While many analysts had it pegged as the next big threat to the U.S. economic recovery, the commercial real estate (CRE) market is actually on the mend.
No doubt, fallout from bad loans will continue to pose challenges to banks for the next several years. But on the whole, commercial real estate seems to have finally found a bottom.
"Balance sheets are firming up, interest rates still are near historic lows and the fundamentals of commercial real estate are improving," Susan Wachter, a finance professor at the University of Pennsylvania's Wharton School in Philadelphia, told Bloomberg News.
Commercial real estate prices plunged for some two years as the financial crisis reached its apex, putting pressure on commercial mortgage-backed securities (CMBS) – many of which are held by the same institutional investors whose balance sheets were eviscerated by the collapse of the housing market.
However, banks last year made significant headway in whittling down the bad commercial real estate loans on their books. Banks had $126.2 billion in nonperforming CRE mortgages and construction loans in early 2010. But that number had fallen to $115.7 billion by September, helping to allay concerns that weakness in the commercial real estate market would trigger another financial meltdown.
"The large commercial property owners and major financiers are no longer fearful of a total meltdown in CMBS, so they have come out from under their beds," said Andrew Waite, publisher of the Personal Real Estate Investor.
Brightening market conditions already have helped several companies dependent upon the health of the commercial real estate market.
Jones Lang LaSalle Incorporated (NYSE: JLL), one of the world's largest real estate companies, last week reported a 62% increase in fourth-quarter profit. U.S. commercial property sales more than doubled to $134 billion, the strongest showing in three years, the company said.
Meanwhile, private equity firm Blackstone Group LP (NYSE: BX) said its real estate unit contributed to a 56% increase in its fourth-quarter earnings. For all of 2010, Blackstone said its real estate segment had revenue of $1 billion, compared to negative revenue of $13.6 million in 2009. The firm reported a fivefold increase in fourth-quarter profit, which climbed to $280.8 million.
Moody's Investors Service (NYSE: MCO) noted in its quarterly report last month that CRE markets were either stable or seeing modest improvements. Moody's scored 55% of U.S. markets with its middle "yellow" ranking, the same percentage as in the third quarter. But "red" markets dropped to 12% from 18%, and "green" markets rose to 33% from 27%.
"The commercial real estate markets are continuing down the road to recovery, though the fact that most markets remain yellow indicates that a comfortable point of stability has not yet been reached," said Moody's Vice President Keith Banhazl.
Even the U.S. Federal Reserve has breathed a sigh of relief.
"While we expect significant ongoing CRE-related problems, it appears that worst-case scenarios are becoming increasingly unlikely," Patrick Parkinson, director of banking supervision and regulation at the Fed, testified at a Congressional hearing Friday.
Parkinson noted that most of the banks struggling with bad commercial loans are small and medium sized with assets of $10 billion or less.
"We do not see CRE losses as a threat to systemically important financial institutions," he said.
Commercial real estate investors and developers have been encouraged by the low interest rates, a slowly healing economy and a gradual improvement in capital markets.
"Investors are seeing this as the bottom of the market, and seeing this as an opportunity to get back into commercial real estate more aggressively," said Hessam Nadji, senior vice president and managing director at Marcus & Millichap, in its most recent quarterly Real Estate Investment Outlook.
The Real Estate Investment Outlook's Investor Sentiment Index hit 152 in the fourth quarter, up from 119 in the third quarter and a low of 91 in 2009. The index measures investors' anticipated changes in property values as well as whether they expect to add to their holdings in the coming year. According to the survey, 69% of the respondents planned to add to their property portfolios in the year ahead.
The degree and speed of the recovery depends on the behavior of commercial banks, however.
"If we start to see commercial banks move back into the market and more willing to lend, that will be a big positive for commercial real estate," Nadji said.
Not all segments of the commercial real estate market are improving at an equal rate. Apartments and hotels are leading the recovery, owing their advantage to leases with far shorter terms than other property types. Apartment sales volume soared 96% year-over-year in 2010, according to Real Capital Analytics. Apartment vacancy rates have declined from 8% in 2009 to 7.1% in the third quarter of 2010.
And while vacancy rates for office space have been stuck at just under 18%, transaction volume doubled from November to December.
"Investors are beginning to anticipate a recovery in the leasing markets," Robert Bach, chief economist for national real estate brokerage services firm Grubb & Ellis, told National Real Estate Investor. "It's encouraging that we're heading in the right direction. The pickup seems to be real."
The retail segment hasn't fared as well, but could be poised for far more progress in 2011. Slightly more than half of the $52 billion worth of retail properties that were in default have completed workouts, the first CRE segment to get over 50% of its distressed properties resolved.
"The dark horse in this race could be retail," Nadji said. "Retail is actually recovering much faster than anyone anticipated."
Make no mistake, it will take financial institutions years to resolve all the nonperforming loans that piled up during the recession. But there's no question the CRE market is on the right track.
"Give a little credit to the strategy put forward by the government: keeping interest rates low and giving lenders some flexibility to hold these troubled assets on their books for a while,"Dan Fasulo, managing director at New York-based Real Capital, told Bloomberg. "Now that values are on the upswing, it's given owners and lenders more wiggle room to work out these troubled situations."
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