Challenging Sales Market Will Push Default Rates Higher in 2009

Deteriorating property fundamentals and a dearth of available financing continued to wreck havoc on the investment sales market in the fourth quarter of 2008, reports New York-based research firm Reis. Sales volumes fell by double digits compared with the fourth quarter of 2007 in office, retail, multi-family and industrial sectors, while cap rates continued to rise.

The deterioration spells bad news for commercial property owners because it will limit their ability to sell assets to avoid defaults on near-term debt maturities, Reis warns.

The research firm estimates there are more than $270 billion in commercial real estate loans coming due in 2009, but securing refinancing remains difficult. In the first quarter of 2009, close to 80% of senior loan officers surveyed by the Federal Reserve reported tightening standards for commercial mortgages.

Normally, asset sales can serve as an alternate route for owners unable to refinance. But with the investment sales market at a standstill, Reis projects the commercial real estate default rate will rise to 4.2% in 2009 and could hit 4.8% by 2012.

The lack of investor interest is “driven by lower expectation of net operating income and unwillingness of buyers to pay for properties the rates they were paying in the past two or three years,” says Victor Calanog, Reis’ director of research.

So far, the office sector seems to have suffered the most, with a 60.1% drop in the number of sales transactions in the fourth quarter of 2008 from the same period a year ago, and a 67.0% decline in dollar transaction volume. On a national basis, the cap rate for office buildings stood at 6.7% at the end of 2008, but the figure won’t peak until 2012, when it is projected to reach 7.5%, according to Reis.

The number of investment sales in the retail sector fell by 45.1% in the fourth quarter of 2008 from the year-ago period, while dollar transaction volume declined 56.7%. Going forward, retail will take the most severe hit from the current recession compared with other property types due to the fall in consumer spending and a certain level of overbuilding, says Calanog. At year-end 2008, the cap rate for retail properties was above 8.3%. By 2012, it will be at 8.8%.

The industrial sector experienced a 50.5% drop in the number of sales transactions and a 54.3% decline in dollar transaction volume compared with the fourth quarter of 2007. Reis does not track cap rates for industrial properties on a national basis.

The number of investment sales involving multi-family properties fell 47.9% during the period, while dollar transaction volume dropped 53.2%. Calanog expects the multifamily sector will weather the downturn better than any other sector. “Jobs might be lost and consumer spending may drop, but people still need some place to live and if they are not buying houses, they must rent somewhere,” he says.

Cap rates for apartment buildings moved past 6.8% by the end of 2008, but they won’t peak until sometime in 2012, when they will rise above 7%.

Reis projects the multi-family sector to experience the lowest loan default rate in 2009 on the commercial mortgage-backed securities (CMBS) side, at 3.8%. The CMBS default rate for office properties is projected to reach 8.8% this year, while the retail sector will likely experience a 5.4% default rate.

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