The Fed Was Right: CRE Sales Up, Cap Rates Down

By Bob Bach,
Senior Vice President & Chief Economist, Grubb & Ellis Co.

The Federal Reserve announced last week that the value of commercial real estate loans held at U.S. banks increased in February after 35 consecutive months of declines. CRE loans fell from a peak of $1.73 trillion in December 2008 to $1.41 trillion in January 2012, a drop of 18 percent, before rebounding slightly to $1.43 trillion last month. Not only are banks making more CRE loans, their delinquency and charge-off rates are coming down – indicating that banks increasingly view commercial real estate as a creditworthy and profitable asset class. The 30-day delinquency rate on bank CRE loans, which peaked at 8.78 percent in the second quarter of 2010, fell to 6.12 percent in the fourth quarter of 2011. This is substantially below the 12.06 percent rate posted in the first quarter of 1991 during the savings and loan crisis, commercial real estate’s last big debacle.

The commercial real estate industry has come a long way since late 2008 when some were calling it “the next shoe to drop,” meaning that the anticipated wave of defaults, foreclosures and bank REOs could deliver a serious aftershock to the financial system on the heels of the residential subprime mortgage crisis. The industry’s three-year rebound from pariah to a favored asset class is all the more remarkable because bank regulators handled this crisis much differently than the S&L crisis 20 years ago. In 1989, the federal government set up the Resolution Trust Corp., which received the loans and properties from failed S&Ls and sold them to private investors for cents on the dollar. This strategy quickly pumped distressed assets through government stewardship back into private hands, helping the commercial real estate industry regain its footing relatively quickly following the massive overbuilding of the late 1980s.

This time around, regulators issued guidelines giving banks some leeway to work with borrowers who were delinquent or in default, essentially sanctioning the infamous “extend and pretend” strategy where banks, if they chose, could restructure loans rather than foreclose. While this strategy frustrated vulture funds that were formed to repeat the success of Sam Zell 20 years ago, it gave banks time to stabilize their balance sheets and dispose of problem loans and assets at a gradual pace rather than selling into the teeth of the tailspin. It was probably not a coincidence that the Fed’s issuance of these guidelines in October 2009 coincided with the bottoming in the Moody’s/REAL Commercial Property Price Index, which plunged 44 percent from October 2007 to October 2009.

Last year, commercial-property sales totaled $206 billion according to Real Capital Analytics, and industry participants are looking for an increase this year in the range of 25 to 50 percent. Cap rates, which declined last year for most property types, may have further to fall this year as leasing markets improve, distress levels recede further and the historically high spread between the average cap rate and the 10-year Treasury yield compresses. That’s quite a comeback from the abyss, and the Fed deserves to take a bow.