To take advantage of the current market cycle investors need to do more than dust off old playbooks from the 1990s. Capturing the upside requires a different mind set and skills than those employed in previous downturns.
The 1982 and 1990 cycles are good points of comparison to today's market cycle. In 1982 the downturn lasted for 16 months with a peak unemployment rate of 10.8%. The 1990s recession had an unemployment rate of 7.8% and lasted just eight months.
The 1982 recession was primarily limited to the manufacturing sector. The recession of the 1990s was marked by the scarcity of debt and an oversupply of commercial property. In the 1990s fortunes were made by buying heavily discounted vacant assets, which were leased up to full occupancy in a subsequently growing market. The current market does not offer this type of opportunity.
Today's market reflects the credit shock caused by the removal of CMBS (Commercial Mortgage-Backed Securities) as a source of debt. The current crisis started with an oversupply of residential inventory, which exposed defects in the securitization process of residential debt that then filtered through to the commercial market.
In the current market cycle the wholesale dumping of space appears to be over while absorption rates are starting to improve in many markets. The positive absorption numbers in many markets are driven by the need for additional space as the economy recovers.
There are currently three major categories of commercial real estate investors. The first group is looking for REO properties that they can acquire for pennies on the dollar. REO investors anticipating a wave of distressed properties, so far, have only seen a trickle. Click on Distressed Properties for more details.
The second group of investors is actively buying quality assets at a discount from their historical valuations. Frequently these buyers are offering all cash to sellers who are under financial stress.
The third and largest group of investors is waiting on the sidelines to see what will happen next.
We are seeing signs of improvement emerging in our investment sales pipeline. New request for quality net lease (NNN) and multifamily properties are significantly above six months ago. The end of 2009 saw an uptick in actual closed transaction.
The debt markets continue their slow thaw for the best properties with spreads narrowing and improved loan to value ratios. Life insurance companies in particular are attracted to the yields available in conservatively underwritten commercial real estate debt.
For 2009 commercial real estate's total return on a year over year basis showed the following by property type according to the NCREIF Property Index:
These return numbers are negatively biased because many owners of performing commercial real estate are waiting out the market. Those that are selling are frequently under financial stress and are forced to accept less than the properties would sell for in a normal competitive market.
The lower prices are also caused by a lack of financing and a dearth of willing buyers. In 2009 over half of all commercial sales were done with assumable or seller financing. The balance of the sales involved all cash basis buyers or new debt in the 50% to 65% loan to value range.
It is important to note that the average income portion of the return held steady at 6.2% during 2009 while the prices investors were willing to pay for properties declined thus the dismal total return numbers.
Much of the reluctance of investors to buy comes from the concern that there will be a new wave of REO properties that will further depress the market. While there is a likelihood of an uptick in REO properties the glut of foreclosures and REO sales seen in the 1990s is unlikely as explained in detail later in this report.
To date regulators have tried to keep the doors of weak lenders open by allowing them to modify and extend terms on their loans for borrowers who can service the debt. This policy has minimized the number of lenders that needed to be taken over by the government and minimizes the associated cost to the taxpayer.
A significant area of lender risk and investor opportunity is the overhang of $481 billion dollars in construction and land loans. These loans are on properties that frequently produce little to no income and will require additional capital to complete making them especially vulnerable to the weak economy. The holders of these loans have little incentive to add capital to complete their projects until demand returns. For REO investors with capital to deploy this area is ripe with opportunity.
Another area of exposure is commercial properties purchased between 2005 and 2007 that tend to be undercapitalized and need new equity contributions, a reworking of the debt, or both. Property owners and lenders are frequently confronted with the uncomfortable reality of actual rents and occupancy factors that are significantly less then the rosy projections used to obtain the loans in the first place.
One proposal from the FDIC is to securitize these potentially troubled loans. This would help clean up lenders' books and strengthen capital requirements. If this happens, lenders would be able to make more loans which in turn would help in the economic recovery. The problem with this approach is the moral hazard of encouraging unwise lending practices in the future and effectively unfairly rewarding REO investors with taxpayer dollars.
The three unknowns in the current market cycle are the length of time to economic recovery, the time to return to availability of viable credit for all types of properties and regularity actions.
The unknown of government future actions has created a game of chicken between those with the capital, regulators wanting to revive the economy, lenders and property owners. The net results are few transactions and low lending activity.
Commercial Real Estate Markets
Markets with the highest expected 2010 employment growth include San Antonio, Austin, Dallas/Fort Worth, Salt Lake City, Portland, Minneapolis-St. Paul, Washington DC and Denver.
Markets such as Detroit, Jacksonville, West Palm Beach, Tampa, Fort Lauderdale, Miami, Cleveland, Atlanta, Oakland and Sacramento could still suffer weak employment with resulting anemic market fundamentals.