Editor’s Note: As the volume of distress continues to rise, commercial real estate fundamentals take on critical importance for investors. To address these issues and trends, NREI is launching a new monthly column by Dr. Victor Calanog, research director for Reis Inc., delivering up-to-date assessments and expert analysis of property level fundamentals.
There is much talk about investment opportunities in light of the ongoing distress in commercial real estate. Many organizations are said to be amassing capital and building war chests to take advantage of property prices that have fallen anywhere from 25% to 45% after the bubble began its slow deflation in late 2007.
Commercial mortgage defaults on loans held by U.S. banks spiked almost eightfold, from less than $6 billion in 2006 to close to $45 billion by the third quarter of 2009.
However, current data on single property sales of office, industrial, retail and multifamily properties reveal continuing declines in transaction volume.
Portfolio sales are virtually non-existent. Less than $9 billion of commercial properties were sold in the third quarter of 2009, representing about a 70% year-over-year decline and close to a 90% fall from peak transaction volumes achieved in mid-2007.
There is some indication of rising investor appetite for deals supported by the Term Asset-Backed Securities Loan Facility (TALF) program, but the private market is essentially still waiting to be resuscitated. Why are investors still waiting in the wings when there is supposed to be a plethora of distressed opportunities?
Investors must think clearly and precisely about how to take advantage of distress in today’s environment. First, a distinction must be made among several forms of distress since not every instance of distress implies that it is a good investment opportunity. Here are the main types of distress:
• Asset-level distress: An office building that lost a large tenant and must now survive with less income is an example of asset-level distress.
• Seller-level distress: The aforementioned office building may trade but that would depend on seller-level distress. If the owner has deep pockets and is willing to tread water as he waits for the building to lease up, he may not be willing to sell the asset at a discount. Conversely, a building may experience no asset-level distress but may be put up for sale at a discount because joint owners may wish to dissolve their partnership agreements quickly.
• Borrower-level distress: This is closely related to seller-level distress, but is conditional on a seller’s debt levels. Dubai World’s recent announcement of the possibility of selling some of its real estate holdings to pay off its debt is a good example. The conglomerate owns several office buildings in New York and London.
Although these properties may be generating acceptable cash flows, they may need to be sold anyway to generate liquidity if no bailouts are forthcoming. This is a case where asset-level distress may not be present but borrower-level distress is compelling the seller to dispose of assets at a price that might justify hurdle rates, or the minimum rate of return an investor requires to invest money.
• Market-level distress pertains to the performance of property fundamentals such as rents and vacancies for the market as a whole, often defined geographically. Given the depth and magnitude of the current recession, 100% leased trophy properties owned or managed by conservative owners may have to contend with downward pressure on net operating income.
Reis projects negative rent growth through most of 2010 and 2011 for office and retail properties, with vacancies breaking historic highs for apartment and retail. Until the overall economy and property markets come back to life, investors need to be wary of assets that seem to be weathering the storm but could suddenly become part of the overall downward trend. Often all it takes for a property to fall into distress is for one large tenant renewal to fall through.
Evolution of distress
As investors carefully distinguish among the different types of distress to unearth attractive opportunities, another important factor to analyze is how distress has evolved over time. An office building that has limped along at 50% vacancy for years — even when market vacancies were at cyclical lows — may not be a viable investment opportunity even if structure-level distress abates as the economy recovers.
Such a property may require major outlays through renovations and marketing campaigns to attract tenants. This is a situation where asset-level distress has been present for some time, even before the current downturn heightened market-level distress.
Given the different manifestations of distress, the dearth of transaction activity may imply that most investors are putting in the time and diligence and using updated market information to properly evaluate opportunities before they make decisions.
On the other hand, arriving late to the party after prices have begun to rise and the best deals have evaporated is something investors want to avoid. Only in hindsight will we be able to evaluate which winners truly thought carefully — or got lucky — with their investment decisions.
Dr. Victor Calanog is the director of research for New York-based Reis. He can be reached at Victor.Calanog@reis.com.