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.

The difficulty of transferring commercial real estate risk out of the banking system makes a stable recovery unlikely, author John Murray, commercial real estate portfolio manager at PIMCO, and his team conclude. “Many commercial real estate assets likely will not return to 2007 prices until the end of this decade,” the report warns.

Still, there are positive signs in the market. “Capital is clearly returning to commercial real estate, helping to stem the value decline,” the 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 and this foreshadows further pressure on values. Against this backdrop, we caution against the presumptions that a rapid broad-based recovery is under way,” PIMCO says in the report released Tuesday.

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 authors 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.

REITs raise equity

Capital has returned to the most liquid sectors of commercial real estate first, through real estate investment trusts (REITs) and commercial mortgage-backed securities (CMBS). REITs were able to raise more than $24 billion in equity and to issue $10 billion in debt in 2009, according to PIMCO.

From the first quarter of 2009 to the first quarter of 2010, as capital flowed into REITs and CMBS, REIT prices rose more than 96% and super senior CMBS tranche spreads tightened by nearly 70%.

Meanwhile, on the debt side, insurance companies have been actively looking to finance quality properties, and former Wall Street investment conduit groups are reforming and several private debt vehicles are raising capital, according to PIMCO.

However, the commercial real estate market shares most of the sins of its residential cousin, namely weak loan underwriting, excessive leverage and the absence of risk management from both banks and rating agencies, the report notes.

Rental rates “misleading”

Market reports on industry fundamentals such as vacancy rates and rental rates are misleading, the researchers said after their interviews with leasing brokers and property owners. Some current reports do not fully depict the extent of concessions landlords are offering to attract and retain tenants, according to the report.

On a larger, economic scale, issues such as limited gross domestic product growth in the U.S., high unemployment and potential re-regulation will force the market to re-evaluate the assumptions it has used to price commercial real estate. These trends severely affect the outlook for rents, vacancies and capitalization rates, highlighting the downside risks that remain in commercial real estate, the investment firm says.

Significant challenges lie ahead for commercial real estate, including the uncertainty related to valuations, which will affect the prospects for recovery, PIMCO says. Because of the complexities that have evolved in the capital markets over the past decade, approaches to analyzing and investing in the recovering market will need to depart significantly from those of previous cycles, according to Murray and the PIMCO researchers.

“Investors therefore should proceed with caution when examining the complex opportunities that are surfacing.”