The very severity of the blows dealt to the US commercial real estate market by the credit crisis and the weak economy could lead to some of the best bargains in CRE investing in our lifetimes, says Michael Pralle

The bursting of the credit bubble led to a correction in the commercial real estate (CRE) market, as capitalisation rates shifted out to reflect reduced access to capital, the higher cost of debt and increased risk premiums.

Now, the weak US economy is causing deterioration in the fundamentals underpinning the sector, resulting in a second cycle of price correction. With capital values depreciating across all sectors and geographies, and transaction volumes down 70%, investors are left pondering the same questions: Where is the CRE market headed and when will it recover? Where will the opportunities lie? Where to go from here?

The key to the questions about where US CRE markets are headed and when they will recover lies in the real estate credit markets, which remain firmly shut. A precipitous decline in demand by investors for commercial mortgage backed securities (CMBS) paper has largely closed the securitisation markets. In the US, only $12.1bn (€8.9bn) of CMBS was issued through 3Q 2008, just 6% of the $215bn issued over the same period in 2007. The situation is compounded by just under $20bn of CMBS loans due for refinancing in 2009.

 Many of the traditional commercial lenders are cnstrained by impairments to their balance sheets. Third-quarter figures from the Federal Deposit Insurance Corporation (FDIC) show that troubled assets continue to mount at insured commercial banks and savings institutions. Nine FDIC-insured institutions failed in the quarter, the largest number since the third quarter of 1993, when 16 institutions went under.

Lenders with capacity are being sidelined by the volatility in the credit markets, making it difficult to price new loans. New loans on prime assets at low loan to value ratios (LTVs) of, for example, 50-60% may carry 300-500 basis point margins. This compares relatively unfavourably with yields on AAA CMBS paper at 20%, particularly when these spreads imply a further 30-40% decline in real estate prices.

As a result, borrowers are encountering refinancing risk as they are unable to refinance highly leveraged maturing debt. Where financing is available, they are facing sharply lower proceeds, higher margins and more stringent covenants. Further, as the recession bites deeper, fundamentals on the commercial side are being adversely affected by downward pressure on rents and rising vacancies.

Forecasters are now predicting that net operating income (NOI) growth might turn negative in the course of 2009, making it more difficult for borrowers to service their existing debt. In many cases 2006-07 vintage loans were predicated on NOI growth, so delinquency rates are expected to increase rapidly as these loans burn through their interest reserves.

Early on, the majority of real estate distress was in the residential sector - land, developments and condominium conversions - which suffered large impairments in value. Asset repricing has spread across all CRE sectors, especially in retail and hotels, which are particularly sensitive to a fall-off in consumer demand. Economic deterioration has also widened the problem from predominantly development assets to income-producing properties.

At the time this article was being written, US capitalisation rates are around 6.5%, still 200-250 bps below their long-term averages, and it is difficult to predict how much further they will rise. We expect cap rates to move closer to the 2002 levels, if not actually reach them, which would be a 150-200 bps reversion.

It is impossible to predict exactly the bottom of the market. However, we expect opportunities to begin emerging over the next six to 12 months. But timing one's CRE investments to produce significant return requires much the same skill as being able to catch a falling knife. While we expect a return to normally functioning credit and CRE markets to take another 18 to 24 months, the risk is that asset prices could decline even more should the recession be prolonged.
But it is not all negative for investors. The current troubles are so pervasive that opportunities will arise in every segment of the real estate market.With physical assets, opportunities lie in sales by distressed owners, particularly those who cannot secure refinancing at lower LTV levels or who must come up with cash quickly to meet their LTV or interest cover covenants. However, as operating incomes fall and borrowers default, more distressed properties will come to market through the foreclosure process.

While the physical real estate market has begun the process of repricing, there remains a considerable bid-ask spread. Equity investors have therefore been more active in the secondary debt market, where sellers have been under more distress. As the FDIC increases its activities, we expect to see more non-performing assets and, indeed whole ‘bad' banks, being brought to market. We see current opportunities in performing loans, which can be acquired at large discounts, driven by lack of liquidity rather than deterioration in cash flow of the underlying real estate collateral.

Many holders of debt or mortgage-backed securities face strong selling pressures. Money managers, hedge funds and SIVs (structured investment vehicles) have faced massive redemptions and margin calls caused by mark-to-market requirements. Institutional investors became overly allocated to real estate as the overall value of their portfolios fell faster than the real estate component.

While CMBS securities are more marketable than the real estate that underlies them, many investors are finding that the current CMBS market is shallow and illiquid. Although the pricing of the paper reflects this, it does set a visible price benchmark for other asset classes.

Such a substantial yield gap between CMBS and capitalisation rates suggests that investors should be considering investing in CMBS paper rather than physical real estate assets, at least until capitalisation rates move out.

Mortgage REITs have been the most adversely affected and, since October, equity REITs have also undergone a massive correction. REIT indices are currently down 70% from their all-time highs. Under normal circumstances, REIT pricing would reflect the underlying property and sector fundamentals. However, the current market is being driven by liquidity, or perceptions about future liquidity.

The largest declines have been in trusts perceived as having liquidity issues with significant debt maturing in the near term. Trusts with lower risk profiles should be strong relative performers. Particularly attractive are those trusts with low exposure to leasing risk, such as triple net lease REITs or those in stable sectors such as healthcare. Investors should also target those trust and sectors with limited development exposure to reduce financing risk.

Real estate private equity funds have always offered investors a trade-off between superior returns and liquidity. With limited partners facing allocation issues, and a need to meet liabilities, the secondary market is expected to flourish, with anecdotal evidence of trade discounts of 40-50%. While the performance of the underlying investments will likely have deteriorated, pricing, as with real estate debt, is driven more by liquidity rather than by asset performance - at least for now.

It is no exaggeration to say that the situation in the US CRE market is unprecedented, as we have never experienced such quick and massive deleveraging. That said, the resulting dramatic asset repricing will present some of the best bargains in CRE investing during our lifetimes.

In this environment, investors should be looking to establish partnerships with long-term players that have been through previous real estate cycles, display expertise in the debt and equity spheres and can unlock value in dislocated markets. It also makes sense to be prepared early for expected opportunities as the increased pace of this downturn, compared with previous down cycles, makes us believe that the CRE recovery - when it comes - could occur just as quickly.

Michael Pralle is the president, chief operating officer and chief investment officer of JE Robert Companies