There's a swelling industry chorus predicting sizeable declines in commercial real estate values over the next 18 months. A number of indices suggest prices have already begun to fall. So what's an investor to think amid such pessimism? Does the scarcity of lending sources spell the demise of venerable institutional real estate empires, similar to what has occurred in the commercial and investment banking businesses?
Disaster is not necessarily imminent. Armies of cash-rich investors are eager to own equity positions in high-quality assets, and lines of short-term lenders are also determined to support sound real estate investments and principals while getting paid well for the risk.
Changing of the guard
Despite this obvious decline in sales volume, the absence of many debt sources, and some preliminary reports of already falling prices, actual property trades such as those measured in the Standard & Poor's/GRA Commercial Real Estate Index for July do not paint a bleak picture. The index ignores anecdotal valuation reports, and while the national composite index is down, it shows an annual price change that was virtually flat compared with July 2007.
The index is down after reporting a gain of 1.5% in June, and is well below its peak of a 14.7% gain reported in August 2006. The Moody's/REAL Commercial Property Price Index also reported declines in sales values through August, after a virtually steady six-year march to record highs, putting current prices at the same levels as in January 2007.
A fundamental capital shift began to occur in commercial real estate approximately a year ago, which initially drove the findings of the Moody's and Standard & Poor's findings. Capital has moved away from the debt origination side of real estate investment and toward the equity investment side, a significant changing of the guard.
Today, there isn't a capital flight from commercial real estate, as was the case in the late 1990s when the stock market and the dot-com boom siphoned investment dollars away from real estate. Instead, much of this capital has moved into private equity, opportunity andreal estate investment funds.
This capital shift underscores the fact that investors seek access to properties via the distressed mortgages. Most estimates say there is still more than $300 billion of capital seeking to buy distressed assets, and this number is growing every day. So one can be sure that this capital will significantly move the market once it is deployed, causing a buying stampede.
Shift in herd psychology
Few investors have ever fared well by following the most popular industry trend. And it is conceivable that market experts can get it wrong, or their timing can be off. A cap rate under 5% for a Class-A office building with 80% occupancy in Midtown Manhattan or downtown D.C. was considered a great investment just 18 months ago. Loans made on properties of that description today are part of commercial mortgage-backed securities issues, or on investors' balance sheets.
The herd psychology at the time would have likely called for making improvements, leasing up the property, and exiting through an asset sale. But for now this strategy is sidelined, and thesewould be considered unthinkable to the herd today.
A recent Real Capital Analytics report captures the market's sentiments well by citing “private equity real estate deal managers have known for the past month that transactions are almost impossible to close in the current environment.”
Short-term lenders also are waiting in the wings to rescue properties that may be heading to distress. Because commercial real estate has such significant capital support on the equity side, trade prices in both the Standard & Poor's/GRA and Moody's reports appear to be on target.
So while the outlook for prices now appears bleak, a fire sale in commercial real estate is still unlikely, except in limited cases involving unworkable properties in secondary and tertiary markets where exit strategies are diminished.
W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.