NREI – With approximately $700 billion worth of loans coming due on distressed properties over the next four years, transaction activity in commercial real estate is picking up this year, albeit slowly, and is expected to intensify in 2011 and 2012.

Investment capital that had been waiting on the sidelines from mid-2008 and the first quarter of this year is getting back into the game as confidence returns in the form of the market’s stabilizing fundamentals.

“For example, life insurance companies, a traditional source of capital, are back in the market,” says Craig Butchenhart, the president and director of capital services for NorthMarq Capital, a national firm that offers commercial real estate investment banking. “And as more traditional sources come back to the market, there will be available capital to access.”

Many of the loans originated in 2006 and 2007 — the height of the commercial real estate boom — come due in 2011 and 2012. Morningstar, an investment resource specializing in fund investing, believes that will create an environment that fosters asset sales more aggressively than in 2010. To date, 2010 has produced better opportunities for refinancing than outright asset sales.

“Most institutions that we deal with believe that values are fairly stable now,” Butchenhart says. “Confidence that fundamentals are stabilizing and not deteriorating further is bringing these institutions back to the market.”

Of course, available capital is just one aspect of the picture. Financial institutions are lending again, but underwriting requirements remain conservative as stronger cash flows continue to be required as well as longer leases, and the ability of the borrower to pay back its loan.


One surprise that may generate more transaction activity in the near future is the return of the commercial mortgage-backed securities (CMBS) market. Many analysts hadn’t expected the CMBS market to turn around this early after it was considered dead for nearly two years during the recession. Since then, few CMBS-backed deals have occurred as investors and issuers, aware of the creditworthiness risks involved, painstakingly do their homework on these securities.

In June, JP Morgan Chase Commercial Mortgage Securities Corp. issued a $716.3 million CMBS-backed bond, primarily consisting of retail properties, in the second such deal this year.

“There’s a little life in the CMBS market,” Butchenhart says.

There’s significant maturity in the CMBS loan pipeline, and most of those maturing CMBS loans are being refinanced due to low interest rates as they are maturing at rates higher than the current interest rates. If they can’t be refinanced, the CMBS loans are being modified or extended for a period of time as the borrowers await capital.

“As long as those properties have maintained a reasonable amount of leasing, loans can be refinanced,” Butchenhart says.

Capital markets continue to struggle, with a slowdown in investment sales and purchasers remaining on the sidelines. It is expected that demand will remain weak as long as companies continue to reduce expenses and shed employees. To make matters worse for property owners, many companies—owing largely to heavy and sustained job losses—are carrying excess space, which will need to be absorbed before new space demand can take hold.

Capital markets

The key story in capital markets currently is the steady increase in troubled commercial assets. General Growth Properties filing for Chapter 11 reflects the challenge to secure new or renew existing financing. According to Real Capital Analytics (RCA), distressed assets continued to increase in February to US$49.2 billion, comprising 2,293 properties, with US$5.7 billion of troubled assets that fell into default, foreclosure or bankruptcy, signaling possibly more trouble on the horizon. The ratio of offerings to closings remains high at five to one, resulting in further downward pressure in prices. As a result, cap rates will likely continue to increase. Cap rates for office alone are up 25 to 50 basis points since December overall, according to RCA, and are up even more for certain asset classes and locations. The increases in cap rates have moved the fastest and highest in the sec- ondary and tertiary markets. The biggest challenge for purchasers and sellers is how to determine value in a falling market—whether based on cap rate, yields, bor- rowing costs or the expected disposition price in three to five years, depending on the purchaser’s objectives. The limited activity also stems from the continued pricing expectation gap between purchasers and owners. Although this gap has narrowed compared with the beginning of the year, the lack of available financing continues to inhibit sales.

Office

The national office vacancy rate increased by 80 basis points from 14.7% at year-end 2008 to 15.5% in the first quarter. The decline corresponds to a 25 million-sq.-ft. decline in net absorption. The biggest increases in vacancy were in San Antonio (up by 320 basis points) and San Jose (up by 270 basis points). Job losses continued to reduce the demand for office space nationwide. The amount of sublease space on the market now accounts for 11.5% of all vacant space—a rise of 55 basis points. The net increase in sublet space occurred in downtown markets, as suburban sublet space actually decreased. It should be noted that the decrease in suburban sub- lease space had more to do with sublet terms expiring than an increase in demand. The overall vacancy rate continued to climb, with the national suburban office vacancy rate increasing by 90 basis points to 17.1% overall, and the downtown vacancy rate increasing by 70 basis points to 12.3% in the first quarter.

Industrial

The national U.S. industrial availability rate increased by 100 basis points from year-end 2008 to 11.5% in first- quarter 2009, due to falling demand and a few new completions. As a result, net absorption fell to negative 36 million sq. ft. Among the top ten industrial markets, the biggest increases in availability were in Atlanta, rising 470 basis points to 16.5%, and Philadelphia, up 150 basis points to 13.7%. The highest availability rates remain in Austin, at 22.0%, and Stamford, at 21.4%. Rental rates continued to fall, but the range was different depending on the market. The Institute for Supply Management (ISM) non-manufacturing survey decreased to 40.8 in March from 41.6 in February. The March ISM manufacturing index, released earlier this week, showed a modest increase. This rein- forces the further weaknesses in the industrial sector.

Multi-family housing

Demand for U.S. rental apartments remained weak in the first quarter of 2009, amid sharp job losses and a glut of vacant single-family homes and condominiums for sale and for rent. The good news is that multi-housing completions are tapering off, falling to an annualized pace of 242,000 units, 50,000 below year-ago levels. Apartment rents and revenues will still be negatively affected by rising unemployment and vacancy rates in the near term, and it will take further major declines in new supply before the market can stabilize and fundamentals turn positive.

Retail

U.S. consumer confidence increased an astonishing 12.3 points to 39.2 in April, after hitting its lowest level in February, according to the Conference Board. Given the Federal government’s various stimulus measures, we may see confidence increase in the coming months. Retail sales will likely continue to waver over the next few months, especially if the predicted job losses continue. Consumers for the most part will continue to focus on necessity items and defer big-ticket purchases. Many retailers will continue to struggle for the remainder of 2009, leading to more anxious moments for retail property owners and lenders.

Hotel

The hotel sector, perhaps the hardest hit in commercial real estate, is struggling with significant decreases in demand and an onslaught of new supply, resulting in lower occupancies and a loss of pricing power. Revenues per available room have declined approximately 18% year to date, with some segments and geographies experiencing declines in excess of 25%. Sector cash flows have taken a significant hit, given highly leveraged operating structures. U.S. transactions activity was down in excess of 80% for 2008 relative to 2007. Year-to-date activity is down compared to 2008; however, early signs of value capitulation are evident based on transaction activity. Further, special servicer and lender activity is increasing daily with an estimated quadrupling of loan defaults for the sector. This will likely cause more pressure to push cap rates upwards.