Ten Reasons Commercial Real Estate Won't Rebound
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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On 3/12, SPG defaulted on loan payments for one of its malls, and the stock rose 12%. What's up with that? All the points you make here are valid, and were known then too, yet the IYR basket has risen 35% (50% as of 4/17) since the March lows.
When, in your opinion, will the expected plunges in these REITs become manifest? Was today finally the beginning?
Also, if you are only trading SRS, how are you choosing your entries and exits?
I am long SRS and have been selling covered calls on them thanks to the high premiums. Effective cost of ownership (after the covered calls that expired or I bought back to close for a profit), is about $32.5. Bad action in the stock today. Should have had a stop loss in at $34 when it shot up to $35+ soon after open... Did not - only to see it close at $27.5 today. Ah well, the $35 May calls still have about a $2.5 premium. I could always sell that and wait... Worst case, come May 20th, by cost basis will be down to $30.
Im going to stick it out as i see in a year big trouble for REITs but please clarify #10.
Pete
2. Goldman is wrong and whoever projected that doesn't understand the CRE market
3. Builders stopped building entirely when things collapsed
4. Wrong and this goes against the premise of your article
5. REITs != CRE
6. There are always good opportunities, you just need to find them. Your statement here goes against the whole premise of the article.
7. Stocks going down have zero to do with CRE
8. REITs != CRE
9. REITs != CRE
10. You can't call the day to day movements (or week to week movements) of a stock
