Updated View of the Commercial Real Estate Investment Sector

A recent Costar Headline read “Rising Demand for Office and Industrial Real Estate Suggests Expanding U.S. Economy” Can this be true?

I guess Costar did not get the latest memo about how the economy by any measure is currently at a virtual standstill. The small gains as reported are nothing to really cheer about. Yes there has been some “slight improvement”.  However, as a reminder, Commercial Real Estate performance is a lagging economic indicator. This report would suggest the relatively minor gains where the result of the 4th Quarter results. Also one needs to keep reminding themselves that CRE deals take a long time. When you see or read about a reported large lease (lately it seems as if any transaction is taking forever) it most likely started several months beforehand when market conditions were different.

I have listed at the end of this the economic conditions which need to dramatically improve in order for CRE to be a good alternate investment for the non- institutional investor.

The investment market is still bifurcated; however the investment community is back to chasing yield. This is being promulgated by the Federal Reserve as they want investment dollars to flow to alternate investments other than the Treasuries. The problem with chasing yield is this is what helped create the bubble that just burst in late 2007-2008. The high-end investors are looking at Tier 1 markets and Class A properties and are willing to accept lower cap rates for that perceived safety. Now they are looking at secondary and tertiary locations. This competition is once again driving price increases for those properties. In the meantime the market for everything else is challenged. Keep in mind that approximately $250-$500 billion in CMBS financing is due to roll over between now and 2014. Many of those loans where 5-7 year terms. Most if not near 90% of those loans were based on peak of the market evaluations. So anyone needing to refinance those is in a heap of trouble. The evaluations have dropped on average 25%-40% and with most lenders requiring 60%-75% LTV’s  and  in most cases are based upon current evaluations, you see the problem.

There were many investors when the bubble burst hoping for what happened in the early 1990’s when banks and lenders began off loading the trouble REO’s at fire sale prices. This time with the Blessing of the Federal Reserve and regulators “Extend and Pretend” was the method, with the lending community hoping market conditions would improve in time. The real problem are the banks are in deep trouble. The public face that is being put on is just that total spin. The banks are sitting on a tremendous amount of Federal Paper; the Fed itself cannot allow interest rates to go up as that would cause a worldwide catastrophe. What would be the value of all the trillions of dollars of low yield bonds/notes if interest rates went up even by a moderate 200 basis points? Right now the Fed is lucky that inflation has been held in check. Why has it been staying low, because the overall economy is bad, very bad as a matter of fact! Economists and those with an agenda are trying to put positive spins on the slightest perceived improvements in statistics. GDP of 1.9% in the first Q was said not to be considered recessionary. It is if you factor in population growth and all the other factors that demonstrate an improving economy. Even China is slowing down.

When I see the above factors I have to ask, why in the world would one want to invest in CRE which is one of the most illiquid investment vehicles. Also keep in mind the minor amount of perceived improvement being reported is based upon the above competition for yield. Also note that CRE is a lagging economic indicator which means it’s the last to be affected and the last to come out of whatever economic cycle is going on. So what I believe has happened is much of the investment buying was predicated on the 4th Q 2011 results and the Investment committees decided “yeah let’s get back into the CRE game”. The public pension funds are desperately trying to beef up their returns and recover significant losses. Just look at the recent release of CALPER’s annual return…1.1%. That is tantamount to being underwater, going backwards. They have on staff supposedly some of the smartest most sophisticated MBA’s who could do no wrong during the bubble years. The one thing they must have forgotten from their undergraduate business school classes that every investor must have an exit strategy, one that is beyond ‘I’ll just sell it to the next investor for a profit, because markets never go down”! Of course they are blaming the stock market as the key culprit.

This will only end badly unless several factors substantially turn around.

1. Employment-sustained unemployment above 6% is a major impediment

2. Housing-It is bumping along the bottom, sure there has been some ever so modest improvement, but new foreclosure activity has picked up in earnest now that the Robo-signing issues have been basically resolved.

3. Reduction of Government Over Regulation and change in attitude toward business.

4. Realty to return to the marketplace. Owners are still in denial as are all those lenders who have willingly gone along with the “Extend and Pretend” strategy.

5. I’m sure there are several others but let’s just leave it here for now.