An ongoing stalemate between buyers and sellers helped to slow commercial property transactions to a crawl in the first quarter, but researchers suggest activity will accelerate near or just after the end of 2008. Commercial real estate transaction volume plummeted in the first three months of the year to $39.2 billion, a 69% decrease from the year-ago level, according to a report by Jones Lang LaSalle.
“Overall transaction volumes have reverted back to roughly 2004 levels,” researchers state in Jones Lang LaSalle’s Spring 2008 U.S. Investment Market Report. “It will take at least the remainder of 2008 and into early 2009 for some semblance of normalcy to return to the capital markets.”
Global sales volume is down as well, but the decline has been more modest than in the United States. In the first quarter, transactions worldwide totaled $154 billion, down 46% from the $283 billion of property that changed hands in the first quarter of 2007, according to Real Capital Analytics. Preliminary data suggests the drop-off in volume will be more severe in the second quarter as troubles worsen in the U.S. and Europe, while Asian markets begin to suffer from the credit crunch and the global repricing of risk.
The pricing correction in commercial real estate stems from several aspects of the credit crunch, explains Earl Webb, CEO of capital markets at Jones Lang LaSalle. Those include tighter lending standards, a substantially smaller and more narrowly focused conduit lending market and sharply higher lending spreads.
As a result, leveraged buyers must contend with a higher cost of capital that limits the amount they are able to pay for an asset. Most sellers, on the other hand, are unable to garner the hefty sale prices they had anticipated for properties acquired near the peak of the real estate cycle. Equity investors are in the market looking for property, but expect a substantial discount in light of ongoing repricing. So far this year, few buyers and sellers have agreed upon prices and closed deals.
When buyers and sellers do see eye-to-eye on asset prices, either later this year or in 2009, it will likely be the sellers who are compelled to give the most ground, according to Josh Gelormini, vice president of research for Jones Lang LaSalle's capital markets team. “Although there will be movement on both parties, I think it will lean in the direction of sellers because there has been such a tremendous shift. It’s kind of a new universe out there as far as the capital markets and pricing,” says Gelormini, who authored the Spring U.S. Investment Market Report.
An increase in short-term borrowing with interest-only periods in recent years means a growing number of property owners will need to refinance those loans as they come to term. In today’s lean credit environment, many will be unable to obtain new financing, increasing the likelihood that they will take a buyer’s offer and sell.
In anticipation of that seller distress, a number of investment groups are building funds to buy up distressed properties and distressed commercial real estate debt. For now, those funds are still waiting for opportunities to appear, according to Josh Scoville, director of strategic research at Property & Portfolio Research. “There has been a lot of capital raised for distressed debt opportunities, but I don’t know how successfully it is being deployed,” he says.
“The bottom line is there’s not a lot of distressed debt right now. Most borrowers are making their payments and we can see that in CMBS delinquencies as well as in the information coming from the banks in terms of loan performance,” Scoville says. Indeed, loan defaults among U.S. commercial mortgage-backed securities in 2007 totaled only $1.2 billion, or 22 basis points of $535 billion in loans outstanding, Fitch Ratings reported this week.
Gelormini agrees that few owners are in trouble just yet, but he believes the equity funds gearing up to buy distressed real estate will begin finding those opportunities in the coming 12 to 18 months. “I have no doubt that money will be put to use.”
Timing of the market recovery and a resurgence in transaction volume will depend on the overall economy, which appears poised for — or perhaps already in — a shallow recession, punctuated by a net loss of roughly 300,000 jobs in the first five months of the year, Gelormini says. Employment should stabilize in the second half of the year due to historically low interest rates and the effect of fiscal stimulus checks on consumer spending.
“Even if there was no job growth it would be an improvement,” Gelormini says. “Once the debt markets begin to normalize and buyers and sellers finally reach a pricing medium by 2009, market fundamentals and realized property income will return as the main drivers of prices paid per sq. ft.”