Getting Off the Dime

After two years of inertia, commercial real estate is finally starting to move.

There's no shortage of bad news — and the sheer volume of it can be paralyzing for investors. Forecasters predict that the first half of 2010 will be an intensely ugly period for commercial real estate, with cash flows dwindling and hundreds of billions of dollars in maturing loans. Yet well-capitalized investors are beginning to awaken from their two-year slumber, the smell of distressed deals and opportunities enticing them back into the marketplace.

“Take Warren Buffet: He's got cash and he's out there picking off assets that he likes, and that's a great play.” says Suzanne Mulvee, a senior strategist with Boston-based research firm Property & Portfolio Research (PPR). “Who knows? This could be the year that the next Sam Zell is crowned.”

There have already been some positive — albeit small — indications that commercial real estate is getting off the dime. For instance, foreign investors have slowly begun to return to the U.S. market in recent months. Domestic transaction activity has turned modestly positive, with $39.2 billion in deals of $5 million or more closed through the end of October, according to New York-based Real Capital Analytics (RCA).

Life companies have begun to make commercial real estate loans again. The new debt originated for sale transactions and refinancing combined in 2009 is less than $10 billion, a quarter of the volume at the peak of the cycle. “Remember though, the trend is positive and that number is getting bigger,” says Ed Padilla, CEO of Minneapolis-based NorthMarq Capital. NorthMarq expects that next year, life insurers will hit $20 billion in new loan production.

Granted, these positive signs are baby steps. For now, disorder permeates the commercial real estate market. Although almost $40 billion worth of assets were sold in the first 10 months of 2009, some $151 billion were still in distress at the end of October, with just $11.6 billion resolved, according to RCA. And that slow process to resolve the embarrassment of distressed riches has kept downward pressure on prices.

“Those [investors] with healthy balance sheets that can take advantage of the market dislocations will be the winners,” says Mulvee. What, then, are the factors savvy investors should consider in order to take advantage of that dislocation in the marketplace?

The foreign factor

Some experts speculate that while U.S. investors dicker over historically low prices, foreign investors will cut in line to buy the high-quality assets at bargain prices, even when they can't find a fire sale. Such aggressive buying from both core and opportunistic overseas investors could help stabilize values, observers say.

Foreign investment in U.S. commercial real estate through the first nine months of 2009 totaled roughly $2 billion, about half of which came from Germany, or $965 million. “We've already seen the Germans start to come in, and we should see more investment from them in early 2010,” says Mulvee of PPR.

In early November, for instance, German real estate investment and management firm Jamestown Properties announced a joint venture with retail REIT Weingarten Realty Investors (NYSE: WRI). The deal encompasses six grocery-anchored projects in infill locations in the Southeast, with a total value of approximately $160 million.

The first four properties, valued at $114 million, were refinanced with new debt while the remaining two properties involved loan assumptions. Atlanta-based Jamestown's equity investment will be approximately $53 million, which gives the firm an 80% ownership interest. It is the first investment for Jamestown's most recent opportunity fund, the $425 million Jamestown Co-Invest V.

Other notable deals by foreign investors this year include IDB Group's acquisition of HSBC Bank's New York headquarters from HSBC Holdings for $330 million. IDB is one of Israel's largest investment holding companies. In June, the $200 billion sovereign wealth fund, China Investment Corp., announced that it would invest between $500 million and $1 billion in Los Angeles-based Oaktree Capital Management.

Affirming demand

The reason more foreign investors haven't yet taken advantage of the cheap dollar, which has traded for months at around $1.50 against the euro, may be that the bulk of foreign investors want to see true stabilization, not just green shoots, says Victor Calanog, director of research for New York-based research firm Reis.

“This is likely going to come in the form of a formal pronouncement that the technical recession is over, and that might not be long in coming,” Calanog says.

The clearest indication of economic stabilization — job creation — may occur later than sooner, however. “I don't see the labor market turning around for at least two years. It will be bumpy,” says the economist. “The Bureau of Labor might turn around two months from now and announce 5,000 jobs gained, and the very next month there could easily be 150,000 jobs lost.”

Since December 2007, the U.S. economy has shed 7.3 million jobs. The national unemployment rate reached 10.2% in October and could reach the mid-10s in 2010. That ongoing loss of demand for commercial real estate will result in a 6% to 10% decline in rents across property types through June on a year-over-year basis, according to PPR.

As rents fall, there is no clear picture of the next demand driver. “For certain industries [demand] will not come back. Whether the housing industry or apparel or whether it's the spending side, those big demand signals are lost. The consumer has retrenched,” says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University's J. Mack Robinson College of Business.

The Greatest Generation's gift to the U.S. economy — the gift that was supposed to keep on giving — has petered out. American industry had budgeted for Baby Boomers to continue spending and demanding homes forever. “That assumption has been proven wrong now, so they have to work with the new reality and it takes a while to get to that point,” says Dhawan.


As investors begin to stretch their legs, stiff from an almost two-year hiatus from business, the federal government continues to enact programs such as the Public-Private Investment Program (PPIP) and Term Asset-Backed Securities Loan Facility (TALF) to promote price stability.

Expressions such as “kicking the can down the road,” “pretend and extend,” “delay and pray,” and “a rolling loan gathers no loss” are just some of the tongue-in-cheek phrases that have emerged to describe actions that lenders and the federal government have taken to stave off a tsunami of distress.

In late October, the Federal Deposit Insurance Corp. (FDIC) issued new guidelines that will allow banks to keep performing loans on their books, even if a property's value is lower than the principal owed, meaning the loan is under water. Critics say the new guidelines could deal a blow to buyers of distressed assets.

They also argue that the FDIC's decision will delay the recovery because it will take longer to clear the wreckage. On the other hand, many experts believe that the federal government had no alternative, given the weak state of the U.S. economy.

“The government's position is that the economy just can't bear more of a correction right now; it would be too painful, too punitive for the populous to bear,” says Mulvee. “That also gives banks, who have to mark to market and hold this stuff, time to grow out of some of these problems.”

Padilla of NorthMarq agrees. “Some people believe that our entire financial system is in worse shape than anyone is willing to admit, including small banks, community banks and the big ones, too,” he says. “The government is in no hurry to force them to deal with their commercial real estate.”

Despite such pronouncements, Robert Bach, chief economist for Santa Ana, Calif.-based Grubb & Ellis, forecasts that next year will be uglier at the start than at the end. “[Distress] will be more gradual, almost like a silent flood where the water just sort of comes up and your once dry town is suddenly flooded. We'll know when the levee has broken and we'll see those flood waters coming in the form of increased transactions.”

Buying out of receivership

Of the $147 billion in CMBS loans maturing over the next two years, $89.9 billion of the debt is backed by five-year multifamily and retail loans originated during the aggressive, frothy years of 2005 to 2007. “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,” says Ryan Severino, a Reis economist.

Through the first half of 2010, 6% to 7% of CMBS loans are forecast to be delinquent by 60 days or more, and could reach 12% by the end of 2012, says Mary MacNeill, managing director of CMBS at New York-based Fitch Ratings.

To stem the tide, in September the Internal Revenue Service and the U.S. Treasury loosened rules to allow loan modifications and extensions, which will either help right some troubled loans or delay the pain, depending on the point of view.

Prior to the new rules, CMBS servicers told borrowers not to contact them until they were in default because regulations prohibited such changes without tax penalties and the potential loss of the real estate mortgage investment conduit (REMIC) status.

Whatever the delay, the sheer volume of maturing CMBS in an illiquid market should continue to present excellent opportunities to acquire high-quality, discounted assets through a process that is much like a loan assumption.

“The bulk of our clients are special servicers because distressed assets are what's trading,” says Kris Cooper, managing director with Jones Lang LaSalle.

With little available debt, Cooper says, the only way to close a property sale in the year ahead will be for the special servicer to essentially rework the existing mortgage, keeping the same interest rate but reflecting a lowered principal balance. The equity contribution required on such deals ranges from 20% to 30%. Experts say price discounts on these properties vary by special servicer and asset, but average between 25% and 50%.

A ray of light

Here's the good news: Commercial real estate brokerages will find plenty of work unwinding troubled assets and debt in the new year.

Seattle-based FirstService Real Estate Advisors, for instance, is leveraging its expertise in real estate asset management to assist small and regional banks to reposition and sell the properties that are coming back onto their balance sheets. Services include intensive property management, lease-up, repositioning and sales.

So far the firm has completed more than 100 sales that would qualify as distressed transactions. The average size of these deals is in the $3 million to $7 million range — bite-sized transactions that go down easier in a tight credit market.

“We are seeing a little bit of movement. That's one gleam of optimism we're seeing going into 2010,” says Dylan Taylor, president of FirstService Real Estate Advisors' U.S. operations.

“The bid-ask spreads are narrowing, mainly attributable to sellers. At one point we were probably at 30% so now we're closer to something like 15%.” Taylor has also observed a number of owner-occupier deals take place in recent months, a trend he expects to continue in early 2010.

Meanwhile, entrepreneurs along with banks and well-capitalized investors will begin to haul away the rubble of the global financial collapse, loan by loan and brick by brick.

In the 2010 Real Estate Investment Outlook, conducted jointly by NREI and Marcus & Millichap, more than one in four investors surveyed indicated they have already started adding to their portfolios. Another 41% say they plan to begin acquiring properties over the next six months.

“Investors have become more engaged in the past few months, and properties that are well priced are getting multiple offers. The trend clearly points to an increase in sales activity in 2010,” says Hessam Nadji, Marcus & Millichap's managing director of research services.

“Happily,” concludes Mulvee, “real estate has one very important thing going for it — it is really cheap.”

Sibley Fleming is managing editor.


NREI asked four forecasters to predict the direction of key economic indicators. Here are their responses:

Rajeev Dhawan
Director, J. Mack Robinson College of Business at Georgia State University

“Be prepared for the ‘new’ norm of lower GDP growth and employment as corporations sit on the sidelines with their investment plans.”

Victor Calanog
Director of Research, Reis

“Vacancies will continue to rise at the national level, but we may begin to see surprising resilience or signs of recovery from specific areas or property types.”

Robert Bach
Chief Economist, Grubb & Ellis

“I think the recovery will hold, but it won't feel much like a recovery, especially for commercial real estate. Look to 2011 for a more vigorous rebound.”

Suzanne Mulvee
Senior Research Strategist, Property & Portfolio Research

“2010 will be the year of cash flow, and those who have it will be fine. Those who don't might not make it to the end of the year.”


GDP growth: 1.7%

Core CPI inflation rate: 1.2%

Monthly job gains/losses: -65,000

10-year Treasury yield: 3.9%

Crude oil ($ per barrel): $65


GDP growth: 2%

Core CPI inflation rate: 1.3%

Monthly job gains/losses: 50,000

10-year Treasury yield: 3.7%

Crude oil ($ per barrel): $85


GDP growth: 2%

Core CPI inflation rate: 2.5%

Monthly job gains/losses: -40,000

10-year Treasury yield: 4.5% to 5%

Crude oil ($ per barrel): $85 to $90


GDP growth: 1.9%

Core CPI inflation rate: 1.8%

Monthly job gains/losses: -5,000

10-year Treasury yield: 4.4%

Crude oil ($ per barrel): $70

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