Investors have slashed commercial real estate prices by 21% from the peak of October 2007, according to the Moody's/REAL Commercial Property Price Indices, which show asset prices across property types fell in January to levels not seen since the spring of 2005. But rather than buy into a declining market, most investors are holding out for even greater discounts.

Consequently, transaction activity is stuck in the doldrums. Only 22 large office properties traded nationwide in February. The month's volume totaled less than $1 billion, fully 80% less than levels a year ago, according to Real Capital Analytics.

“Overall volume is terrifyingly small,” says Pete Culliney, research director at the New York-based research firm. “The state of despair in the market is almost palpable. Investors are waiting for buyers to feel comfortable making big transactions.”

Observers say asset values are sure to slip further this year as recession spoils Corporate America's appetite for space and as rental incomes decline. Half of 165 industry experts polled at a Real Estate Investment Advisory Council gathering in Atlanta last month indicated they expect commercial values to sink at least 25% — perhaps as much as 35% — from peak to trough. That means prices still need to fall further before the market hits bottom and buyers resume acquisitions.

Data in doubt

The greatest hindrance to commercial real estate investment activity in 2009 is the uncertainty that haunts every statement of asset value. With sales volume so greatly diminished, the real estate community lacks reliable data and is struggling to determine prices and gauge where real estate values are likely to bottom out.

“Everyone is looking for a strategy, but all the strategies are predicated on value,” says Woody Heller, executive managing director at real estate services firm Studley. “At the moment, no one has a clear sense of value.”

Recent deals illustrate that some sellers are swallowing bitter losses in order to shake buyers into action. In January, an institutional investor sold a 240-unit apartment complex in Mesa, Ariz. for $20 million, or 36% lower than the $31.1 million it paid for the complex as part of a portfolio acquisition in 2006, according to Real Capital Analytics.

In another example, Bircher Development repurchased a strip retail shopping center in Costa Mesa, Calif., earlier this year for $34 million, or about one-third of the $100.8 million the company received when it sold the same property in the summer of 2007.

“[Sellers] are taking significant haircuts,” says Culliney, referring to these extreme sale prices. “The haircut is not quite as dramatic on a market-wide basis, but the clippers are certainly coming out.”

Stalemate eases

Lenders and appraisers are coping with the lack of sales comparables by extracting data from distressed deals, examining tenant default risk and projecting rental incomes under various economic scenarios. Those methods may help investors gain insight into the value of their own properties.

Institutional investors, at least, are finally acknowledging that asset values must be written down to reflect buyers' increased capital costs amid the credit crunch.

Asset values measured by the NCREIF Property Index fell 9.54% in the fourth quarter from the end of the previous quarter. That's the largest quarterly decline in the index's 31-year history, according to Doug Poutasse, executive director of the National Council of Real Estate Investment Fiduciaries (NCREIF), which publishes the index.

Why the rapid change? For one, both in-house evaluators and third-party appraisers acknowledged declining values in the portfolios they assessed. The second reason is that an uncharacteristically large proportion of NCREIF members chose to appraise their holdings in the fourth quarter. Those investors provided updated values for more than 86% of the properties represented in the NCREIF Property Index, Poutasse says.

The index, which tracks asset values as well as overall real estate returns, showed an 11% drop in values for all of 2008. The index showed a much slower pattern of write-downs in the 1990s, falling just 4% in the first year of that real estate slump and continuing with incremental declines for another five years. Poutasse finds the pace of correction this time around encouraging: “That means we definitely won't be doing this for six years this time.”

Falling rents steepen slide

Yet continued price declines are a near certainty. That's because falling values in 2008 reflected only an adjustment to reconcile prices with buyers' increased capital costs during the credit crunch. "Now with the economy in recession, income growth has stopped and incomes will start declining this year," Poutasse says, "so there's a second leg of declines happening now as a result of rental income declines."

Indeed, office rents have dipped significantly in markets across the nation, says John Sikaitis, research director in the Washington, D.C. office of real estate services firm Jones Lang LaSalle. Landlords must compete with low-cost sublease space that has increased by 25% or more in nearly every market.

Office asking rents in downtown Los Angeles are down 7% to 10% from their peak, while rates in the Boston central business district have plunged as much as 20%, Sikaitis says. Rents in New York, perhaps the market hardest hit by contraction in the financial sector, have fallen 20% already and will likely fall 35% from peak to trough, according to Jones Lang LaSalle's projections.

"It's a trend that we're seeing nationally," Sikaitis says. "All companies have been affected by this downturn, and when you see demand decreasing and sublease space increasing, that spells rent depreciation."

Based on the few deals that have closed, capitalization rates for office and retail properties averaged between 7% and 7.5% in the early months of 2009, according to Real Capital Analytics. Cap rates held at a steady 7% for apartments and around 8% for industrial.

In a simplified version of an appraiser's income analysis, an investor can produce a rough price estimate for a property by dividing its income by the market's average cap rate. With more and more tenants downsizing or even defaulting on leases, however, even net operating income has come into question, further complicating the appraiser's task.

Appraisers work harder

Fair market value is defined as the price a willing buyer will pay a willing seller at a given point in time. Most of the deals closing today are distressed sales, meaning the seller had a pressing need for capital that drove them to accept bids in a depressed market.

Distressed sales don't provide a clear indication of market pricing, but a trained assessor can glean valuable information from a distressed sale, according to appraiser Leslie Sellers, owner of Sellers Realty LLC, a brokerage based in Clinton, Tenn. "There are no straight-up deals in these times; they've all got unusual circumstances," says Sellers, who is also president-elect of the Appraisal Institute.

The Appraisal Institute plans to host seminars for its members this year that will provide a refresher on valuation methods appropriate for markets in a downward cycle, when few transactions are available for comparison.

By interviewing the parties to a distressed sale after closing, an appraiser can learn what price the seller would have demanded in less-pressured circumstances, or what the buyer might have been willing to pay if, for example, a vacant property had instead come to market with more tenants in place.

Market analysis is also crucial and requires that the appraiser consider the balance of local supply and demand for space as well as merits of the property itself. Are landlords in the area providing free rent, expanded tenant improvement allowances, or other concessions that would temper potential rental income?

Lenders take charge

No matter how painstaking the appraiser's research, an appraisal is an opinion. Opinions concerning property values vary widely in the current transitional market. Many lenders are ignoring third-party appraisals and are instead basing their value assessments on the results of their own due diligence.

"There is almost a capitulation on the part of borrowers today that it doesn't really matter what I think my valuation is. It's what the lender thinks the value is," says Josh Scoville, director of strategic research at Property & Portfolio Research in Boston.

Power in the hands of the lender marks a reversal from the days when investment activity was nearing its peak in 2006 and 2007, according to Jeff Friedman, principal of Los Angeles-based lender Mesa West Capital.

"When borrowers had the market power not only did they bully lenders, but they also bullied the appraisers to conclude higher valuations based on a fancy pro forma," or projection of rent growth, Friedman says. "Now lenders have seen the errors of their ways and are more likely to appreciate the importance of doing their own work."

Ironically, lenders still rely on pro formas in their due diligence. Rather than rental growth, however, today's projections plan for shrinking income streams due to the heightened risk of tenant default or lease expirations coming due without renewal.

Likewise buyers, especially those holding out for fire-sale prices, will look forward and view a property's value based on its projected and possibly diminishing income, says John Kevill, managing director in the Washington, D.C. office of Jones Lang LaSalle.

"Sellers will say, ‘I have a proven income and I want to value the property based on that proven income.’ That's one of the many factors contributing to that bid-ask spread," says Kevill.

Strive to survive

Owners who hope to outlast the recession before divesting may need to keep their properties for several years beyond their planned hold period, a prospect that has renewed investor interest in coaxing maximum cash flow from every asset.

"To create value, leave no stone unturned," says real estate finance consultant Elizabeth Kulik, senior managing director of The Schonbraun McCann Group in Roseland, N.J.

Kulik urges her clients to examine their portfolios and align their real estate with their business goals, including plans for eventual growth. Next, she says, focus on efficient asset operations to maximize value. Investors should position themselves to benefit from economic growth when the economy returns to an expansion mode, she says.

An economy in recession offers plenty of opportunities to cut costs, says Debra Tantleff, vice president of development at Roseland Property Co. based in Short Hills, N.J. Roseland develops and manages luxury residential communities and mixed-use projects. "Your biggest emphasis in increasing your yield is obviously going to be on reducing hard costs," she says.

Contractors and consultants may be willing to reduce their fees in exchange for continued business in a slowed market, Tantleff says. Even municipalities may be receptive to negotiations, perhaps agreeing to prorate utility hookup fees rather than requiring a lump-sum payment.

Like Kulik, Tantleff stresses the importance of continual planning and being ready to grow when business picks up again. "The successful developer will be the one that has continued to move ahead," she says.

Obstacles ahead

Don't look for commercial property values to establish a price floor until the end of the recession is in sight, experts say. That's because commercial values are predicated on cash flow, and rental income will remain uncertain as long as the likelihood of tenant defaults remains high due to the recession.

Increased liquidity in the market would allow more refinancing and even leveraged acquisitions to close, increasing the number of sales and facilitating accurate pricing and even more deals.

But Kevin Nunnink, principal and chairman of appraisal services provider Integra Realty Resources, doesn't expect lending to accelerate until banks can unload the conduit loans and commercial mortgage-backed securities (CMBS) held on their balance sheets.

"I expect the commercial market to recover, if and when the CMBS market receives the same kind of [government] assistance that the residential market received," he says.

Tax consultant P.J. Olzen believes property values will remain elusive while tenants wrestling with recessionary pressures put building income at risk. The director of tax services at SMART Business Advisory and Consulting in Devon, Penn., has faith that real estate values will eventually rebound, and that now is a good time to invest.

"Real estate is a very cyclical market," he says. "We won't be in this downturn forever, so if you've got the stomach for it, go out and buy some property."

Back at Real Capital Analytics, Culliney has his eye on a deal that just might signal to investors that it's time to start buying commercial properties again. According to news reports, ProLogis is under contract to sell a 33 million sq. ft. portfolio of industrial buildings to the Teachers Retirement System of Texas and San Francisco-based Stockbridge Real Estate Funds.

The Denver-based real estate investment trust listed the portfolio for sale last year for $1.5 billion, so if the transaction closes anywhere near that price it will be a mega deal. "That could be the catalyst that makes other people say, ‘Ah, they did a big deal, maybe it's safe to go out and do deals,’" Culliney says. "Somebody has to do that first large deal."

Matt Hudgins is a writer in Austin, Texas. writer writ.

Customized appraisals perpetuate bid-ask gap

One reason that transaction volume has fallen off so much in 2009 is that buyers and sellers in many cases are both armed with appraisals that support their opposing opinions of an asset's value. While appraisals may lend credence to an argument, it's important for investors to differentiate among various types of appraisal values.

Most sellers rely on a fair market value appraisal, which attempts to establish the price a buyer will pay a willing seller for a property in today's market. It differs from liquidation value, in which the seller is motivated to dispose of the asset quickly.

"If it normally takes 10 to 12 months to sell this type of property and you want to sell it in 30 days, that's going to drastically reduce the value," says appraiser Leslie Sellers, owner of Sellers Realty LLC in Clinton, Tenn.

Investors waiting to snap up distressed properties for cents on the dollar seek liquidation pricing, or the price a bank might seek for a property after foreclosure. In another variation, a buyer who requires a specific return can order an appraisal of investor value, which gives the highest price the acquirer can pay and still realize a given return on investment.

Holders of senior or junior debt even wield appraisals as weapons to control the destiny of troubled real estate, says Steve Williams, global advisor for research firm Real Capital Analytics. Investors in the first-loss position may have already been wiped out, he says, leaving the remaining junior lenders to argue whether an asset is worth operating long enough to recoup some or all of their investment.

"If it's at all litigious, they each have their own appraisal," Williams says. "If the senior debt doesn't hang on long enough, then the junior debt at all its various positions becomes nonexistent."

The complicated nature of dealing with multiple parties involved on the seller's side is another reason so few transactions have closed, according to Peter Hauspurg, chairman and CEO of New York-based Eastern Consolidated, a real estate investment services firm.

"It's not just a lender and a borrower anymore," he says. "It's a lender, a borrower and a number of mezzanine lenders. It's very difficult to buy into that kind of situation where nobody controls anything."

More data from increased deal volume would facilitate appraisals and give existing debt holders a better grasp of their stake in the deal. "A gigantic amount of selling pressure has built up," Hauspurg says, "but it still has to work through the negotiations between all the stakeholders."