With the IShares DJ US Real Estate (IYR) up 50% from the March 6 lows, I'm not the only bear on commercial real estate (CRE) wondering whether this sector has seen its worst days and is ready for a comeback. To try to answer that question, it may be useful to review how the majority of CRE deals in the last 5 years were put together.

I wrote in Small-Cap Recap: What's Behind Real Estate Cap Rates?:

“As late as 10 years ago institutional investors had investment time frames of 5-10 years; today they are looking out 2-5 years at the most. In such a short period, cash flows are viewed as a source of funds to spruce up the property until the next fool rushes in to buy it at a higher price... . Therefore cap rates are ignored because 'this time is different'... . The valuation stick of choice today is 'replacement cost.' Would it cost more to put up a property or to buy one already there?...

Naturally, the key to the game is the “projected” capital gain factored into the equation at the time the asset is purchased. Over the last 5 years that type of appreciation has been a no-brainer, and it's  now a foregone conclusion that it will continue forever... . 

The next logical question is why anyone would dump money into this type of scheme. There are several reasons. The bulls will tell you that assuming a 4%/year appreciation for a 5-year period is nonsense, as annual appreciation has been closer to 15%/year for the last 5 years.”

This is the framework within which most deals were being structured as late as 2006 and early 2007: Buy 'em and flip 'em. Unfortunately for those left holding the bag, the game has now ended. These deals, which were never underwritten to last more than a couple of years, are now falling apart.

The Arse-Backwards Unwind

In the CRE busts of yesteryear, the unwind cycle consisted of owners acknowledging that their equity had vanished; mezzanine lenders fighting tooth and nail to come out whole on the strength of the usurious fees and interest charged to provide the loans; and first lien holders sitting there waiting for the liquidation process to take its course.

In the current meltdown, however, the secondary market trading of securitized senior loans, (Commercial Mortgage-Backed Securities (CMBS) pools), has allowed senior lenders and speculators to discount the problems in the underlying properties by driving down the prices of CMBS; to add to the mess, we have the rating agencies climbing all over each other to downgrade CMBS in which the flippers’ loans were packaged - causing their own share of exogenous pressures. The upshot of all of this is that Fitch has about 10% of all 2006-2008 vintage CMBS under negative watch, and even super senior CMBS tranches now trade at spreads to Treasuries of more than 10%.