Five Indicators of the Bottom of the Commercial Real Estate Market

As a commercial real estate broker and investor, I am often asked about the arrival of the low-point of the stressed, distressed, value-add and opportunity property market. "When will we be at the bottom? Are we there yet? Is it this year? Will it be next year? Will the pending CMBS mess push property values lower? When should I get in?" are just a few examples of questions I am fielding. Funny thing is, I don't think we ever actually see the bottom before it passes us by.

That said, I think we are darn close, if not already there. Here are five indicators that it may be time to get into the pool before it is too late:

1. CMBS Mortgage Pools are Selling. Not only are these pools selling (some which contain so called "toxic loans"), but the yields are dropping. GlobeSt.com recently reported: "Spreads on AAA-rated CMBS have narrowed by 100 to 150 basis points as a rally in these securities continues for the second straight month, particularly in five-year triple-A paper, according to a new report from Trepp. Predictably, the spreads have narrowed more on loans backed by stronger collateral, Trepp says. The narrowing has occurred even amid what the CMBS information provider calls "continued negative headlines." Today, the Fed announced a six-month extension to the TALF Program, which is only good for newly issued and legacy triple-A-rated CMBS loans, but they left the door open to include other issuance's if the economy requires it. This trend will open up the debt market, as long as the investors see enough reward in the risks they are taking.

2. The Bad News is At a Crescendo Level. To wit; Reuters; "Commercial property execs expect more bad news", Hernando Today; "Analysts: Disaster looms in commercial real estate", GlobeST; "Property Sales Plummet in First Half of Year", Reed Business Information; "Industrial rents drop on slumping demand", Financial Times; "CMBS delinquencies add $2bn per month"...I could go on and on, but the press and industry insiders and experts are pounding this market day after day with bad news, predictions, and comments, pointing to a pending total industry melt-down and absolute doom. Though this has been like a wildfire jumping from sector to sector, spreading negativity with a "scorched earth policy", I've noticed a marked up-tic in relatively good news. A recent report from the Massachusetts Institute of Technology Center for Real Estate (MIT/CRE), actually goes as far as to say "A commercial real estate price index... posted a staggering 18.1 percent drop in the second quarter. The index, which collects commercial real estate purchase and sales data from leading real estate firms, is now down 22 percent for the year and 39 percent from its peak in Q2 2007" Commercial Mortgage Loans, the author that analyzed the data suggests that "All the bad news, however, is a harbinger of good news. The very best financial professionals know that pessimism is a bullish indicator. A market bottom, by definition, is the moment of maximum pessimism. The sheer magnitude and the incredible speed of the price declines could be an indication that sellers have capitulated and now believe that getting out is more important than getting their price". I find it incredibly interesting that we have to have the lowest of lows in recent history to start our way back up, but this could be true, and good news is starting to trickle out...http://seekingalpha.com/article/153491-commercial-real-estate-record-declines-may-be-good-news

3. The Smartest Players Are Getting Back In The Game: Realty Income (NNN) recently announced that they are back in the acquisitions game. I know the CEO Tom Lewis personally, and think he's one of the most brilliant leaders and thinkers in CRE. When he starts to feel bullish, it makes me think we may be at our near the bottom.

Recently, CB Richard Ellis Investors suggested that the slump in pricing could be over. http://nreionline.com/finance/news/slump_nearly_over_says_cb_richard_ellis_investors_0810/index.html CBRE has access to the best research, real time market activity, have penetrated all financial and real estate segments and have unmatched U.S. and international market coverage. If they think we are at (or near) bottom on pricing...well, who am I to argue? Also, I’ve noticed that some smart retailers and others are taking advantage of the downturn to get access to excellent real estate at fire sale pricing. This type of activity should lead value-add investors into the pool too.

4. U.S. Housing Woes May Have Bottomed Out. Residential experts are predicting an imminent flattening out or an end to the housing financial crisis. Small "shafts of light" are entering the dark depths, such as; pending sales are increasing a smidgen, prices are not falling quite as fast, monthly sales are increasing slightly, activity and pending sales are up a bit, foreclosures are abating a little, builders are building...OK, well that might be a bit aggressive, but nationally the news is improving a titch. Face it; we need a housing financial re-birth to lead us out of our doldrums. Sam Zell recently said, "The key to everything is single-family housing because that's where consumption comes from," Zell said. "If people don't have confidence in their biggest asset, they won't have the confidence to spend." This confidence will drive spending, which leads to jobs-which drive commercial real estate metrics. Keep track of housing or you might miss a big indicator.

5. Capital is Returning to Real Estate. The U.S. REIT and Real Estate Funds markets have had significant success in raising money to pay down debt and for property acquisitions. There are more IPO's to follow. In July and the first week of August there were approximately 25 new registrations alone. This new money is clearly earmarked to buy distressed assets. When the big boys start buying, the bargains may be waning. Recently, I read of competition in the debt market in a Reuters article. I especially like this quote “recent signs of "aggressive" competition to fund office properties, including from insurance companies and foreign banks, mean borrowers could find it tougher to seek breaks on existing loans, the analysts, led by Darrell Wheeler, said in a research note. With more access to funding, they argued, prices would be buoyed, making foreclosures viable alternatives". http://www.reuters.com/article/bondsNews/idUSN1430571420090814 Hines REIT, Brookfield Properties and other big players are eying IPO’s. Cash will be king and the treasures will be there.

There are a myriad of indicators that can and do signal the fall of a market, but there are not as many clear indicators cuing investors of the very bottom. The aforementioned five should be clear hints that we are either at, or very close, and as most savvy investors know, you won’t actually see the bottom until it’s passed you by.

As you consider whether or not to dip your toe into the pool, remember that money is made in down markets, and those most successful are willing to take the additional risks and stand to do the best. When investors are closing deals all around you, it will be too late to be called one of them.

Michael K. Houge, CCIM, SIOR

(Chief)

info@chiefcompanies.com

651-288-0300

Chief Thoughts on Commercial Real Estate Demand

This is the first "Chief Brief".

When looking at the demand in the business of commercial real estate, I think there are a variety of factors to consider. They are:

Leased space demand.
Commercial mortgage demand.
Commercial real estate services demand.
Investment property demand.

Leased space demand.
The crash of the housing expansion and overall residential real estate market has had considerable impact on employment. Unemployment has caused vacancy rates to skyrocket in office and manufacturing space, has had negative effect on industrial, distribution, and warehousing properties, as well as almost every class of retail space. I think that until we experience significant increases in job creation, we will not have demand for further development, in any of the aforementioned classifications, nor will we see a swing back to a meaningful increase in absorption of the current vacancies. Jobs drive commercial real estate demand.

Commercial mortgage demand.
The housing crisis lead directly to the capital markets meltdown. The CMBS debt packages were co-mingled with sub-prime and other “financially engineered” debt products that were soon exposed as significant risk, and in most cases, caused these huge packages to be unable to be effectively underwritten, and thus they became “poison assets”. The buyer pools ran in the opposite direction and the mortgage and investment bankers were left holding the bag-with no buyers. This effectively took the knees out from under the conduit mortgage business which were at that time, originating approximately 65-70% of all commercial debt. No replacement product or program has emerged, and none is in sight. There is an estimated $1.8 Trillion of CMBS debt maturing in the next four years, without a cohesive plan or capital source for refinancing, except a recently coined strategy of “pretend and extend”. Which is a nice way of saying “stick our head in the sand” and hope the values hold up by pushing out the term, and pray that another capital source returns to the market. The demand for quality commercial debt is and will be considerable. My concern is whether a supply will materialize-in time.

Commercial real estate services demand.
As the ancient Greek philosophers said, “The only constant is change”. There will always be a demand for commercial real estate services, as there are, and will always be owners that have no desire, aptitude or resources to operate, lease, sell, manage or finance their assets. The question will be in what area will there be an increase in demand for these services?

With the recent economic deterioration, quality leasing services will be likely be in the highest demand, especially if there is a fallout in leasing agents unable to sustain in a much more “hit and miss market” with a greatly reduced opportunity for earning.

Demand for asset and property management services will likely remain the same, with some of the players being replaced by specialists like receivers, as many properties will go into default and or foreclosure and lenders will want to protect the assets. Demand should also increase for special loan servicers who will assess current property conditions, develop a plan for continued operations, negotiate with borrowers, and make asset based decisions, including the hiring of receivers, property managers, and leasing and sales brokers.

Investment property demand.
Buy low sell high. One would think that this strategy would be more than achievable. Overall commercial property values are estimated to have dropped by 20-40%, so arguably one can “buy low”. The mystery is whether the values will continue to drop, thereby delaying or preventing the rise in value that necessitates the “sell high” part of the old real estate adage.

The current demand for commercial real estate is dimmed by three major factors.

Lack of debt capital. Although debt exists, it is in low supply, the terms are less palatable to investors, and the risks are not in alignment with the current cap rates or pricing. Why would an investor take significant recourse mortgage risk, coupled with the inherent risk associated with commercial real estate in a very unstable and unforgiving economy? Demand is definitely driven by favorable financing.

Lack of market confidence. Until the American consumer feels confidence in the economy, the value of their most significant investment (their home), and do not fear losing their job, they will not shop, which sadly is the driving engine of America’s financial health. Currently there is no confidence to invest in commercial real estate.

Lack of 1031 Exchange activity. Most brokerage metrics put their investment sales figures at 7-20% of 2007 numbers, while 2005-and 2006 were even better. With transaction velocity this low, 1031’s are almost non-existent. Another significant factor is the aforementioned decrease in property values. Even if a property owner sells, he/she is not likely to experience enough appreciation to recognize significant capital gains, which is the main driver of the 1031 tax deferred exchange.

Obviously, institutional investors are less impacted by tax ramifications and debt constraints, but their confidence levels remain low, and they are “staying out of the pool” until they can see the bottom. The same can be said of the riskier, value–add, opportunistic individual investors.

Once we see a long-term, fundamentally sound commercial real estate market, that behaves with a modicum of predictability, we will experience an increase in commercial investment demand.

Michael K. Houge, CCIM, SIOR
(Chief)