False Recovery in Commercial Real Estate?

Via Pension Pulse.

Daniel Thomas of the FT reports, CBRE upbeat on global recovery:

CB
Richard Ellis, the world’s largest real estate consultancy, has
reported the strongest growth in revenue and earnings since 2007 as it
has benefited from the global recovery in commercial property activity.

CBRE,
whose main business is advising on the acquisition and leasing of
commercial property around the world, has been one of the main
beneficiaries of improving market conditions. Commercial property
markets slumped for almost two years after peaking in 2007, but have
stabilised in most countries over the past year.

Brett White, chief executive of CBRE,
told the Financial Times that the rebound in global commercial real
estate was progressing apace. “We are a good proxy for the global
property market. Virtually all global economies are in early stages of
recovery and others such as China are in full-blown expansion phase, and
[so] the majority of property markets are either flat or slightly
improved.”

Mr White said that occupiers were more optimistic on the mid- to
long-term horizon, with a more normal market for lease terms, which
tended to be a forward indicator for job growth. He pointed out that
rents were rising in 48 of the 55 markets tracked by CBRE in Europe,
while yields – which measure rental income as a percentage of property
value – on property transactions had begun to narrow again.

The
US saw a strong increase in transactions over the past year, while
Europe also produced robust growth in the period, fuelled by recovering
property sales markets in the larger economies such as the UK, Germany
and France. Asia-Pacific sustained strong growth that had begun late
last year.

This
recovery boosted CBRE’s second-quarter results. Property sales rose
globally by 61 per cent year-on-year, led by a 93 per cent improvement
in sales in Europe and 67 growth in Asia Pacific.

One
side effect of the recovery in the market has been that the number of
distressed owners of property being forced to sell has been lower than
expected, although CBRE said that it was still marketing more than
$7.5bn of distressed assets in the US, and had sold more than $1.3bn of
such assets since the beginning of the year.

Mr White predicted
that there would be no new wave of distressed property sales as banks
were working with borrowers rather than foreclosing on property backed
by bad debts.

CBRE isn't the only one calling for a revival in real estate. Darren Currin of The Jounal Record recently reported that Prudential and Moody’s offer positive news for national market:

The
good news continues to pour in for the national commercial real estate
market. Either improvement is occurring in the market or some industry
experts have hired some great public relations experts as a majority
of the news stories released over the past week related to the industry
have been extremely positive.

The latest news comes from Prudential Real Estate Investors,
which said earlier this week that the national commercial real estate
market will recover much more quickly than it did in the downturn of
the 1990’s. The reason for this being that a lack of financing will
limit new supply and investors flush with cash will be competing for
properties. Marc Halle, a manager of the Prudential Global Real Estate
Fund, noted that Prudential is “relatively optimistic” about the office,
retail, apartment and hotel sectors as large institutional owners in
these sectors are seeing multiple bids for their assets.

Halle said the following:

“Last
time it took five years for real estate values to go down to where
they bottomed. … We’ve done that now in about two years. So we are
going to see a faster recovery, a faster write-up in the market.”

Halle
also explained that the way credit markets are limiting financing to
developers will prove beneficial to the national market’s recovery. He
said this trend may keep new supply from hitting the market for up to
five years. Rents are also bottoming, which should prove beneficial to
commercial owners’ cash flows, according to Halle.

In other good news, Moody’s/REAL Commercial Property Price Indices
reported that U.S. commercial real estate prices increased 3.6 percent
in May. This marked the second-straight monthly increase as average
prices in April also rose 1.7 percent.

Nick Levidy, managing director of Moody’s, said the following in a press release about their findings:

“We
expect commercial real estate prices to remain choppy in the coming
months. The positive news of increasing prices over the past two months
is tempered by low transaction volumes, forecasts for slowing
macroeconomic growth and the rising risk of a double dip recession.”

While
this is encouraging, the reality is that commercial real estate
activity remains weak. David M. Levitt of Bloomberg BusinessWeek
reports, U.S. Commercial Property Sales Trail Six-Year Average:

U.S.
commercial real estate sales in the first half totaled about a quarter
of the average of the previous six years as owners kept properties off
the market, impeding investors with record funds for purchases.

Buyers
and sellers completed $34.2 billion of deals through June, or 26
percent of the average first-half dollar volume since 2004, according
to preliminary figures from Real Capital Analytics. The total was about
12 percent of the 2007 peak, when $277.7 billion of properties changed
hands in the same period, data from the New York-based real estate
research firm show.

Sales climbed 58
percent from last year’s first half, when purchases dried up after the
U.S. credit crisis and recession sent values tumbling. A dearth of
available properties has sparked demand for the few deals being
offered, according to Alan Kava, co-head of Goldman Sachs Group Inc.’s
Real Estate Principal Investment Area in New York.

“People
are frustrated that not a lot has been trading,” Kava said. “When
something does come to market, that lack of supply is causing almost a
feeding frenzy. People have real estate funds that are not on an
infinite time line -- they need to put capital to work.”

Private equity real estate funds have a record $104 billion of
equity available for U.S. deals, London-based research firm Preqin Ltd.
reported last month. Blackstone Real Estate Advisors has the most to
invest, with Goldman Sachs second, Preqin said.

Goldman Sachs, Blackstone

More than half of the $8.4 billion available for Goldman Sachs’s
property funds is reserved for overseas investments, Kava said.
Blackstone has about $12 billion for real estate purchases, said Peter
Rose, a spokesman for the New York-based private-equity firm.

Much
of the money raised by private equity firms was in anticipation of a
rush of foreclosure sales that failed to materialize, said Sam Chandan,
Real Capital’s chief economist.

In
top cities such as New York and Washington, owners who owe more than
their properties are worth are instead finding new sources of equity
and lenders are willing to restructure their loans, he said. In less
attractive markets, banks have been extending loans, waiting for higher
prices so they don’t record losses, according to Chandan.

“Many
people were looking to acquire distressed assets, but those
opportunities have been few and far between,” he said in a phone
interview from New York. “That’s been leading to bidding more
aggressively for some of these core assets.”

No ‘Armageddon Scenario’

Record-low interest rates make it easier for owners to hold a
distressed property, said Tom August, president and chief executive
officer of Equity Office Properties, a unit of Blackstone Group LP.
Equity Office owns more than 60 million square feet (5.6 million
meters) of so-called Class A office properties in cities including
Boston, New York and Los Angeles.

“The
Armageddon scenario that several people predicted two or three years
ago just hasn’t occurred,” August said in a phone interview from
Chicago. “Part of it is the lenders realize the current borrowers are
in a better position to work out problems than they the lenders are.”

Landlords will eventually need more money to maintain or lease their properties, likely triggering more sales, he said.

There
is little incentive for owners who bought as the market climbed to
sell now. Values in April were down 41 percent from their October 2007
peak, according to the Moody’s/REAL Commercial Property Price Index.

Four Markets

Demand for properties is strongest in New York, Boston, Washington
and San Francisco, “where domestic and foreign investors alike have
sought to acquire high-quality assets,” said Chandan.

Those four markets accounted for 20 percent of first-half sales,
compared with about 15 percent last year, according to Real Capital.
For office buildings, the largest category, the cities made up almost
35 percent of the volume, up from almost 32 percent in 2009.

Manhattan totaled $2.92 billion of completed sales in the first
half, up 70 percent from a year earlier. About $1.42 billion were
office deals, up 62 percent.

SL Green Deals

SL Green Realty Corp., New York’s largest office landlord, was
both a buyer and seller. The company agreed in May to sell a 45 percent
stake in Manhattan’s McGraw-Hill Building at 1221 Avenue of the
Americas to Canada Pension Plan Investment Board for $576 million, a
deal that values the building at about $500 a square foot, according to
Real Capital.

It also purchased 600
Lexington Ave. for $636 a square foot, and agreed to buy 125 Park Ave.,
a tower across 42nd Street from Grand Central Terminal. That deal was
valued at about $507 a square foot, based on data in a company
statement.

Those
prices reflect a rebound off market lows reached last year, when
similar midtown Manhattan properties sold for about $350 a square foot,
said Chandan. In 2006 and 2007, readily available loans that were
packaged and sold as commercial mortgage-backed securities helped drive
prices for top Midtown skyscrapers beyond $1,000 a square foot.

“We basically went around the world talking to capital sources, in
Asia, Europe, Middle East, Canada, and domestically, and hearing the
same thing,” said Andrew Mathias, SL Green’s president and chief
investment officer. “People’s confidence in Manhattan was not at all
shaken, because of the extraordinary supply/demand metric that exists
here, where you have very, very limited new supply, and the interest
rate environment.”

Monsanto Purchase

The company paid $523 million for its two acquisitions, combining
both closed and contracted deals. Its sales of partial property
interest totaled $663 million.

The biggest
completed deal of the year so far was Monsanto Co.’s purchase of
Chesterfield Village Research Center, a research and development
complex in Chesterfield, Missouri, from Pfizer Inc., according to Real
Capital. Monsanto paid $435 million, said Kelli Powers, a spokeswoman
for the St. Louis- based company.

Distressed
building sales probably will remain scarce, Chandan said. There are
$184.6 billion of troubled properties facing foreclosure or bankruptcy,
out of a total $239 billion since the credit crisis started in 2008,
according to a June 1 Real Capital report.

“There’s tons of liquidity out there,” said Barden Gale, chief
executive officer of JER Partners, a McLean, Virginia- based company
with about $500 million available for investment. “The trouble is it’s
having a problem finding a place to reside.”

There
is tons of liquidity out there - and that's the problem. Prabha
Natarajan of the Dow Jones Newswire reported earlier this month, commercial real estate bargain hunting is making bargains scarce:

At
a bankruptcy auction in Washington late last month, the winning bidder
paid almost 90 cents on the dollar for the mortgage on the Shops at
Georgetown Park even though the developers are suing each other over
who actually owns the property, the current operator has defaulted on
its mortgage and the original lender is bankrupt.

Such
high prices and long lines for such a distressed property are not
unusual these days despite rising delinquencies and surging vacancies
in commercial real estate. Sometimes it seems that so many investors
are cruising for so few bargains in this troubled sector that they are
making true bargains hard to find.

Many
investors had raised billions of dollars to create opportunity funds
to buy such troubled assets. They had envisioned a scenario similar to
the early 1990s when through the Resolution Trust Corp., banks and
savings and loans sold distressed properties at 5 cents on the dollar,
and buyers booked stupendous gains within three years. They have been
disappointed, with many closing down such funds.

"This
market is different," said Jack Taylor, a managing director and head of
Prudential Real Estate Investors' global high-yield debt group, adding
some hyperbole about buyers' enthusiasm: "There is no such thing as
distressed asset."

There is, however, some hope of a flood of
troubled assets coming to market, and these are expected to trade at
more reasonable prices.

Taylor
and other market participants say overlevered properties and
distressed sellers are likely to emerge in the next few months and peak
next year as banks and lenders start looking to clean up their books.

The
paucity of troubled assets for sale is mainly due to the practice of
lenders not forcing owners into foreclosure, preferring instead to
"pretend and extend" - an industry term to describe lenders' preference
to extend maturing loans by a year or two in the hope that both the
economy and the property's finances will improve during that time.

This, in turn, has helped maintain status quo in commercial real
estate despite a 10% delinquency rate. Typically, delinquency rate
averages below 1% in this sector.

"The pig in the python has
now grown to elephant size, and only small bits of it has been
digested," Taylor said, describing the volume of dodgy assets banks have
been forced to swallow.

The bits that have been digested are mostly loans backed by high-end or trophy properties in large metro areas.

"Demand
has exceeded supply, and as a result, the pricing is just not
appropriate for the risks still there," said Maury Tognarelli, president
and chief executive of Heitman LLC, a real estate investment
management company with $22.9 billion in assets globally.

Not only that, it also creates an illusion of normalcy.

"This makes some investors think a rapid, broad-based recovery is
underway; but these transactions don't paint a good picture of what's
happening for a substantial segment of the industry, where properties
remain under-capitalized," said John Murray, a senior vice president and
a portfolio manager at PIMCO, while talking about the company's
extensive study on commercial real estate released in June.

Market participants say that delinquent properties that are slowly
creeping into defaults and foreclosures are likely to hit the market
later this year.

"We are at the start of the period when banks
start looking at their balance sheets, and try to repair them, while
the economy stabilizes," said Taylor of Prudential.

This
period of resolution is likely to extend until 2013, and during that
time "commercial real estate will see a slow recovery, where the
returning capital is met by deleveraging at banks and CMBS levels,"
Murray of PIMCO said.

Others are raising similar concerns. Jeff Harding of the Daily Capitalist recently asked, Is The Real Estate Market Turning Around?, and concluded:

Reports
from people I know who are active in CRE in the L.A. area also lead me
to believe that lenders are starting to do deals on REO properties.
While two years ago no deals were being made, today there is more
opportunity and activity. Further there appears to be less “extend and
pretend” as banks are less willing to accommodate defaulting borrowers;
lending standards have tightened rather than loosened. They have about $500 billion in CRE loans maturing in the next couple years.

In
my view, it is CRE that is critical to a recovery. We will need to see
more positive signs, such as an increase in business loans, more CRE
foreclosures, and a reduction in bank excess reserves, before we can
say there is some kind of trend, but it could be that the CRE logjam is
starting to break up. I do not expect any recovery of the CRE market
any time soon because of the volume of debt maturing, but I am beginning
to think that more defaults will be pushed into special servicing
resulting in foreclosures. The result will be further downward pressure
on CRE prices (they have already declined 24% since the peak in Fall
2007).

And it is interesting to note that Deutsche Bank just recently announced that it's dismantling a group that advises companies on
commercial real estate transactions. Hardly the sign of confidence in the CRE market.

Finally, I had the pleasure of meeting
up with a former colleague of mine who is a real estate expert. He is
bearish on residential and commercial real estate, and told me "it's too
risky taking equity stakes in CRE". He advises pension fund managers to
play "junior debt on high quality assets".

We also talked about
active management in real estate, which he believes can add tremendous
value to a pension fund "if they have the right expertise". "Why have a
real estate group if all they do is farm out money to funds? Unlike
private equity, real estate deals are very similar, so you don't need
outside experts to deliver alpha -- you just need a smart team that
knows how to structure deals". He did however mention that "there are
excellent real estate funds" but there are a lot of "mediocre ones" as
well.

We ended off by talking about the revival of structured finance, which
he thinks is "essential" for the market as it would fill the gap in the
market in term of financing CRE as banks become more reluctant at
lending in order to preserve their capital. He told me
that pensions can play a key role here and that funds like CPPIB and the Caisse de dépôt et placement du Québec should be originating commercial real estate
backed debt, selling it off to insurance companies who by regulation have to invest in
AAA debt.

The problem is that following the crisis, "'structured finance" is a dirty
expression and depositors' appetite for anything sounding remotely risky
or "structured" is just not there. It's too bad because the truth is
the real estate professionals at the Caisse have been at it for decades and are years ahead of others when it comes to structuring complex real estate
deals. They should be taking advantage of this internal expertise,
capitalizing on opportunities in commercial real estate debt markets.

Comments

[Leo Kolivakis]

***UPDATE: Interview with Citigroup's head of real estate***

Discussing the state of real estate, with Thomas Flexner, Citigroup global head of real estate:

[BoyChristmas]

Lazy money. Way too much money was raised to chase CRE because it's easier than try to invest in and actually build a company. 

[Leo Kolivakis]

More evidence of a weak CRE market:

Deutsche Bank Shutting Commercial Real Estate Adviser Group

Edited my comment above.

[emma goldberg jewboy]

They sell it and don't have to smell it. TBTF is a massive stay of execution for fools and they are back at it. Propping up ill gotten gains ensures the status quo. Cycles shorten exponentially with these fools.

[j0sh1130]

all of the positives in the first few blocks of quotes are true for those firms.  but none of that takes in to account the rollign debt and the fact lending wont come back at that high of a level and property prices will still be depressed.  so unless investors have significant equity to invest in the properties they already own, we will see more deals come back to the banks.  and as the market recovers and the banks heal, they will take less of a loss.  its just a balancing act at this point.  and the banks are hoping they can balance it long enough to make their way out of it.

[Gromit]

"There is no such thing as a distressed asset."

Exactly.

Back in the RTC days banks could not borrow for .25%, they had to pay 10%, whatever. So they had real cash flow problems which had to be addressed by deleveraging.

CRE is about rents. They are going down. Expenses, (utilities, taxes etc.) are going up. No sense in taking an equity position until banks are forced to cough this stuff up.