A Glimmer of Light in Commercial Real Estate

Posted by jeff

Thu Jul 15th, 2010 04:37 AM

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Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of July 15th, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.


Bob Knakal of the eponymous New York City commercial real estate brokerage Massey Knakal put out his "Summer Commentary" recently. While Bob has every reason to paint a rosy picture of New York City commercial real estate (his firm is consistently the largest broker in NYC in terms of number of deals due to their dominance in sales of smaller buildings). Bob actually is as much of a straight shooter in his market commentaries as he is in real life....no grain of salt needs to be taken with regards to the following:

According to his summer commentary "the acute imbalance between supply and demand today appears to be impacting the market more than it usually does. Presently there is excessive demand met by a relatively weak supply of available properties for sale." Sound strange? It is actually highly intuitive. Those who are not over-levered or facing maturity defaults (see my recent piece "Real Estate & Banking Reality Check") don't feel a great need to sell into a market overshadowed by a slow economy and high unemployment and dominated by vulture buyers. Meanwhile distressed sellers are being thrown lifelines by their banks. As opposed to the popular belief that they are under-capitalized and can't afford to take the losses (they have all taken TARP and raised equity), banks simply imagine a better time to liquidate REO (real estate owned) than today and also don't want to miss Wall Street earnings estimates by prematurely calling in loans. Knakal goes on to profess that investment sales volume will increase by at least 40 percent year to year in the second half of 2010 as sellers seek to beat the increase in cap gains taxes, pent up demand for 1031 exchanges is released and (my words not his) funds put together in past years invest it as opposed to handing it back to their limited partners (at least they can continue to collect fees).

Interestingly, a similar scenario seems to be playing out in other markets around the country (particularly Boston, San Francisco and Washington). A recent Time Magazine article entitled "Is Commercial Real Estate Bouncing Back", quotes Mike Kirby of respected REIT research firm, Green Street Advisors, saying that "It's mainly Arab money. They have been the main source so far. The German syndicators are back in business. They've been toeing around the market. There's also been interest from sovereign wealth funds of all stripes.". Kirby contends that prices for commercial real estate are up 20% off their lows, which has not yet been captured by market indexes which track closed rather than announced transactions.

A Dow Jones Newswires article last week entitled "Commercial Real Estate Bargain-Hunting Makes Bargains Scarce" discussed how investors are bidding aggressively for assets in foreclosure, paying as much as 90 cents on the mortgage dollar. So, despite delinquency rates of 10% versus a more normal 1%, according to Jack Taylor a managing director and head of Prudential Real Estate Investors global high-yield debt group, "There is no such thing as a distressed asset". According to Maury Tognarelli, President and Chief Executive of real estate management company Heitman LLC, "Demand has exceeded supply, and as a result, the pricing is just not appropriate for the risks still there". John Murray a senior vice president and portfolio manager at PIMCO added "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".

From my perch covering regional and local banks this promises to be an interesting earnings season as construction and development loan write-offs hand the baton to maturity defaults on commercial owner occupied and investor owned property loans. Troubled Debt Restructurings (TDRs) will be the topic of discussion for those with significant numbers of maturing loans, however in many markets, commercial bank loans were largely made with 10 year or longer maturities (5 with an option for 5 more was typical in NYC) and these loans will not be recognized as problems as long as payments continue to be made. Considering the generally well capitalized status of survivor banks (there are certainly many zombies that will be merged and purged by the FDIC) I don't expect properties to be blown out with 20 - 30% liquidation discounts. The banks that acquire troubled loans through FDIC assisted takeovers have strict reporting requirements which will enable regulators to see whether they are leaning too hard on loss sharing deals by liquidating bad loans willy nilly.

According to a recent Bloomberg article, data from Real Capital Analytics shows commercial real estate sales rose 58% year-to-year in the first half, despite running at a quarter of the rate of the prior six years. In my mind, while some unique circumstances have conspired to cushion commercial real estate's fall, the avoidance of "liquidation discounts" is probably a positive for the economy (prevents further deflation due to acquirers with super low basis costs slashing rents) and the improved liquidity being evidenced in the markets bodes well for the commercial real estate market, the banking system, and by extension the economy. If we can avoid a bear market in stocks, that would help too.


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