Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

US Commercial Real Estate: Will the Good Times Last?


The CRE market has experienced a gradual recovery in asset pricing since the 2008 financial crisis, but it is uncertain whether this will continue.

Since hitting a valuation trough in early 2010, US commercial real estate (CRE) properties have rebounded, recovering roughly half the losses they suffered during the financial crisis. Nearly four years later, the state of the market evokes both caution and optimism among investors.

Devin Chen, co-head of US CRE investing, discusses PIMCO's view that many parts of the CRE market remain attractive but warns that asset selection is critical. He explains why the potential for gradually rising interest rates in the years ahead won't necessarily mean poor returns for CRE assets, why having a flexible investment approach can help achieve optimal risk-adjusted returns, and where he is finding the most attractive value in today's market.

Q: How has the US commercial real estate market evolved since the 2008 financial crisis?

Chen: Conditions have greatly improved, but not without the market first experiencing significant pain. While stocks were having one of their better years in 2009 (the S&P 500 (INDEXSP:.INX) was up 26.5%), prices were still falling in the private CRE market (see Figure 1). Only $66 billion of CRE properties traded hands that year, an 88% decline from $572 billion in 2007. Liquidity for private CRE assets was so challenged that even well-collateralized performing loans would sometimes trade at a large discount to par value.

While few were buying and selling CRE properties, another form of investment activity was occurring behind the scenes: restructurings. Many CRE investors had to address balance sheet issues such as looming debt maturities in the face of weak property fundamentals, falling values and minimal liquidity. (The commercial mortgage-backed securities market, which was the biggest source for CRE financing in 2007 with $230 billion of new issuance, was almost nonexistent in 2009.) In 2010, PIMCO estimated that $300 billion to $500 billion of deleveraging in US CRE was needed -- the realities of a nearly 40% decline in unlevered asset values.

The CRE market has experienced a gradual recovery in asset pricing since then. The prospect of quantitative easing (QE) induced inflation and the opportunity to buy assets for significantly less than the cost to construct them have attracted investors. CRE property values are generally up over 30% since the trough, and in some cases are even higher than 2007's peak levels. However, the recovery has not been evenly distributed. For instance, large investors have generally gravitated toward the perceived safety and liquidity of core assets. One result has been a wider-than-usual yield gap between major and non-major markets. So despite the duration of the recovery, there continues to be dislocation in the CRE market that astute investors can capitalize on.

Q: What's been driving this CRE recovery? Has the market primarily been the beneficiary of lower interest rates?

Chen: There's no question that US monetary policy has helped property values. Lower interest rates make CRE assets appear attractive given the strong current yield component and cheap financing available. This has particularly been true for assets with predictable income streams, so-called stabilized properties. An investor could generate a 10%–11% current yield by purchasing a property at a 7% capitalization rate and financing half the cost at 3%.

Other important and interrelated factors have contributed to the CRE recovery as well. The economic outlook is generally improving, and commercial real estate fundamentals have stabilized and are on the upswing. The ability to obtain construction financing has been limited, reducing the amount of new supply for tenants. That means less demand growth is needed to boost rental income. Investors can (i) buy assets below replacement cost, (ii) attain cheap financing to generate high current cash flow and (iii) underwrite for future rent growth. These circumstances have made CRE a pretty attractive asset class for investors.
< Previous
No positions in stocks mentioned.
Featured Videos