While sagging credit conditions were initially responsible for the weakened commercial real estate capital markets, today poor and declining fundamentals are adding to the problem, according to Reis economist Ryan Severino.
“The decline in transaction volume and transaction prices is broad-based, consistent with continuing weakness in property fundamentals as well as little improvement in credit availability,” said Severino during the New York-based research firm’s third-quarter capital markets briefing today. “Neither of these is likely to improve in the immediate future so we should expect volumes and prices to remain depressed for some time, even if the pace of decline slows.”
Moody’s Economy.com projects unemployment to peak at 10.6% in 2010. The impact on demand for commercial real estate space will result in peak vacancy rates of 18% for the office sector and 8.3% for apartments in 2010, according to Reis. Retail vacancies are not expected to peak until 2011 when they reach 12.5%, but Reis anticipates no recovery for the sector until 2012 “at the earliest.”
Meanwhile, transactions by dollar volume for single-asset sales of office, apartment, retail and industrial properties valued at $2 million or more fell to $6.86 billion at the end of the third quarter this year, down 73.7% from $26.10 billion over the same period last year.
The lack of available debt from the commercial mortgage-backed securities (CMBS) market has had a major negative impact on deal volume. Severino points out that at its apex, CMBS accounted for slightly more than 30% of the total $3.5 trillion in commercial mortgage debt outstanding. In the second quarter of this year, asset-backed securities added up to just $714 billion (21% of total debt outstanding), down from $759 billion a year earlier.
“Nonetheless, we have actually observed a year-over-year increase in commercial real estate debt outstanding,” adds Severino. “The increased lending activity of commercial banks over the last year more than compensated for the decreased lending activity across all other lending segments.”
At the end of the second quarter, commercial banks’ debt outstanding rose to $1.55 trillion, up from $1.46 trillion in the prior year, an $89 billion increase.
Commercial mortgage loan performance, however, has been less than stellar. The national delinquency rate for CMBS rose to just over 4.5% in the third quarter, says Severino, up 152 basis points from the previous quarter’s rate of 3%. Hospitality contributed the most to the increase due to the $4.8 billion default associated with the Extended Stay Hotels bankruptcy.
The good news is that CMBS AAA and BBB spreads over swaps have begun to stabilize, perhaps as investors take heart in the federal government’s Term Asset-Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP). “During the third quarter, AAA spreads fluctuated in the 500-600 basis point range as slightly greater market activity was interpreted as a sign of price stabilization for CMBS,” says Severino. “With TALF buttressing demand for super-senior paper, and PPIP supporting some interest in riskier tranches, spreads are at their lowest level of 2009.”
Shopping center real estate investment trust Developers Diversified Realty Corp.’s $400 million bond sale represents the first new CMBS issuance in more than a year, and part of that amount was TALF-eligible.
“October also marked the beginning of the government’s PPIP, with the U.S. Treasury announcing that five of its PPIP partnerships have lined up over $12 billion in private and federal money,” Severino explains. “These PPIP partnerships are designed to help banks shift toxic assets out of their balance sheets.”
Whether government programs or commercial bank lending will be enough to satisfy the $147 billion in commercial mortgage-backed security loans maturing over the next two years remains to be seen. Included in that volume is $89.9 billion in debt backed by five-year multifamily and retail loans originated during the aggressive, frothy years of 2005 to 2007.
“Despite the lending activity that we are currently observing,” says Severino, “unless credit availability improves, it is likely that a good portion of these loans maturing will seek extensions or be forced to enter default on maturity.”