Three years after the collapse of the financial markets, capital is back for commercial real estate. But it is largely targeting the same types of investments, especially multifamily housing, in the same handful of top-tier cities as investors fight for yield in a difficult market.

That was the theme of the ULI Real Estate Capital Markets Conference, held in New York City in late June. For two days panelists and participants debated what that might mean for the second half of this year and beyond.

The availability of investment capital is no longer the issue in the commercial real estate market because insurance companies, private equity funds, overseas financial institutions, and real estate investment trusts, among others, are all searching for places to put their money, both debt and equity. The volume of transactions has picked up dramatically this year, with $35.4 billion in office, retail, and industrial transactions in the second quarter, preliminary data from Real Capital Analytics (RCA) show, compared with $16.8 billion in the second quarter of 2010.

But with prices and rents down, large quantities of troubled loans remaining, and continuing macro¬¬economic jolts, it remains a difficult market for commercial real estate buyers, lenders, investors, and developers. “It is a very complex marketplace right now,” said Robert White, founder of RCA.

More than $300 billion in mortgages have defaulted since Lehman Brothers collapsed in fall 2008. Only 42 percent of those have been worked out to date, with some of those workouts likely not permanent, according to data presented by RCA. More distressed deals are expected to come to market over the next few years as loans made during the bull market mature and as banks work through their existing portfolios.

“I think a lot of lenders took great pains not to dump assets and sell at distressed prices,” said Frank Cohen, a senior managing director in the real estate group at Blackstone. Instead, borrowers and lenders have reached agreements to extend the maturities of their loans, a practice known as “extend and pretend.” Meanwhile, loan payoffs on commercial mortgage–backed securities (CMBS) reaching maturity have been very poor, White said, even as the CMBS market has started to come back to life.

How quickly and at what prices properties now in default—or at risk of default because their loans exceed their value—work their way through the system will be a key issue going forward. Nicholas Schorsch, chairman and CEO of American Realty Capital, said he had been waiting for markdowns of 35 to 50 percent, but has yet to see them.

For now, with interest rates low, inflation potentially lurking, and institutional investors searching for yield, money is flowing to pockets of the market believed to have the least amount of risk and the highest potential for immediate cash flow. Vacant or partially vacant properties, development deals, and properties with unknown risks are a tougher sell. While those deals still may get done, they are more likely to be done as equity deals and on terms more favorable to the investors. “Everybody is looking for the same thing—cash flow,” said E.J. Burke, executive vice president and group head of real estate capital and corporate banking at KeyBank in Cleveland.

Fear remains a big part of the market psychology. “People are very afraid of fundamentals and very afraid of taking any lease-up or execution risk,” said Alec Burger, president, North America, for GE Capital Real Estate. “People are ineffectively pricing the risk of lease-up. . . . My view is that there will be a narrowing because people want to deploy capital, so the spreads will likely compress.”

For now, however, the market remains bifurcated. In the top-tier markets, such as New York City,
Los Angeles, San Francisco, Boston, Chicago, and Washington, D.C., the money is there and properties—especially trophy properties—are changing hands quickly. Multi¬family housing, which has had a very strong comeback, al¬¬ready may be getting overheated. Risk-averse investors are chasing the same locations and properties in a flight to quality. “There is a feeding frenzy for good-quality, well-located assets,” said Burger.

In second-tier and third-tier cities like Pittsburgh, Cleveland, or Indianapolis, financing is tougher to obtain. So, too, is financing for new development because many investors do not want to wait for returns or to assume the risk that such projects require. “You have a bifurcated, or trifurcated, market,” said James Reilly, executive director of J.P. Morgan Securities.

Whether in New York City or Indianapolis, the underlying issue is the economy—whether there will be economic growth, whether unemployment will come back down, and what direction interest rates will go. If the economic recovery continues, real estate will follow the same trajectory, with expanding businesses needing places to locate and job growth driving housing.

Dean Maki, chief U.S. economist at Barclays Capital, forecasts continued economic improvement. He argued that though growth in gross domestic product (GDP) in the first half of the year was weak, it will improve in the second half, with 3 to 3.5 percent growth. One reason he believes this is that higher gasoline prices act like a tax, so as they fall back—as they had through early summer—it will leave consumers with more cash to spend. “Our view is that consumers will spend this additional income they will be earning over the next few months, and that’s why we are confident the second half will improve,” Maki said.

An added plus for the commercial property market is the prospect of inflation in the future because real estate is considered a hedge against inflation. “That is part of the positive story,” White said. “I think it is a big driver of the marketplace right now.”

Risks remain from financial shocks to the system, such as the debt crisis in Greece, and from structural changes in the American economy that may keep unemployment at a higher level than in the past. As was the case in the previous real estate downturn two decades ago, it will take time to work out the inventory of properties. “I think this will be a five-year recovery as well,” said Stephen Furnary, chairman and chief executive officer of Clarion Partners.

With more money chasing fewer deals, some real estate lenders and investors are beginning to worry about a new bubble, especially in multifamily housing. “I’m not saying we’re in 2007, but there is some look of it,” said William Hughes, senior vice president and managing director at Marcus & Millichap Capital Corp.

There has been “tremendous creep” in loan-to-value ratios recently, said Steven Kohn, president of Cushman & Wakefield Sonnenblick Goldman. Meanwhile, capitalization rates have fallen; cap rates on central business district offices, for example, were below 6.5 percent on average in the first quarter, according to RCA.

“The supply/demand imbalance has compelled people to overpay for deals and to accept risk that is not necessarily commensurate with return,” said Ethan Penner, president of CBRE Capital Partners. The problem for most investors is that the alternative is keeping the money on the sidelines. “Today you are being offered a paltry return for risk and zero return for keeping cash in your pocket,” he said. “You are better off keeping cash.”

Real estate historically offers returns a few percentage points above inflation—not the double-digit returns of the bubble years—and is subject to boom/bust cycles. As the market recovers, the question is whether participants will be able to balance on the tightrope between the greed of the boom times and the fear of the bust. But Schorsch is skeptical that anything will change: “We’re not going to learn anything.”