By Jeff Harding
SEEKING ALPHA
October 8, 2010
The recovery of the economy depends on several important factors, but the recovery of the real estate market is near the top of the list, especially commercial real estate (CRE) because most of America’s banks are loaded down with CRE debt. As a result of a massive infusion of capital into the real estate market since 2002 resulting from the Fed’s historic pumping of money into the economy from 2001 to 2006, CRE prices skyrocketed causing the boom-bust cycle from which we are now trying to recover.
As a result, cheap money poured into projects that, but for the false prosperity of an inflated money supply, were unprofitable. All this malinvestment came to a head when the Fed turned off the money spigot starting in 2006 and led to an historic bust.
As a result banks, especially regional and local banks that financed most of the CRE (we are not talking about trophy properties here) have been seriously jeopardized by their CRE loans.
A tally by SNL Financial LC found that 94% of bank failures since 2008 had either residential or commercial real-estate as their largest category of delinquent loans. KBW says their riskier construction loans were 23% of their total portfolio, compared with 7.2% for the industry as a whole. The delinquency rate of commercial real estate was 13.5%, far above the current national average of 1.7%, SNL said.
Until banks clear their balance sheets of this defaulted debt, they will remain reluctant to lend, worried as they are of further loan defaults and the need to protect their capital base. Banks are one-half of the “credit crunch” which the Fed has been trying to remedy. Yet government policies encourage lenders to delay the inevitable and necessary (“extend and pretend”, “mark-to-make-believe”, and “delay and pray”).
With these thoughts in mind, a look at the commercial real estate markets should give us some idea of how this malinvested real estate is working its way through the system.
Based on a review of data for commercial real estate, the following is becoming apparent:
1. There are two real estate markets: trophy/investment grade and general CRE. According to the CoStar Commercial Repeat-Sale Indices (CCRSI):
For the past three months, all three indices (the composite, general and investment-grade) are negative: down 3.92% for the broad general index; down 3.24% for investment grade; and down 3.92% for the composite. For the past 12 months, all three indices are down approximately 10% to 11%.
For the past two years, the general real estate index is down 24%, investment grade is down 32% and the composite is down 26%. From the peak in February of 2008, the general real estate price index is down 27%, the investment grade down 34% and the composite index down 29%.
However, the repeat-sale values for investment grade commercial property reversed their negative trend from July and moved positive again with a 3.73% climb in August.
2. The CRE market is attracting huge pools of capital for investment.
According to the CCRSI September report:
Companies and funds reported raising $6.88 billion in September for real estate-related investments and financing.
The amount raised brings the total inflow for the first nine months of the year to $69.69 billion raised from about 1,352 funds and firms. … For September, 174 different funds and firms reported raising $2.5 billion earmarked for debt repayment and $700 million earmarked for debt, mortgage or securities purchases. That leaves approximately $3.68 billion of the money raised available for property investments.
At a conservative 65% loan-to-value ratio, the money raised in September could fund $27.6 billion in property purchases. That amount far outpaces the amount of deals getting done. Property sales of $1 million or more have totaled slightly more than $14 billion in both August and July, according to CoStar Group’s COMPs database. (As of this writing CoStar has verified more than $11.5 billion in September property sales of $1 million or larger, and continues to tally the total transaction volume for the month.)
Of the total amount raised in September, $5.47 billion was raised from publicly offered shares in REITs and real estate operating companies with a little more than half of that money specifically to be used debt repayment or refinancing. The other $1.42 billion came from private fund raising efforts and is all earmarked for new investment. Pooled investment funds including private equity and hedge funds raised $730 million of the total of private efforts – the lowest monthly amount for such funds this year.
The highest percentage of funds raised (approximately 23%) was earmarked primarily for office-related investments. Funds targeting multifamily investments raised 17% of the total; health care-related real estate 15%; and industrial-related 10%. Funds targeting investments related to hotels, retail and debt/mortgages each accounted for about 8% of the total.
3. The CRE market is still under considerable stress, but sales activity, distressed and otherwise, is rising because of perceived deals.
Moody’s reported:
Since 2007, the ratio of distressed sales to overall sales has increased from approximately 1% to approximately 23% currently. Discounts on distressed property sales (REOs and short sales) compared to non-distressed sales are running an average of 40% for multifamily, 20% for office and industrial and 17% for retail property based on 2010 data to date.
Commercial real estate prices dropped another 3.1% in July, the second-straight month of declines and only 0.9% above the recession low in October 2009, according to the credit rating agency Moody’s Investment Services.
Currently, prices are 43.2% below the peak in October 2007. Over the past year, commercial real estate prices have fallen 7.3%. According to Trepp, an analytics firm, commercial real estate problems are the culprit behind the most recent bank failures.
Marcus & Millichap reports:
Distressed sales activity during the first half of 2010 nearly tripled the activity levels recorded in the same period in 2009, with assets under $5 million comprising over 80 percent of the transactions. This controlled liquidation will continue over the next year as lenders clear their balance sheets of bad commercial real estate debt, whether through note sales, short sales or REO dispositions.
The average recovery rate increased from 63 percent in 2009 to 67 percent in 2010, with approximately 15 percent of all resolutions resulting in full first-mortgage recoveries, bolstering lenders’ confidence in the market and generating a rise in REO sales activity. By delaying their liquidation of distressed assets until after the worst of the downturn, lenders have been able to avoid the fire sale many investors and opportunity funds anticipated. Lender recovery rates will continue to edge up through the remainder of 2010 and early 2011 as vacancy rates stabilize and transaction velocity accelerates, allowing lenders to bring additional properties to market.
Trepp Data, which reports very reliable data for CMBS, for August, 2010 says:
The delinquency rate for commercial real estate loans in CMBS accelerated in August. This comes after two successive months in which the increases in the delinquency rate had moderated. The August numbers may give ammunition to those who argue that the commercial real estate crisis is far from over. The rate in August was up 21 basis points after an increase of only 12 basis points in July; the overall delinquency rate [is] 8.92%. …
The increase for seriously impaired loans saw a similar jump. The percentage of loans seriously delinquent (60 days + in foreclosure, REO, or non-performing balloons) was up 20 basis points.The number of loan modifications remains elevated. This will continue to put some downward pressure on the delinquency number as troubled loans get resolved and move from the delinquency category. REO loans that are liquidated will have a similar impact. Separately, the average loss severity in 2010 for liquidated loans has been 45%. However, if the losses are backed out for loans where shortfalls have been 2% or less, that percentage jumps to 60%.
Spreads on CMBS super seniors fell again in August but the real action was in mezzanine AAA bonds (AMs). Overall, spreads tightened 15 to 30 basis points for the month of August for recent vintage super senior bonds. With Treasury yields continuing to drop, some AAA bonds are approaching prices of $110. AM bond prices jumped by $5 to $10 in some cases. The dollar prices on some AM bonds now exceed par for higher quality names from 2005 and 2006. Many 2007 AM bonds are now trading above $90. At various points in late 2008 and early 2009, these bonds were quoted at 30 cents on the dollar or less. The strength in AM bonds began to lift the prices for junior AAA bonds (AJs) late in the month. Credit bonds ( those rated single-A or lower ) from vintages 2005 and earlier continued to attract strong bids.
But rising default rates can also be seen as a positive as banks have less patience with their borrowers and they are pushing them toward foreclosure.
What these data say is that investors are snapping up prime real estate, and even paying premiums for top properties. Which bears out the old saying that [piles of] idle money chases prices. This has been borne out by some really big deals for trophy properties that are just hitting the market.
BXP is on a buying binge:
Boston Properties Inc. (NYSE: BXP) agreed to buy Boston’s 62-story John Hancock Tower, New England’s tallest building, from a joint venture between affiliates of Normandy Real Estate Partners and Five Mile Capital Partners for $930 million, or about $550 per square foot.
The deal would be the largest sale of a commercial building of any type in the U.S. for at least the past two years. More than a dozen potential buyers, including Vornado Realty Trust (NYSE: VNO) and Beacon Capital Partners of Boston participated in ferocious bidding for the iconic tower.
On Sept. 24, Boston Properties closed the $275 million acquisition of the 350,000-square-foot 510 Madison Ave. office tower in the Plaza District of Midtown Manhattan. BXP bought the newly built tower from an affiliate of developer Harry Macklowe, who was forced to sell properties after taking on too much debt. …
Boston Properties has joined many other REITs that have become net buyers of property this year. BXP’s acquisition spree is driven at least in part by the more that $1 billion in cash sitting on the company’s balance sheet earning next to nothing due to the current ultra-low interest rate environment, said Alexander Goldfarb, REIT analyst for Sandler O’Neill + Partners, LP. But it also shows a growing appetite for the best assets in the best markets.
With the huge pools of capital raised for investment, with banks being enticed back into the market and disposing of REO properties, it appears that the CRE market is getting healthier, yet far from being resolved. While the John Hancock Tower makes headlines, it is the “general CRE” properties, the B and C properties, that are clogging up the regional and local banks. The ongoing problems of high delinquency rates and still declining prices will continue to plague banks. But from the sales data presented here and from anecdotal evidence I am seeing, more properties are now being offered by banks which is a good sign. In addition sales are increasing in most key markets.
If I were to guess, all things being equal, we still have another two years or so for the CRE market to tighten up. On top of all of the above is the $1,5 trillion of CRE debt that still needs to be refinanced over the next five years. If prices firm, if banks clean up their REO departments, and if interest rates stay low, then that will help the refi problem. But it’s not over yet. There are positive things happening, a loosening up of the REO market that we haven’t seen for the past two years, plus growing sales, which are good signs.
