by Gibson Kerr, CCIM - Nearly a year has passed since the stock market crash of September, 2008. In spite of the recent bounce, stocks remain nearly 40% off their all-time highs. Single family housing prices, which also appear to be stabilizing, are down 20-30% in most markets. According to the S&P/Case-Shiller Home Price Index, home prices are down 33% from the peak in 2006 and are now at similar levels to where they were in 2003. (Note: Kansas City is not among the 20 cities tracked in this index, and our local market has performed significantly better than the national average).
Just when we feel like maybe we can catch our breath and relax, we get hit with more dire predictions, this time concerning unemployment and commercial real estate. It’s like we’re living the economic equivalent of an Indiana Jones movie, dodging one perilous situation just in time to confront another, even more perilous problem.
For the last few months, the economic pundits have been repeating the talking points about how commercial real estate is “the next shoe to drop”. If you feel like the shoe has already dropped - and possibly landed painfully on your head - you may be correct. According to the “All Properties National Index” by Real Capital Analytics and the MIT Center for Real Estate, commercial values peaked in January of 2008 and have plummeted 29.5% since then.
Commercial values have returned to where they were in late 2004. The question, of course, is where will they go from here? Are commercial values going to stabilize like the stock market and home prices, or do we have further to fall?
The most notable characteristics of today’s commercial real estate market are 1) a paucity of transactions, 2) a growing amount of distressed assets and 3) difficulty obtaining financing. In 2007, office investment transactions averaged approximately $8 billion per month. So far this year, office sales have been averaging under $1 billion per month, or less than 13% of 2007 volume! Properties simply are not trading hands.
Meanwhile the list of distressed assets is soaring, led by hotels, retail and development sites. Real Capital Analytics’ “Troubled Assets Radar” has identified over $173 billion in distressed assets, the vast majority of which remain on the lenders’ books.
“Perhaps more alarming than the rapid growth in the distressed totals is the very modest rates at which troubled situations are being resolved. While $60.5B of troubled assets have been added YTD, just $4.1B have been resolved this year.”
- Real Capital Analytics
If nothing is being sold, then where is all the action? Apparently, investors are focusing their attention on buying paper rather than real assets. Interestingly,
“in the first quarter of 2009, the FDIC sold mortgage loans with a face value of $1.1B, recovering an average of 46% of par, with non-performers garnering 36% and performing loans achieving 52%.”
- Real Capital Analytics, FDIC
Likewise, special servicers have just begun the enormous task of liquidating CMBS loans and REO properties. According to Realpoint, special servicers succeeded in moving $220 million off the books through the first five months of 2009, with an average recovery rate of approximately 40% of par. Obviously, $220 million is just a drop in the bucket with a troubled asset total of $160 billion and growing.
With up to $200 billion in loans maturing this year, owners are confronting a hostile reality when looking to refinance. A combination of lower valuations and higher equity requirements leave owners with few attractive options. They can either scrape together additional equity, hand over the keys to the lender, or - what is happening most often - work out a short-term arrangement with the lender. This “extend and pretend” practice, though, is temporary and can only delay the inevitable for so long.
On the subject of CRE loans, their availability varies depending on property type. Investors can still get loans for existing multi-family properties, albeit with higher equity requirements and more conservative underwriting standards. Likewise, local banks still have a healthy appetite for owner-occupied real estate and, for smaller properties, the SBA is very active. But if you’re looking for a loan for a new hotel or speculative development, good luck.
The investment real estate market remains dominated by fear and expectations of continued erosion of values. Investors are waiting for blood to flow when the lenders finally face up to reality and move the assets off their books. Rising unemployment and an increase in bankruptcies - particularly among retailers - are taking their toll on fundamentals as vacancy rates have jumped dramatically and net operating income has fallen.
Given this bleak scenario, I am reminded of the words of General Ferdinand Foch at the Battle of the Marne in 1914: “My center is giving way, my right is in retreat. Situation excellent. I am attacking.” Indeed, it is precisely when matters appear to be at their worst that the bold take action.
Am I suggesting that today’s investors take reckless steps? Of course not. But we should also remember that real estate is a long-term investment. Most investors have seven to ten-year hold periods, and it is not uncommon for properties to be held for twenty years or more. Concerns about short-term fluctuations in value should be kept in perspective.
Good opportunities exist today. Investors should not forego the chance to acquire solid, cash-flowing assets priced significantly below replacement cost simply because other properties are falling in value.
We cannot paint commercial real estate with one broad brush. Some properties may have already hit bottom, while others remain in free-fall. But it is important to recognize that quality properties with sound fundamentals will not erode in value in the same fashion as vacant or unimproved assets. A new Walgreen’s, for instance, is an entirely different animal from a vacant big-box store.
Investment advisors always stress the importance of “dollar cost averaging” and warn against trying to time the market. This advice applies equally to real estate as it does to stocks and bonds. The time is here for investors to cautiously start tip-toeing back into the market.
Tags: Gibson Kerr, Kansas City, Kansas City Commercial Real Estate