No Movement in Commercial, Report Says

Commercial real estate still frozen, upcoming report says

By Arleen Jacobius
May 15, 2009, 9:55 AM ET

The gale-force winds that have struck U.S. real estate could shake loose some bargains within the next year or two, but investors and money managers shouldn’t crawl out of the root cellar just yet.

Commercial real estate loans are tough to come by, with lenders reluctant to offer debt for transactions worth more than $50 million, according to a soon-to-be-released study by ING Clarion Real Estate. Lenders are requiring a lot more cash in the loan-to-value ratios (the comparison of the size of the mortgage to the value of the deal). The ratio has dropped to 50% to 60% in March from 70% to 90% in 2006, according to ING Clarion Research & Investment Strategy, ING Clarion’s research unit.

The cost of debt in commercial real estate loans in the U.S. also has increased, to 7.5% in March from 5.5% in 2006. This means that the return investors need to earn also has gone up, to 10% from 8%, ING Clarion’s research showed.

This combination — more cash required and a higher cost of debt — is devastating for commercial real estate investors because most investment hinges on the availability of affordable debt, the survey noted. The average transaction cap rate for all properties worth more than $5 million in the fourth quarter rose to 7.2%, according to data from Real Capital Analytics cited in the ING Clarion report. By March, the cap rate — which measures how fast an investment will return capital — was up to 8.5%, the ING Clarion study indicated.

ING Clarion anticipates that cap rates for core properties — the most stable but lower-return set of real estate investments — will stay in the range of 7.5% to 8.5% for the next 18 to 24 months.
Prices down but deals not up

“It’s a very serious crisis,” said David J. Lynn, managing director at ING Clarion Real Estate, New York. “There is a perfect storm and real estate fundamentals (such as rent and demand) will continue to decline.”

All of these factors are causing prices to decline but transactions have not yet picked up. Buyers and sellers have not had a meeting of the minds on value, mainly because the market adjustments and the exceedingly low number of transactions are making it almost impossible to price a property, Mr. Lynn explained.

Properties are producing less income because owners are cutting deals on rents to retain tenants, one of the strategies ING Clarion considers a top priority for real estate owners for the near term. The Catch-22 of this strategy is that it’s adding to the bid/ask spread standoff between potential buyers and sellers of commercial real estate.

Also adding to that standoff is that most investment managers aren’t all that eager to sell properties in their portfolios at loss.

“Many of these guys have low-cost debt” that will not have to be refinanced for another few years, Mr. Lynn said. This means the cost of keeping the properties in their portfolios is relatively low.

“They are content to hold,” he said.

Defaults on commercial loans are projected to grow to 5% to 6% during the next 18 to 24 months. Right now, mortgage defaults are 2%, Mr. Lynn said. Defaults on commercial mortgage-backed securities are growing too, but most of those securities won’t start coming due until sometime later this year. When default rates rise more, investors will be able to get equitylike returns for senior debt. Buying cheap debt on property could be a good way to end up owning the real estate.

In the coming 18 to 24 months, investors will be able to buy loans at a discount, he said. But not yet.

“It’s a different horror movie than in the early 1990s,” Mr. Lynn said. “It happened really quickly (then). There were huge opportunities and it was all for sale. Now there will be huge opportunities, but a lot of people are holding on.”

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