Prices paid for income-producing properties in the United States have been shrinking for the past year and real estate observers say values still have not hit bottom. With few lenders offering more than 60% leverage, the trend is particularly troublesome for landlords who need to refinance expiring mortgages that amount to 75% or more of asset value.

The Moody's/REAL Commercial Property Price Index tracked an 11.5% drop in prices across property types from their peak in October 2007 to the end of August. Because that index only tracks repeat sales — or how much that a sold property has changed in value since the last time it traded — market-wide declines in real estate values may be even deeper, say some industry experts.

A preponderance of trophy acquisitions this year may be skewing that index to obscure an even greater decline in overall value, they argue.

With so much gloom and doom engulfing the capital markets and the economy, many owners have taken their properties off the market, hoping that leverage will return and enable buyers to meet their asking prices.

Only 1,089 U.S. office properties had sold this year through August, down 70% from a year ago, according to New York-based researcher Real Capital Analytics.

The limited number of property sales has deprived buyers and sellers of market data they need to set values for their non-trophy assets, further delaying a price correction, says Keven Lindemann, director of the real estate group at SNL Financial in Charlottesville, Va.

“You have a lot of real estate owners right now who don't know what their property is worth,” he says. “We need to start seeing some transactions so that we can establish some data points about where real estate is trading.”

Recent sales suggest that prices have dropped further since August. Consider the recent history of 1372 Broadway in New York, a 21-story office building, which at press time was under contract for sale to investor Lloyd Goldman for a reported $275 million. That's nearly 18% less than the asset's $335 million value in July 2007, when Wachovia acquired an 85% stake in the property.

“Anecdotally, I think that's very much in the ballpark for Manhattan,” says researcher Dan Fasulo, managing director of Real Capital Analytics. “There's no question that prices are off for most properties around the country.”

The Moody's/REAL index detected a 15% spike in real estate prices from the fourth quarter of 2006 through mid-year 2007, a surge that Fasulo attributes to the tremendous amount of leverage available at the time. “Now that the liquidity has dried up, that 15% of froth has been wiped out.”

Another shoe to drop?

The Moody's/REAL index shows that prices flattened at the end of this summer, and it seemed a correction had largely run its course. Don't believe it, say analysts at Real Estate Analytics LLC (REAL), which owns the Moody's/REAL index.

In a special report, analysts described the halt in price declines that occurred in July and August as “a false bottom to the market, with the potential for prices to fall much further.”

Observers say a new dynamic — softening fundamentals — is beginning to weigh on the investment market. Mounting job losses that totaled 760,000 for the year through September, bank failures, the government takeovers of Fannie Mae and Freddie Mac, and worries over what may already be a recession in the U.S. economy are driving tenants to delay commitments to new space, and many are downsizing.

The effects of a withering economy are already showing up in the office market, where the national vacancy rate rose to 14.3% in the third quarter compared with 13% a year ago, according to Grubb & Ellis.

A five-year run of positive absorption, or a rise in occupied space from one quarter to the next, ended earlier this year. Negative absorption measured 3.05 million sq. ft. in the second quarter and negative 2.10 million sq. ft. in the third quarter.

“It's not just the credit markets anymore that are causing prices to come down,” says Robert Bach, chief economist at Grubb & Ellis. “If we're facing a tougher recession than the last two recessions, that will cause prices to come down further.”

The economy isn't likely to regain its footing until mid-2009 at the earliest, Bach says. The job creation that drives demand for commercial real estate typically lags growth in gross domestic product by three to six months, so Bach doesn't expect fundamentals to improve until early 2010.

In the meantime, he expects asset values to keep falling until they bottom out at about 25% below the peak of 2007.

That's in line with projections made earlier this year by JP Morgan analyst Alan Todd, who predicted that prices on trophy assets could decline by 15% from their peak and that tertiary markets could see price declines of as much as 30%. In February, analysts at Goldman Sachs predicted a decline of 21% to 26% in commercial asset values through 2009.

Commercial real estate professionals appear to agree with analysts' projections. Based on a recent survey of 600 real estate executives, including investors, developers, lenders, brokers and consultants, the consensus is that prices will fall as much as 20% from their peak. The finding comes from “Emerging Trends,” a report compiled jointly by PricewaterhouseCoopers and the Urban Land Institute.

Unconventional solutions

The few investors that are closing deals in a paralyzed debt market have employed some creative strategies, the most popular of which is to assume the existing mortgage on a property rather than seek new financing. Almost half of all property acquisitions this year have relied on assumable debt, according to Real Capital Analytics.

Equity partnerships and all-cash buying are another option, says Howard Hallengren, chairman of New York-based Falcon Real Estate Investment Co. “People who have very strong cash positions can go into partnership with a current owner who is having difficulty refinancing the property,” he says.

Landlord distress in the coming year will be tied chiefly to balloon payments coming due as mortgages expire, Hallengren says. Many owners will have trouble obtaining replacement financing. Either they will be forced to seek equity partners, or sell their properties at a discount to avoid foreclosure.

Savvy investors with the means to close a deal may consider this a good time to buy commercial real estate while the outlook for the sector is gloomy, says Bach of Grubb & Ellis. “The way to make money is to question conventional wisdom and then finally to be willing to act within the bounds of prudence,” he says.

“Don't bet the farm that the economy is going to get better by the middle of next year, but when everybody is selling that's the time to buy and vice versa,” adds Bach.

Owner strategies

Falling asset prices present a serious challenge for landlords with loans approaching the end of their term because most lenders are using loan-to-value ratios of 60% to 65% these days. If the value of an asset hasn't appreciated sufficiently, then the buyer won't be able to borrow enough money to pay off a mortgage written to cover 75% of the asset's value.

For owners with loans coming due while the credit crunch lingers, it is a better idea to seek an extension to the existing mortgage than it is to refinance in an unfavorable lending environment, says Beth Lambert-Saul, director of Archon Group LP, a Dallas-based subsidiary of Goldman Sachs.

To qualify for a loan extension, the borrower must usually provide the lender with credit enhancements, which can be a partial paydown on the principal or the establishment of a capital reserve on the borrower's balance sheet.

“Unless you've got a pretty large balance sheet and can take more risk on a piece of real estate, people are looking to produce more equity and bring partners in,” says Lambert-Saul. Archon Group is evaluating opportunities to become a capital partner in order to help borrowers qualify for loan extensions.

Craig Butchenhart, president and director of capital services at mortgage banker NorthMarq Capital, says finding replacement financing for loans coming due is a prevalent problem. “There's really nobody out there supplying debt,” says Butchenhart, who's based in Philadelphia.

There's also no guarantee that the original lender will agree to extend a loan beyond the first term. But if the borrower is in good standing and is simply unable to find replacement financing, most lenders would prefer to extend the term rather than foreclose.

Even owners with years left to pay on their loans would be wise to plan how they will refinance or market their properties for sale, in the event that sufficient credit doesn't return to the commercial real estate market for a several years, says Sam Chandan, chief economist at real estate research firm Reis.

There may not be enough credit to go around if the market doesn't come back for commercial mortgage-backed securities (CMBS) or an equivalent to conduit lending, which provided the bulk of financing in the most recent real estate cycle.

That would force more owners to sell, take on partners or even forfeit their properties, Chandan says. “There is room for the market to think of the next 12 to 18 months as a window of opportunity to develop strategies for the refinancing of debt that will mature in larger and larger volumes later on.”

Matt Hudgins is an Austin-based reporter.

Where cash is king, 'tis folly to be leveraged

Many opportunity funds counting on leverage to seal their deals will be thwarted by the credit crunch, insists Washington-based attorney Jay Epstien, who chairs the real estate practice at global law firm DLA Piper. “If they can't get leverage, I don't think they have the authority or the willingness to be all-cash buyers,” he says.

Few investors are prepared to make all-cash acquisitions because that type of deal concentrates risk. The conventional wisdom is that it is safer to combine $100 million of equity with leverage and buy five buildings than it is to sink all $100 million into a single cash purchase.

Macfarlan Capital Partners, based in Dallas, and a few other vulture investors are taking a hybrid approach. They are closing cash deals with the expectation of refinancing later. Company founder Dean Macfarlan is currently acquiring tracts of residential land that he says have been marked down by as much as 70% from the market's peak.

Macfarlan expects commercial prices to bottom out about 20% below the highs of 2007. That's when his company plans to buy debt and assets, and to invest with property owners feeling a recapitalization squeeze. “This will be one of the greatest opportunities in our careers for value creation,” says Macfarlan.

Rather than be all-cash buyers, a more accessible option for vulture investors is to become an equity partner with struggling owners. The investor gains an interest in the property while providing capital to better manage existing debts, says Howard Hallengren, chairman of New York-based Falcon Real Estate Investment Co. LP, an advisor to overseas investors. “If you have a really strong cash position or can even buy all cash, there are going to be some good opportunities ahead,” he says.

So far, even low-leveraged buyers have had a hard time finding deals at an acceptable risk-adjusted rate of return, says Spencer Garfield, managing director of Hudson Realty Capital in New York. The investment manager has acquired $150 million in debt and equity this year, but has $350 million still to invest. “Like almost every other opportunity fund, we have been hoping for a large distressed debt market, a large flow of deals priced appropriately,” Garfield says. “Candidly, we have not seen that.”

In underwriting acquisitions amid today's economic turmoil, investors must be certain that the properties they buy will generate a sufficient risk-adjusted return even if market fundamentals soften, Garfield says. Hudson Realty controls its cost by using 50% leverage or less on most deals. “As a prudent investor, you need to count on less leverage,” he says. “The smartest lesson that can be learned from this cycle is that leverage is a double-edged sword.”
Matt Hudgins