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Dean C. Hurley , SVP
Capital Markets Group

Commercial Real Estate Outlook

Wednesday, April 13th, 2011

In this article, we take a close look at a market that for the most part seems to be in recovery. This recovery is at best uneven geographically, and a weak recovery is being tested by Mideast shocks that are driving up energy and food costs.

Economic Situation

For the commercial real estate markets generally, the key driver is employment and income growth. The forecasts we’ve seen recently are a little better than the one in the chart below – about 3.2% GDP growth for all of 2011 as of February’s reports.

The reverse of that is the prolonged unemployment we continue to experience. This appears likely to exceed in duration the longest such period of high unemployment since World War II.

The CRE markets, as evidenced in the charts above, is now embarking on a slow but steady recovery of the CRE markets in 2011 and beyond. We believe that Net Operating incomes will grow moderately as occupancy improves and rents require fewer concessions.

Loan Performance
An important indicator is CRE loan delinquency and charge-off rates at banks. It clearly shows a leveling off, but not a decline, in the rates of problem CRE loans. Problem loan rates at banks remain at the highest levels seen since the early 1990’s.

Bottom of the Real Estate Cycle

MIAC notes that this real estate cycle has been different from the normal cycle. In the typical real estate cycle, over-building leads to over-supply when the economy hits a bump, and then rent growth goes negative. This cycle saw less over-building and considerably more over-leveraging, in part because capital markets provided additional leverage, which drove up prices as investors sought to invest in the asset class. Also different in this cycle, there is significant capital on the sidelines. The “fix” needed to move the cycle into favorable territory is loan resolution. With levering at 75% or more at peak values, a drop in market values leaves significant over-leverage. Add to that the fact that most CRE loans are written as ten year balloon loans and it becomes clear that only economic recovery or loan liquidation can resolve the situation.

While this hasn’t been the worst CRE price downturn, it ranks high. The chart below compares downturns.

Another thing about this cycle that is interesting is just how unevenly the impacts have been felt. The trophy properties (better than “Class A”) have experienced less value decline and the fastest value rebounds.

A sub-trend worth noting is that smaller properties most typically in a local bank portfolio frequently saw a lesser value decline than the CPPI (Constant Proportion Portfolio Insurance?) indicates (providing that the properties were not “Distressed”).

Property Markets

The commercial space rental markets show all the aftereffects of a recession. Vacancies are high, but declining. The table below makes clear just what that looks like, with the national average office vacancy rate at 16.7%.

Interestingly, Class A vacancy rates are a bit higher than Class B because of tenants looking for savings in downsizing and in seeking more favorable rents. We also think it is interesting that in some markets, like New York City multifamily, prices are recovering to levels near the peaks of late 2006. NYC cap rates on multis are in the 5% to 6% range, down from 7% to 8% a year earlier (“Bubble or Recovery”, Candace Taylor, October 1, 2010). According to the Urban Land institute’s 2011 Emerging Trends in Real Estate study, investors’ top choices now are New York and Washington DC, followed by San Francisco, Boston and Seattle. Los Angeles is considered a top choice, while Chicago is only considered “Fair”.

COMMERCIAL PROPERTY PRICES

Some of this may be demand related, as there are fewer properties selling and investors see upside potential and are bidding up prices accordingly. The forecast from CBRE, below, shows that there is a broad movement towards declining vacancy.

There has been an increase in CRE sales transactions in 2010 over 2009, although there does remain a gap between seller expectations and buyer capacity in most markets. The increase was partly fueled by sales from special servicers. Nevertheless, the data suggests that the rebound in sales is sustainable, and that 2009 was the bottom. See the graphs below.

Renewed Lending and Securitization

Another encouraging trend is increased loan commitments by life insurance companies, and a re-emergence of CMBS issuance. Life companies traditionally lend on only the best properties, which must be institutional grade. Life companies severely curtailed lending starting late in 2008 and continuing in 2009. That trend has now been reversed.

Similarly, CMBS issuance is a sign of renewed confidence by bond investors in the asset class. Spreads on new issues are declining, and the expected volumes in 2011 are up over 2010.

Even spreads on older CMBS bonds have declined, though those bond issues are not yet out of trouble.

The key problem with those older deals – ignoring heightened delinquency - remains the higher LTVs due to “bubble” timeframe appraisals and difficulty refinancing balloon maturity loans. Again, the “trophy” properties are far better off in terms of refinance-ability. Although the data presented in the chart below indicates that the worst is yet to come, we believe that even with the lag timing on a CRE recovery, a rising economy will mitigate the worst possible scenario outcome (unevenly by type of property and region) well before 2017 even though CRE problems will continue to be a drag on the economy for years.

Summary

In summary, MIAC sees a recovery, spotty in places and weak overall. It is a recovery that could be knocked in the head by a major economic shock, but it is more likely to be a slow and uneven recovery with pockets of strength as consumers return to spending and investors return to the markets. MIAC is accustomed to navigating changing commercial markets. We are happy to assist you in navigating the choppy waters ahead. Providing our clients with the best tools and comprehensive market knowledge they require to be successful is MIAC’s mandate.