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Ten Reasons Commercial Real Estate Won't Rebound

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With prices still falling, repair of REITs could take a very long time.

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I promised a follow-up on A Commercial Real Estate Comeback, so here it is.

Given that I've already spelled out my thinking on the sector, I'll use a "bullets" format here, pulling in ideas from recent reports by Goldman Sachs (GS) and Stifel Nicolaus, as well as information from a very well-placed broker in the Washington area:

1. In prime office markets, closings for trophy properties are being done at 7.5-8.5 cap rates; anything other than "trophy" quality is above 9.0 caps. Against a backdrop of halcyon-era deals, which happened at nominal 3-4 caps (in reality cap rates were at zero since under normalized financing terms there would have been no cash flows), and leveraged 75% plus, this means that many properties have now lost approximately 50% of their value.

To wit, Normandy's $660 million foreclosure of Brodway's Hancock Tower in Boston took place at 50% of the original price, but only because Normandy chose to assume the very favorable loan on the property. In a regular auction sale, the property might have pulled in less than $500 million (Stifel Nicolaus).

2. "CRE fundamentals will continue to worsen for the next 12-18 months; cap rates will rise another 3 to 5 points, to the low teens; secured financing costs will rise to the 8-10% range; unsecured financing will command double digit rates." (Goldman Sachs).

I agree completely, and it matches the assumptions surrounding many troubled projects we're familiar with.

3. Because of the number of projects yet to be delivered in the next 6-18 months, absorption rates even in the best markets are likely to be negative for at least the next 18-24 months, putting pressure on rents.

4. To further depress prices, smaller landlords are finding "tenant improvement/leasing commission" too costly relative to falling rents. This means 1 of 2 things: defaults by those landlords, or investments to finance the TI's and LC's in exchange for very large chunks of equity. Incidentally, in selected areas/projects, we think this structure can create significant investment opportunities.

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Positions in IYR, SRS
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