By Steven Bandolik and Scott Hileman
With property values rebounding, greater availability of debt financing and a slew of significant recently completed merger-and-acquisition and individual property transactions, commercial real estate investors might be tempted to believe that a robust market recovery is underway. However, a closer look reveals a highly bifurcated market with enough potential future roadblocks to cause investors concern. Much like the broader economy, the ongoing recovery of the commercial real estate market is expected by many to be uneven, inconsistent across asset types and geographies, and occur at a halting rather than a steady pace through the remainder of 2011.
The biggest question mark looming over commercial real estate is the expected performance of the U.S. economy. While quarterly GDP growth has been positive since the second quarter of 2009, the increases have been volatile and consensus growth forecasts for the next 12 months vary widely. At the same time, post-recession employment growth has been weaker than historical trends. While the Bureau of Labor Statistics reported that 1.2 million jobs were added to the U.S. economy during 2010, this total represents just 13.6 percent of the 8.5 million jobs lost since the recession began in 2007. Jobs are a critical indicator for commercial real estate demand, as evidenced by a commonly held rule of thumb that four jobs equal 1,000 square feet of commercial real estate activity.
Notwithstanding the weak employment data, commercial real estate has recently exhibited a number of positive trends, starting with an upward movement in property values. The Moody’s/REAL Commercial Property Price Index has risen more than 5 percent since dropping 42.1 percent from peak pricing levels in October 2007. (The Moody’s valuation index includes all transactions greater than $2.5 million, including those involving distressed properties and those that are repeat sales.) This recent valuation increase can be attributed both to improving property fundamentals within certain asset classes (particularly with respect to multi-family and hotels) as well as to increased overall investor demand for commercial real estate.
Real Capital Analytics Inc. reported that the volume of commercial real estate transactions totaled $120 billion in 2010, a nearly 120 percent increase over the prior year. Private investors accounted for the largest share of completed transactions, followed by REITs and foreign investors. Demand was greatest for high-quality, core assets in gateway cities, including office buildings and hotels. As a result of the increased transaction activity, capitalization rates across all asset classes have now declined from their peak 2009 levels. However, weak demand continues to persist for smaller, non-core assets in secondary and tertiary markets.
Going forward, many analysts expect continued increases in transaction volumes during 2011. This has already been demonstrated in the first quarter, with a number of significant completed individual property transactions across all asset types as well as large-scale M&A activity within the retail, industrial and healthcare sectors. Continuing a trend begun in 2010, distressed asset sales are projected by many to account for a larger share of transaction activity as overleveraged borrowers and banks with foreclosed properties are forced to make dispositions. Real Capital Analytics reported that distressed sales totaled $23.9 billion in 2010, or nearly 20 percent of total sales for the year.
Another recent encouraging sign for the commercial real estate market has been the return of debt liquidity, with the larger commercial banks and insurance companies once again making loans collateralized by commercial real estate, albeit using conservative underwriting standards. At the same time, the reemergence of CMBS lending is facilitating the transaction markets and aiding borrowers with maturing debt. “Commercial Mortgage Alert” reports a CMBS pipeline of $16 billion for the first half of 2011, already above the total issuance of $11.6 billion for all of 2010.
The importance of the availability of such debt for borrowers is reflected in the fact that CMBS accounted for more than one quarter of all commercial real estate loans completed at the height of the market.
Despite the recent uptick in lending activity, issues remain regarding the depth of the existing market. Well-capitalized borrowers with larger stabilized properties in primary markets currently have a plethora of available financing options. In contrast, weaker borrowers with smaller assets in secondary locations have limited or no choices. This may at least partially be attributed to the absence of smaller regional and community banks from lending, due to their existing overhang of troubled commercial real estate loans.
The continued easing of underwriting standards and broadening out of debt availability will be important to the market revival, particularly given the nearly $1.7 trillion worth of commercial real estate debt due to mature between 2011 and 2015, according to Trepp L.L.C. This total includes a significant share of loans completed between 2005 and 2007 at peak transaction pricing levels and would be even larger with the inclusion of the “amend and extend” loans from the past several years. Trepp estimates that 60 percent of maturing loans are “underwater,” indicating the amount of existing debt exceeds the market value of the property itself.
The potential impact of a rise in interest rates is a major factor that could cloud the outlook for commercial real estate and create additional distress in an already fragile market. The existing low-interest-rate environment imposed by the Federal Reserve has reduced the cost of capital for financial institutions and allowed many commercial real estate borrowers with floating-rate loans to remain current on their obligations.
However, interest rates are eventually expected to drift higher, concurrent with a rise in inflation. This trend would increase capital costs for banks and borrowers alike, and pose further challenges.
For further information, listen to a rebroadcast of a Deloitte Real Estate brief titled “Real Estate Markets 2011: Which Factors Will Influence Your Decisions?” available on Deloitte’s Web site at www.deloitte.com/us/realestatewebcast2011. Steven Bandolik and Scott Hileman are directors with Deloitte Financial Advisory Services L.L.P. This article contains general information only, and is based on the experiences and research of the authors. Deloitte is not, by means of this article, rendering professional advice or services.
This article originally appeared in the April 2011 issue of CPE’s magazine.