False Recovery in Commercial Real Estate?

Daniel Thomas of the FT reports, CBRE upbeat on global recovery:

CB Richard Ellis, the world’s largest real estate consultancy, has reported the strongest growth in revenue and earnings since 2007 as it has benefited from the global recovery in commercial property activity.

CBRE, whose main business is advising on the acquisition and leasing of commercial property around the world, has been one of the main beneficiaries of improving market conditions. Commercial property markets slumped for almost two years after peaking in 2007, but have stabilised in most countries over the past year.

Brett White, chief executive of CBRE, told the Financial Times that the rebound in global commercial real estate was progressing apace. “We are a good proxy for the global property market. Virtually all global economies are in early stages of recovery and others such as China are in full-blown expansion phase, and [so] the majority of property markets are either flat or slightly improved.”

Mr White said that occupiers were more optimistic on the mid- to long-term horizon, with a more normal market for lease terms, which tended to be a forward indicator for job growth. He pointed out that rents were rising in 48 of the 55 markets tracked by CBRE in Europe, while yields – which measure rental income as a percentage of property value – on property transactions had begun to narrow again.

The US saw a strong increase in transactions over the past year, while Europe also produced robust growth in the period, fuelled by recovering property sales markets in the larger economies such as the UK, Germany and France. Asia-Pacific sustained strong growth that had begun late last year.

This recovery boosted CBRE’s second-quarter results. Property sales rose globally by 61 per cent year-on-year, led by a 93 per cent improvement in sales in Europe and 67 growth in Asia Pacific.

One side effect of the recovery in the market has been that the number of distressed owners of property being forced to sell has been lower than expected, although CBRE said that it was still marketing more than $7.5bn of distressed assets in the US, and had sold more than $1.3bn of such assets since the beginning of the year.

Mr White predicted that there would be no new wave of distressed property sales as banks were working with borrowers rather than foreclosing on property backed by bad debts.

CBRE isn't the only one calling for a revival in commercial real estate (CRE). Darren Currin of The Jounal Record recently reported that Prudential and Moody’s offer positive news for national market:

The good news continues to pour in for the national commercial real estate market. Either improvement is occurring in the market or some industry experts have hired some great public relations experts as a majority of the news stories released over the past week related to the industry have been extremely positive.

The latest news comes from Prudential Real Estate Investors, which said earlier this week that the national commercial real estate market will recover much more quickly than it did in the downturn of the 1990’s. The reason for this being that a lack of financing will limit new supply and investors flush with cash will be competing for properties. Marc Halle, a manager of the Prudential Global Real Estate Fund, noted that Prudential is “relatively optimistic” about the office, retail, apartment and hotel sectors as large institutional owners in these sectors are seeing multiple bids for their assets.

Halle said the following:

“Last time it took five years for real estate values to go down to where they bottomed. … We’ve done that now in about two years. So we are going to see a faster recovery, a faster write-up in the market.”

Halle also explained that the way credit markets are limiting financing to developers will prove beneficial to the national market’s recovery. He said this trend may keep new supply from hitting the market for up to five years. Rents are also bottoming, which should prove beneficial to commercial owners’ cash flows, according to Halle.

In other good news, Moody’s/REAL Commercial Property Price Indices reported that U.S. commercial real estate prices increased 3.6 percent in May. This marked the second-straight monthly increase as average prices in April also rose 1.7 percent.

Nick Levidy, managing director of Moody’s, said the following in a press release about their findings:

“We expect commercial real estate prices to remain choppy in the coming months. The positive news of increasing prices over the past two months is tempered by low transaction volumes, forecasts for slowing macroeconomic growth and the rising risk of a double dip recession.”

While this is encouraging, the reality is that commercial real estate activity remains weak. David M. Levitt of Bloomberg BusinessWeek reports, U.S. Commercial Property Sales Trail Six-Year Average:

U.S. commercial real estate sales in the first half totaled about a quarter of the average of the previous six years as owners kept properties off the market, impeding investors with record funds for purchases.

Buyers and sellers completed $34.2 billion of deals through June, or 26 percent of the average first-half dollar volume since 2004, according to preliminary figures from Real Capital Analytics. The total was about 12 percent of the 2007 peak, when $277.7 billion of properties changed hands in the same period, data from the New York-based real estate research firm show.

Sales climbed 58 percent from last year’s first half, when purchases dried up after the U.S. credit crisis and recession sent values tumbling. A dearth of available properties has sparked demand for the few deals being offered, according to Alan Kava, co-head of Goldman Sachs Group Inc.’s Real Estate Principal Investment Area in New York.

“People are frustrated that not a lot has been trading,” Kava said. “When something does come to market, that lack of supply is causing almost a feeding frenzy. People have real estate funds that are not on an infinite time line -- they need to put capital to work.”

Private equity real estate funds have a record $104 billion of equity available for U.S. deals, London-based research firm Preqin Ltd. reported last month. Blackstone Real Estate Advisors has the most to invest, with Goldman Sachs second, Preqin said.

Goldman Sachs, Blackstone

More than half of the $8.4 billion available for Goldman Sachs’s property funds is reserved for overseas investments, Kava said. Blackstone has about $12 billion for real estate purchases, said Peter Rose, a spokesman for the New York-based private-equity firm.

Much of the money raised by private equity firms was in anticipation of a rush of foreclosure sales that failed to materialize, said Sam Chandan, Real Capital’s chief economist.

In top cities such as New York and Washington, owners who owe more than their properties are worth are instead finding new sources of equity and lenders are willing to restructure their loans, he said. In less attractive markets, banks have been extending loans, waiting for higher prices so they don’t record losses, according to Chandan.

“Many people were looking to acquire distressed assets, but those opportunities have been few and far between,” he said in a phone interview from New York. “That’s been leading to bidding more aggressively for some of these core assets.”

No ‘Armageddon Scenario’

Record-low interest rates make it easier for owners to hold a distressed property, said Tom August, president and chief executive officer of Equity Office Properties, a unit of Blackstone Group LP. Equity Office owns more than 60 million square feet (5.6 million meters) of so-called Class A office properties in cities including Boston, New York and Los Angeles.

“The Armageddon scenario that several people predicted two or three years ago just hasn’t occurred,” August said in a phone interview from Chicago. “Part of it is the lenders realize the current borrowers are in a better position to work out problems than they the lenders are.”

Landlords will eventually need more money to maintain or lease their properties, likely triggering more sales, he said.

There is little incentive for owners who bought as the market climbed to sell now. Values in April were down 41 percent from their October 2007 peak, according to the Moody’s/REAL Commercial Property Price Index.

Four Markets

Demand for properties is strongest in New York, Boston, Washington and San Francisco, “where domestic and foreign investors alike have sought to acquire high-quality assets,” said Chandan.

Those four markets accounted for 20 percent of first-half sales, compared with about 15 percent last year, according to Real Capital. For office buildings, the largest category, the cities made up almost 35 percent of the volume, up from almost 32 percent in 2009.

Manhattan totaled $2.92 billion of completed sales in the first half, up 70 percent from a year earlier. About $1.42 billion were office deals, up 62 percent.

SL Green Deals

SL Green Realty Corp., New York’s largest office landlord, was both a buyer and seller. The company agreed in May to sell a 45 percent stake in Manhattan’s McGraw-Hill Building at 1221 Avenue of the Americas to Canada Pension Plan Investment Board for $576 million, a deal that values the building at about $500 a square foot, according to Real Capital.

It also purchased 600 Lexington Ave. for $636 a square foot, and agreed to buy 125 Park Ave., a tower across 42nd Street from Grand Central Terminal. That deal was valued at about $507 a square foot, based on data in a company statement.

Those prices reflect a rebound off market lows reached last year, when similar midtown Manhattan properties sold for about $350 a square foot, said Chandan. In 2006 and 2007, readily available loans that were packaged and sold as commercial mortgage-backed securities helped drive prices for top Midtown skyscrapers beyond $1,000 a square foot.

“We basically went around the world talking to capital sources, in Asia, Europe, Middle East, Canada, and domestically, and hearing the same thing,” said Andrew Mathias, SL Green’s president and chief investment officer. “People’s confidence in Manhattan was not at all shaken, because of the extraordinary supply/demand metric that exists here, where you have very, very limited new supply, and the interest rate environment.”

Monsanto Purchase

The company paid $523 million for its two acquisitions, combining both closed and contracted deals. Its sales of partial property interest totaled $663 million.

The biggest completed deal of the year so far was Monsanto Co.’s purchase of Chesterfield Village Research Center, a research and development complex in Chesterfield, Missouri, from Pfizer Inc., according to Real Capital. Monsanto paid $435 million, said Kelli Powers, a spokeswoman for the St. Louis- based company.

Distressed building sales probably will remain scarce, Chandan said. There are $184.6 billion of troubled properties facing foreclosure or bankruptcy, out of a total $239 billion since the credit crisis started in 2008, according to a June 1 Real Capital report.

“There’s tons of liquidity out there,” said Barden Gale, chief executive officer of JER Partners, a McLean, Virginia- based company with about $500 million available for investment. “The trouble is it’s having a problem finding a place to reside.”

There is tons of liquidity out there - and that's the problem. Prabha Natarajan of the Dow Jones Newswire reported earlier this month, commercial real estate bargain hunting is making bargains scarce:

At a bankruptcy auction in Washington late last month, the winning bidder paid almost 90 cents on the dollar for the mortgage on the Shops at Georgetown Park even though the developers are suing each other over who actually owns the property, the current operator has defaulted on its mortgage and the original lender is bankrupt.

Such high prices and long lines for such a distressed property are not unusual these days despite rising delinquencies and surging vacancies in commercial real estate. Sometimes it seems that so many investors are cruising for so few bargains in this troubled sector that they are making true bargains hard to find.

Many investors had raised billions of dollars to create opportunity funds to buy such troubled assets. They had envisioned a scenario similar to the early 1990s when through the Resolution Trust Corp., banks and savings and loans sold distressed properties at 5 cents on the dollar, and buyers booked stupendous gains within three years. They have been disappointed, with many closing down such funds.

"This market is different," said Jack Taylor, a managing director and head of Prudential Real Estate Investors' global high-yield debt group, adding some hyperbole about buyers' enthusiasm: "There is no such thing as distressed asset."

There is, however, some hope of a flood of troubled assets coming to market, and these are expected to trade at more reasonable prices.

Taylor and other market participants say overlevered properties and distressed sellers are likely to emerge in the next few months and peak next year as banks and lenders start looking to clean up their books.

The paucity of troubled assets for sale is mainly due to the practice of lenders not forcing owners into foreclosure, preferring instead to "pretend and extend" - an industry term to describe lenders' preference to extend maturing loans by a year or two in the hope that both the economy and the property's finances will improve during that time.

This, in turn, has helped maintain status quo in commercial real estate despite a 10% delinquency rate. Typically, delinquency rate averages below 1% in this sector.

"The pig in the python has now grown to elephant size, and only small bits of it has been digested," Taylor said, describing the volume of dodgy assets banks have been forced to swallow.

The bits that have been digested are mostly loans backed by high-end or trophy properties in large metro areas.

"Demand has exceeded supply, and as a result, the pricing is just not appropriate for the risks still there," said Maury Tognarelli, president and chief executive of Heitman LLC, a real estate investment management company with $22.9 billion in assets globally.

Not only that, it also creates an illusion of normalcy.

"This makes some investors think a rapid, broad-based recovery is underway; but these transactions don't paint a good picture of what's happening for a substantial segment of the industry, where properties remain under-capitalized," said John Murray, a senior vice president and a portfolio manager at PIMCO, while talking about the company's extensive study on commercial real estate released in June.

Market participants say that delinquent properties that are slowly creeping into defaults and foreclosures are likely to hit the market later this year.

"We are at the start of the period when banks start looking at their balance sheets, and try to repair them, while the economy stabilizes," said Taylor of Prudential.

This period of resolution is likely to extend until 2013, and during that time "commercial real estate will see a slow recovery, where the returning capital is met by deleveraging at banks and CMBS levels," Murray of PIMCO said.

Others are raising similar concerns. Jeff Harding of the Daily Capitalist recently asked, Is The Real Estate Market Turning Around?, and concluded:

Reports from people I know who are active in CRE in the L.A. area also lead me to believe that lenders are starting to do deals on REO properties. While two years ago no deals were being made, today there is more opportunity and activity. Further there appears to be less “extend and pretend” as banks are less willing to accommodate defaulting borrowers; lending standards have tightened rather than loosened. They have about $500 billion in CRE loans maturing in the next couple years.

In my view, it is CRE that is critical to a recovery. We will need to see more positive signs, such as an increase in business loans, more CRE foreclosures, and a reduction in bank excess reserves, before we can say there is some kind of trend, but it could be that the CRE logjam is starting to break up. I do not expect any recovery of the CRE market any time soon because of the volume of debt maturing, but I am beginning to think that more defaults will be pushed into special servicing resulting in foreclosures. The result will be further downward pressure on CRE prices (they have already declined 24% since the peak in Fall 2007).

And it is interesting to note that Deutsche Bank just recently announced that it's dismantling a group that advises companies on commercial real estate transactions. Hardly the sign of confidence in the CRE market.

Finally, I had the pleasure of meeting up with a former colleague of mine who is a real estate expert. He is bearish on residential and commercial real estate, and told me "it's too risky taking equity stakes in CRE". He advises pension fund managers to play "junior debt on high quality assets".

We also talked about active management in real estate, which he believes can add tremendous value to a pension fund "if they have the right expertise". "Why have a real estate group if all they do is farm out money to funds? Unlike private equity, real estate deals are very similar, so you don't need outside experts to deliver alpha -- you just need a smart team that knows how to structure deals". He did however mention that "there are excellent real estate funds" but there are a lot of "mediocre ones" as well.

We ended off by talking about the revival of structured finance, which he thinks is "essential" for the market as it would fill the gap in the market in term of financing CRE as banks become more reluctant at lending in order to preserve their capital. He told me that pensions can play a key role here and that funds like CPPIB and the Caisse de dépôt et placement du Québec should be originating commercial real estate backed debt, selling it off to insurance companies who by regulation have to invest in AAA debt.

The problem is that following the crisis, "'structured finance" is a dirty expression and depositors' appetite for anything sounding remotely risky or "structured" is just not there. It's too bad because the truth is the real estate professionals at the Caisse have been at it for decades and are years ahead of others when it comes to structuring complex real estate deals. They should be taking advantage of this internal expertise, capitalizing on opportunities in commercial real estate debt markets.

***UPDATE: Interview with Citigroup's head of real estate***

Below, Thomas Flexner, Citigroup global head of real estate, discusses the state of CRE: