009 through the first quarter of this year. Data from New York research firm Prequin place the tally of private equity fundraising for the same period at $58 billion. Although it is unclear how much of the private equity fundraising was targeted at real estate purchases, this capital—especially the capital raised by REITs—could be considered a loose starting point for putting a dollar figure on potential demand for CRE.
A recent query to Green Street Advisors, a Newport Beach, California, research firm, asking how supply and demand would balance out in the coming months and years was prefaced with the comment, “It seems that there is much more money chasing ‘distressed deals’ than there are ‘distressed deals’—so much so that it seems that the typical lemming-like behavior of the market has created an environment where ‘distressed deals’ do not trade at distressed prices, and, in effect, market participants are pricing themselves out of the very deals they have raised so much capital for.”
“It’s going to come down to the old adage: location, location, location,” says Miguel Vasquez, vice president of development for Coastal Rim Properties of Orange County, California. “Supply-constrained markets with high barriers to entry will be the first to rebound with increasing demand. We are seeing this in the [San Francisco] Bay Area now, and we’re gambling on it in Honolulu.” In the future, investors will be returning to an emphasis on the basics, he added.
“The amount of money raised for distressed real estate purchases will not completely nullify the amount of product that comes on line. The amount of demand, however, may affect pricing in the short term,” says Matt Masterson, an acquisitions specialist at McKinley Partners. The reason for this, he says, is that “the capital that was raised in anticipation of taking advantage of ‘distressed’ real estate was raised with expected returns that cannot be achieved at current pricing. Most of these funds have a time frame as to when this capital needs to be allocated.” That time frame has come to an end, he says, and while it may result in a short-term boost to demand, over the long term, pricing will continue to decline.
“Empty retail stores, office complexes, malls, and hotels are hardly an enticement to any investor looking for current return, and long-term gain is a risk that will depend on the pace of an economic recovery and financial markets over the next several years,” says Hildt. He cautions that “the demand side must act prudently in the coming months, or it may find itself in the same predicament as the suppliers of the portfolios in the first place.”
“With the combination of ‘extend and pretend,’ dried-up financing, the expectations of these mysterious pools of money, a declining rental market, unemployment, and a fearful government, how can the market adjust naturally?” asks Daniel Arms, multifamily loan underwriter at Bank of Internet, based in San Diego. “This will not be an Econ 101 freemarket adjustment. Chances are it will drag on like a stalling Pinto ten blocks away from home.