CRE Prices

Apr 30, 2010

CRE Prices

Back to 2004

By: Jay Cox

While it has been widely assumed that the bulk of the damage from the devaluation of commercial real estate would hit properties purchased at the peak of the market in 2006 and 2007, Wall Street is now worrying about the deals completed in 2005 and earlier. If its concerns are right, tens of billions of more dollars in commercial mortgage-backed securities are at risk of credit downgrades; and future property transactions and loan reviews are subject to greater scrutiny from investors and banks.

According to analysts, today's average cap rates are now higher than they were in 2004 and the average price per square foot or per unit being paid today are either at or less than 2004 price levels.

Office properties are approaching the average price paid in 2004 ($168.05 now vs. $164.02 then);
Industrial properties are already 13% less than the average paid in 2004 ($70.66 vs. $80.90);
Shopping center properties are 23% less than the average paid in 2004 ($83.79 vs. $108.71); and
Multifamily properties are 19% less than the average price per unit paid in 2004 ($70,352 vs. $86,487).

Today's average property sale prices are now 22% off their peak in 2007 for industrial property, 29% for multifamily and shopping center properties and 31% for office buildings. And the projection is that commercial real estate values likely face further pricing pressure.

Forecasts predict that the emerging trends for 2010 are hardly encouraging for the industry, with rents and values continuing to plummet across virtually every commercial real estate sector, with little prospect for near-term improvement. About the only good news is that the market is either now hitting or will hit bottom next year, bringing a riot of loan workouts, write downs, defaults and foreclosures - along with a rush by savvy, cash-rich investors, who, with impeccable timing, will be able to take advantage of very attractive buying opportunities at bottom-of-the-cycle prices.

Bond rating agency Fitch Ratings said it expects that real estate fundamentals will continue to deteriorate over the next 18 to 24 months, even as a recovery begins in the broader economy. That deterioration is likely to cause rating downgrades for seasoned U.S. CMBS deals.

Fitch plans to close out 2009 with a thorough review of its rated portfolio of older U.S. CMBS deals (originated in and before 2006). Large loan floaters, pre-2000 vintage CMBS, and deals originated in the latter half of 2005 will be most susceptible to downgrades. It should be noted that the magnitude of these expected negative rating actions will not be as significant as that of recent actions already taken on later vintages.

While Fitch expects these older vintage transactions to perform better from a ratings standpoint, it is now evident that all CMBS vintages are susceptible to the severe economic conditions of the past two years.

Fitch's third-quarter review of 2006-2008 CMBS deals, which concluded earlier this month, resulted in rating affirmations on 80% by balance (totaling $186.1 billion), and downgrades for the remaining 20% ($44.3 billion). Fitch expects few additional near-term negative rating actions among these 78 deals.

Fitch currently has $10.8 billion from pre-2006 vintage fixed-rate transactions and $3.3 billion of the $30 billion of outstanding large loan floating-rate transactions on ratings watch negative. The ratings company expects that operating cash flows will continue to weaken across all sectors.

While the economy has recently shown some positive momentum, Fitch recently reported it does not expect that this momentum will translate into near-term stabilization for commercial real estate. Fitch's current outlook on every major property type is negative.

The hotel sector has demonstrated the most volatility due to the daily resetting of rates and the discretionary nature of the operating business. Demand from both leisure and business travelers remains low. With travel concentrated at hotels with lower price points, the luxury segment has faced the greatest declines. Across the larger markets, revenue per available room (RevPar) has declined approximately 20% during the past year. Analysts think that the largest market value declines, of up to 50%, will occur in the hotel sector.

Though delinquencies remain low, the office sector will see stress in the coming months, asunemployment climbs through the coming year and longer term leases come up for renewal.

Vacancies have reached 15% nationwide and are expected to rise higher in the coming year. Though larger central business district markets continue to outperform suburban markets, landlords are facing a swift decline in base rents, significant concessions, and vacant sublet space, now that tenants have gained the upper hand.

The retail sector continues to struggle due to cautious consumer spending, increased vacancies, and limited store openings, which have pressured rents. Owners are struggling with vacant big box spaces, as retailers across the country review their lease agreements for co-tenancy clause rent reductions or rights to terminate.

Rising unemployment continues to affect multifamily loans, which have the second highest rate of delinquency. Vacancy has risen to over 8% nationwide and is expected to reach 10% by next year. Falling rents won't rebound until the supply overhang and shadow space are absorbed.

Fitch reported that it anticipates CMBS delinquencies will hit 6% by first-quarter of next year and double digits by 2012.