A Commercial Real Estate Comeback?
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%.
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the ripple effect is already being felt.
GGP owns 2 malls in Tucson and while these AREN'T in trouble, the saying goes that you have to shed your good assets to pay for your bad ones.
It's effectively in bankruptcy now.
I work in the commercial arena and I can say that there are many, many more to come.
I know of a california design center that was built for $3.5 million, has a $300,000 deposit from tenant and a loan amount of $2.5 million
A 25,000 SF building which is now worth $1 million - RTC prices
of course the lender and owner don't get it YET but they will
I told the attorney to make a deal ASAP with the lender, pay whatever and GET OUT.
Why? unlike the RTC days, most commercial loans have RECOURSE and therefore those who have other property and assets are going to get creamed when lenders start going after these also.
caveat emptor my friends
I anticipate looking in about 18-24 months when the commercial arena is as bad as the housing is right now.
I'm sure there is a down side but considering that IYR and URE are restricted from being sold short most of the time, this might be a valid alternative.
I love, love, love ALL your posts. Your data/information over the years (very long-time Minyan here) have been/remain top-shelf.
One question for you. What is it about PSA that you like?
Fillipo, we have similar value-based CRE investment philosophies. Congratulations on not getting caught up in the game of musical chairs. Stay in touch!
