Real Estate Forum - September 2011

Adding to the challenges facing the continued recovery of CRE markets is the massive overhang of maturing CRE loans created by “extend and pretend” loan extensions by banks and other lenders. There are approximately $850 billion of commercial mortgages and construction loans coming due this year, of which approximately $450 billion (55%) are extended loans, according to the CoStar Group. CoStar also estimates that 25–50% of these loans have balances exceeding the value of the properties securing them, setting the stage for a wave of refinancing, restructuring, and potential liquidations. The great majority of these loans are held by banks, many of which are small regional and community banks already under pressure by bank examiners to strengthen their balance sheets. Approximately 90 billion (12%) of the total is maturing CMBS.

Two things should help mitigate the impact of the expected avalanche of maturing loans. The 10 year treasury rate is at historic lows, having fallen from a high of 3.77% earlier this year to around 2.10%. This should help curb the cost of refinancing maturing loans. Furthermore, CoStar reports that real estate investment trusts (REITs) and private equity funds have raised $66.4 billion of new capital during the first half of the year, paving the way for new acquisitions and the refinancing of CRE debt. Currently, 441 private equity funds are raising real estate funds, which are 63 more than a year ago and almost twice their number in 2008 (London researcher Preqin Ltd). The investment of these funds should help support CRE markets during the second half and in 2012, as the industry works through the massive amount of debt coming due.

While CRE markets are expected to continue to recover in 2011, non-distressed transaction volume is likely to slow somewhat during the second half, due to limited conduit financing and weak economic recovery. While July CRE property sales were 13 billion the increase in the number of transactions versus last year was the lowest recorded since growth turned positive in December 2009.

CRE fundamentals are expected to continue to
stabilize and improve this year and next, as the
supply of new buildings coming on stream remains
at historic lows. New construction is at a standstill
due to weak demand and the lack of construction
financing. Sixty-three percent-of architects
responding to a recent survey by the American
Institute of Architects (AIA) reported that the lack of
construction financing stalled at least one project
during the past year. The AIA’s Architecture Billing
Index, considered a leading indicator of
construction activity for 9 to 12 months ahead, fell
to 47.6% in April. (A score below 50% indicates that
new construction is slowing or stalled.) With the
supply of new buildings limited, even a slow
economic recovery should help prevent CRE
fundamentals from declining further.

Demand for high-quality, well-located, stabilized properties is likely to continue to outstrip supply as investors seek low-risk, predictable returns. Cap rates for these types of properties are expected to remain low and perhaps tighten somewhat. At the other end of the quality spectrum, distressed asset funds are well positioned to buy distressed CRE as it becomes available. Properties located in secondary and tertiary markets with weak-quality tenants are likely to lose demand during the next six months, given investor aversion to risk and the lack of financing for these types of properties.

POSITIVE ABSORBTION KEEPS OFFICE RECOVERY ON TRACK The recovery in the office sector slowed somewhat during the second quarter as positive absorption dropped to 3. 7 million square feet, from 5. 5 million square feet in the first quarter. Still, the second quarter marked the third consecutive quarterly increase in occupied space following 11 quarterly decreases. Slowing economic growth has made businesses more cautious about leasing and space requirements, which is likely to slow office space absorption during the second half of the year.

Office vacancies were unchanged during the first half of 2011, at 17.5% and 0.1% higher than one year prior. Central business district (CBD) vacancies have trended down since the third quarter of 2010 and were at 14.5% in June. Suburban vacancies remain at more than 19%, and are flat with the third quarter of 2010. Reis Inc. reported that new office completions declined to 1. 8 million square feet in the second quarter, down from 3. 5 million square feet in the first quarter. This level of new office completions is the lowest since the late 1990s.