Even though commercial real estate sales are picking up for trophy properties in cities like Washington, D.C. and New York, a sobering new report by global investment management firm PIMCO cautions that investors should be wary as they enter the recovering market. National price indexes are misleading when transactions are limited, the report says, and the prices fail to reflect uncertainty about property valuations.

In the capital markets, lengthy deleveraging and banks' accumulation of distressed assets make a stable recovery unlikely, author John Murray, commercial real estate portfolio manager at PIMCO, and his co-authors conclude. “Many commercial real estate assets likely will not return to 2007 prices until the end of this decade,” the report warns.

Assets bought a few years ago at the peak of the market and property types that were overbuilt in some regions will be particularly susceptible to weak prices, asserts Murray. “I think we're headed for a massive wave of deleveraging that's going to take place over the next several years,” he cautions. Buyers are likely to lose their appetite for commercial real estate risk as delinquencies mount in commercial mortgage-backed securities (CMBS). Buyers' expectations already have diminished since 2007 as the recession and credit crisis took their toll, he says.

Because of their concerns over hard-to-define property values and CMBS delinquencies, as well as their own risk-aversion, U.S. investors are unlikely to plunge en masse into the commercial real estate market over the next few years as the deleveraging cycle plays out, Murray believes. Prices for certain assets could be depressed for lengthy periods. And buyer hesitation and suppressed prices could lead to more conservative underwriting and higher capitalization rates.

Shadow of distress

Still, positive signs are appearing. “Capital is clearly returning to commercial real estate, helping to stem the value decline,” the PIMCO report states. And high levels of bidding activity in some metro areas are generating optimism. However, the transactions and capital flows have been concentrated in trophy properties and in assets for which below-market financing is available.

“This has provided a false sense of clarity on the real level of property values. A significant volume of weaker and distressed assets has yet to be liquidated,” the PIMCO report says. The sheer volume of distressed assets foreshadows further pressure on values, warns PIMCO. “Against this backdrop, we caution against the presumption that a rapid, broad-based recovery is under way.”

The Newport Beach, Calif.-based investment firm conducted research in 10 metro areas across the country, meeting with commercial real estate lenders, special servicers, real estate owners and developers, investment sales advisers, leasing brokers, and other industry specialists. The PIMCO team concluded that changes in the structure of capital markets, including securitization, since the commercial real estate crisis of the early 1990s will lengthen the deleveraging process and suppress a recovery.

The somber tone of the PIMCO report echoes cautionary views expressed in a capital markets briefing by New York-based research firm Reis. Although it appears the economy and labor markets have turned a corner, notes Reis economist Ryan Severino, those signs should not be overestimated. “A recovery is not imminent,” Severino advised. “Debt performance will continue to deteriorate in the near term.”

However, as sentiment in the market improves, transaction and credit activity should begin to increase, says Severino.

“We agree,” says Murray. CMBS illustrates the problems facing the commercial real estate industry, he adds. “CMBS is not full of trophy assets.” CMBS loans were made for diverse assets across the country, and the full force of delinquencies hasn't hit yet. More than $50 billion in CMBS maturities will come due in the next few years, and owners won't be able to refinance many properties, he says.

Despite the difficulties, capital is funneling into the industry through CMBS and real estate investment trusts (REITs). REITs raised more than $24 billion in equity and issued $10 billion in debt in 2009, according to PIMCO.

On the debt side, insurance companies are actively looking for quality properties to finance, while former Wall Street investment conduit groups are reforming and private debt vehicles are raising capital, according to PIMCO.

However, weak loan underwriting, excessive leverage and the absence of risk management from banks and rating agencies raise concerns, the report notes.

Rental rates ‘misleading’

Price indexes and national data can mislead investors not just in valuations, but also in reports on industry fundamentals such as vacancy and rental rates, PIMCO says. Some reports fail to depict the extent of concessions landlords offer to retain tenants, for example.

High unemployment and financial re-regulation will force investors to cast a critical eye on assumptions used in the past to price commercial real estate.

Big challenges lie ahead for commercial real estate, including uncertainty related to valuations, which will affect prospects for recovery, PIMCO says. Financial vehicles have become so complex that traditional methods of analyzing and investing in the market will need to depart from those applied in previous cycles, the authors warn.

The takeaway: Rigorously scrutinize potential investments and take prominent national price indexes with a grain of salt when considering attractive but complex new financial opportunities. As the authors advise, “Investors should proceed with caution.”