Just as a good thriller can bring an audience to the edge of its seat in anticipation of that pinnacle of dread, the anxiety has mounted in intensity this summer within commercial real estate markets waiting for that long-predicted moment of economic distress when it will all come crashing down.

The problem, if that's the right word, is that the market so far has not played out to a well-scripted ending. And while a jolt could still come, the end of this market drama could likely play out as more of a dud.

It's no secret why people in the business feel anxious. Even the National Association of Realtors (NAR), which has been an energetic cheerleader for the economy - and just as incredulous in many ways - is now saying the softening of economic conditions in recent months should impact commercial real estate markets in the months ahead.

Lawrence Yun, NAR chief economist, said commercial real estate activity is projected to weaken over the next six to nine months, as measured by net absorption and the completion of new commercial buildings.

"The pace of decline has intensified due to job cuts and very sluggish economic activity since the beginning of the year, particularly in those industries requiring commercial building spaces," he said. "We anticipate the weakest commercial brokerage activity in nearly three years as a result."

"The U.S. commercial real estate market continues to have an uneasy 'Waiting for Godot' feeling about it," wrote Philip Conner, principal U.S. Office of Prudential Real Estate Investors (PREI) in Parsippany, NJ, in a new report this month titled "Waiting for Distress."

"With the credit market troubles still hampering the orderly flow of capital and growing uncertainty about the near-term outlook for the economy, bid-ask spreads have widened as activity throughout the commercial real estate market, from lending to leasing to transactions, has slowed to a crawl," Conner wrote. "Though signs of distress remain largely confined to highly leveraged deals consummated at the peak of the investment cycle, in late 2006 and early 2007, there is an undeniable and growing sense of anticipation among investors that U.S. commercial property values are poised to fall and that widespread distress is just around the corner."

From a personal perspective, it's hard to ignore the Down Under diggery doo sound from the media, economists and financial bloggers. At the same time, there has been no single triggering event that would appear to throw the commercial real estate industry into a tailspin.

With the residential markets, the collapse of subprime market was the triggering event that wiped out a huge chunk of the buying market. The deterioration in value of those loans then prompted the credit market crunch. And those events have clearly spilled over into a slowdown in commercial transactions, but not with severity.

In drama, the adage is that if a gun or other weapon is introduced in the first act, then someone will be killed in the third act. But as the commercial markets have played out this summer, if there is a weapon in the picture, it remains hidden. If there is a killer, it hasn't emerged.

Commercial real estate fundamentals have continued to hold up this year. Conner of PREI only set up the overriding tone of the industry, but he also sees countering trends.

"While today's low cap rates make it fairly easy to arrive at some sobering estimates for how far asset values can fall in the near term, it remains to be seen what kind of role distress will play over the next year or two," Conner wrote.

"Property values already appear to have fallen 10% or more from the pricing at the peak of the market, and they may continue to decline over the near term." he continued. "But with property market fundamentals still relatively balanced, a modest supply pipeline, soaring construction costs, and a wall of capital waiting in the wings, prospective investors anticipating a repeat of the capital-starved distress in the early 1990s and the deeply discounted transaction market it produced may be disappointed."

Then going back to his reference to the Samuel Beckett play, Conner noted that Godot never appears onstage.

"His off-stage presence, whether real or imagined, and his expected arrival largely dictate what does and does not happen in the play," Conner wrote. "To be sure, more distress will surface in the transaction market before the credit market normalizes, and the combination of higher capital costs and lower rent growth will depress asset values in the near term. Though it's hard to generalize, it would not be surprising if property values decline 15% to 20%, on average, from peak-to-trough before values stabilize, which, if property values are already down by 10%, would mean that the correction is about halfway done, if not more. But most of the distress - and opportunities for investors - should remain "offstage" in the capital markets."

Looking at Some Fundamentals

U.S. CMBS delinquencies have moved up this summer, according to the latest Fitch Ratings Loan Delinquency Index. However, the delinquencies are not widespread.

Small balance loans of from $150,000 to $15 million make up 10.8% of all delinquencies. Only 0.38% o the larger CMBS loans that make up the bulk of CMBS deals are experiencing, according to Fitch.

Also, Fitch has noted that a high concentration of delinquencies correspond to transactions issued in 1998, many of which contain a large percentage of loans with 10-year terms. In July, approximately 10% of all delinquent loans were classified as non-performing matured.

Standard & Poor's in August S&P/GRA Commercial Real Estate Indices reported a +3.6% uptick in commercial property prices in May compared to a year earlier.

The numbers offer some encouragement, said David Blitzer, managing director and chairman of the Index Committee at S&P.

"It will take a few more months of data to determine if commercial real estate is ending its two-year period of growth deceleration or is this just a temporary seasonal bounce," Blitzer said.

But he noted that only one U.S. region and two of the property sectors saw price declines. Everything else was positive.

Then Moody's Investor Services in its Commercial Property Price Indices reported in August that transaction volume, which had fallen in each of the first five months of the year, reversed that trend in June.

Moody's did add that it was too early to tell whether the June uptick was the first sign of stabilizing transaction volumes - and thus a predictor of future price stabilization.

However, Moody's noted that the 10 largest U.S. cities in each property type are performing better than the nation as a whole, with milder price declines, and a smaller drop-off in transaction volume.

"Unlike prior cyclical downturns, commercial real estate fundamentals remain relatively strong going into this downturn. Despite this strength, commercial real estate is viewed as a lagging economic indicator and is subject to the effects of the broader economy. There is growing concern about where commercial property net operating income might be trending given general economic conditions," said Jeffrey D. DeBoer, president and CEO of the Real Estate Roundtable, a lobbying group in Washington, DC. "Real estate continues to face one of its biggest liquidity challenges in over a decade. Even though loan delinquencies to the sector are very low, the ongoing lack of credit for real estate has led to weaker property values and has stalled transactions."

"Despite current challenges, we remain encouraged by U.S. real estate markets' historical resilience," DeBoer added.

The TIAA Real Estate Account, with $17.1 billion in commercial real estate assets, also noted the discrepancy between expectation and reality in its second quarter economic and commercial real estate overview.

"Management believes that the full economic effect of the recent economic deterioration has yet to fully impact commercial real estate markets and, as economic conditions are likely to weaken further, commercial real estate market fundamentals should reflect a mild decline in the near term," the TIAA fund reported.

"At the same time," it continued, "current commercial real estate fundamentals have, for the most part, only been marginally affected, and therefore suggest a capacity to weather these pressures. While further erosion in employment would dilute the demand for space, the effects may be mitigated by the modest flow of new construction due for delivery over the year ahead."

TIAA said that while commercial real estate fundamentals may be well positioned to weather current economic conditions, it is expected that these fundamentals will continue to weaken through 2008 into 2009.

It added that the quality of commercial mortgage credit is holding up well with delinquency rates remaining very low and distressed sales of commercial property are not, at this point, very prevalent. However, TIAA also said it believes that before commercial real estate market conditions begin to improve, fundamentals in the near term will continue to soften.

And while that just doesn't make for a very dramatic ending, in this case I don't think the audience would be too upset.

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Reader Comments

The Perils of Pauline
In 2004-2006, I saw many many CRE TIC offerings with 5 & 10-year IO, 80%+LTV terms. I cautioned my customers to avoid them like the plague. Not only were the TICs acquired at record-low CAP rates but the TIC sponsor fees effectively even lowered those rates. It only took a little "back of the napkin" calculation to indicate what would happen to the owner's value and cash-on-cash returns should cap rates return to historical norms, interest rates return to historical norms and for underwriting to reestablish it's primacy over the trading desks. The numbers were never pretty!

Admittedly not all TICs were so 'constructed' but enough were to know that if those terms were available to TIC deals then it was likely those terms were pretty widespread throughout the CRE credit market. As some other commentators have noted, as these loans mature over the next five years or so, refinancing is likely to be challenging and where it's not possible then a 'distressed' sale is the likely recourse. More distressed sales mean higher CAP rates meaning more sales, a far from salutary spiral.

To offset this kind of scenario, the NOI's must improve. With costs rising due to inflation, for NOI to increase rents must increase, perhaps substantially - is that possible? Well, with increased population and stable employment percentages (say, 94-96%), and credit markets effectively dampening new construction, there is a possibility we could see healthy enough rental increases, at least in some property types.

We are going to be living with this sword over our heads though for a number of years and this uncertainty will create a lot of volatility and subsequent wealth transfer. Rather than "Waiting for Godot" the better analogy might be "The Perils of Pauline." I like the ending better, after all she always ends up safely in her man's arms.

Kevin Murphy
Principal
The BridgeTown Group
Jacksonville, FL

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The Killer Isn't Readily Apparent
While a highly leveraged 5% interest only loan does not represent the majority of the loans that were originated in 2006 and 2007, these loans best describe the current phenomenon. Under this loan scenario, its not hard for most assets to generate sufficient cash flow to service the mortgage, and so from the lender's standpoint, everything is fine, it's a solid performing loan, and will probably stay a performing loan notwithstanding the current economic turmoil.

In my opinion, the real risk is at maturity, when the borrower want to refinance and discovers that a) he can't satisfy a 70% loan to value requirement , nor b) a 1.25 debt coverage ratio, or c) the higher quoted interest rate, and lastly, d) an increased cap rate has reduced property valuations.

You can observe some of this phenomenon in your delinquency lists, there are always a few borrowers who have run past their maturity date who I suspect are having trouble finding a capital source to refinance their asset, likewise, as you have also pointed out, a number of capital sources have formed mezzanine lending groups who are I think targeting these borrowers.

A borrower, in today's environment, has a choice, write a big check and refi, or bring in a mezzanine lender and give up some of the equity, and I think that is what is happening currently and also why it is not so readily apparent.

David Sydney
Managing partner for Real Estate Investments
Granite Capital, Inc.
Dallas, TX

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It May Not Be Pretty
Reader Lane Jorgensen of MG Properties, San Diego, has got it right.

I think of all the comments posted thus far, it is the comment of reader Lane Jorgensen (MG Properties, Inc.), dubbed "Prolonged Stagnation" that correctly and appropriately makes the link between project financing and the rumbling of predicaments that is only now beginning to impact commercial real estate owners and buyers. He provides credible insight in linking the "thriller" aspects of the current credit crisis, which has and is creating fundamental upheaval in our economy, to what lies ahead in commercial real estate.

Mr. Jorgensen is right-on in predicting that because of the structure of existing commercial real estate loans (lots of them!), there will be problems for commercial real estate owners at the point of loan maturity and refinance. He notes that these problems are likely to emerge over the next few years because maturity dates and changes in LTV limits, debt coverage ratios, guarantees, i.e. lender recourse, etc.

He notes that while default rates are currently low, as rent revenues are currently adequate to cover debt service, especially on an interest only basis, this may change when the loan terms change. It is a very interesting question to ponder, how many of these currently performing properties would fare as well if their loan were maturing and they had to refinance at current market rates and terms?

Will there continue to be buyers and sellers? Of course. Will it be pretty? I guess it will depend upon whom you represent in the transaction.

I suggest that all who are seriously interested read carefully what Lane Jorgensen has written in his post, in particular think about his comment, "The potential multi-year duration wave of maturity date forced sales and defaults have the potential to prolong the value stagnation even if we find the value floor relatively quickly." Makes sense to me.

Roger H. Potthoff
APR Strategies
Tigard, OR

(See Jorgensen's comments below).

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When Will Sellers Get Motivated?
In our market we have seen office transactions come to a complete halt. In the last 3-4 months the few deals we have seen come to market have all been pulled as seller's are still clinging to their 2007 appraisals. But as others have commented, this cycle is different in its dearth of new construction and construction costs.

Also, we have seen our best institutional equity sources - almost without exception - move to the sidelines. I recently bid an opportunity office deal to yield a 20% IRR for a 3-year hold and found no takers for the senior equity. Interestingly, despite what we hear in the media, the debt was not an issue, albeit at 65% LTC and spreads of T + 250-350bp.

The question is whether sellers will get motivated and sell for the best offer (i.e., whether cap rates will rise) or will they hunker down and wait until 2009-2010 for improvement in the markets. My sense is that the 7 cap days are over for the foreseeable future.

Michael Louis DiFede
Director of Acquisitions
Bergman Real Estate Group
Iselin, NJ

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The Big Thud is coming
I must say that in my opinion the article has not portrayed reality, and what I am surprised about, and you did mention this in the article, is that commercial real estate is a lagging economic indicator, and you being with a data provider should be well aware of this fact. All indicators say fasten your seatbelts.

The fundamentals are of course still looking OK sort of. They will begin to deteriorate over the next 6-9 months. Subleases are once again increasing. We/you know that subleases put downward pressure on overall rental rates. Companies are not expanding and layoffs have begun.

The credit situation if it was isolated to just real estate would be workable to some extent; however, the entire credit universe has been negatively impacted. If the United States economy's is reliant on consumer spending which is responsible for 2/3 of the total GDP, then how in the world can corporate America withstand this kind of squeeze. The answer, it can't. Corporate decisions don't get made usually until two quarters worth of company results are in.

Commercial real estate is extremely sensitive to financing, even leasing, so I will ask the question of how building owners will fare when vacancies begin to rise in earnest. Those multiple billions of investment purchases bought in the last three years don't need a tremendous amount of vacancy to wind up under water. Many bought at the thinnest margins in a generation with unrealistic "pro-forma" income models will now be in major trouble.

Trust me, the big thud is coming.

Bob Canter
President/Founder
Performance Realty Solutions, LLC
North Potomac, MD

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Collapse of Credit
I gather you're referring to that great cataclysmic shock that actually "brands" the period that one is in, such as the bankruptcy of Canary Wharf as the icon for the '91 collapse. Some might contend that it already has happened. I have a friend at Moody's who, several months ago, was on a panel and had to talk about such a subject. I reminded her to think of the TV commercial --------------"Remember the O's" (for Overstock.com). I reminded her of MacklOwe and CentrO (one being the disaster of a privately held firm, the other being the poster child for a publicly held firm). Notwithstanding other catastrophes, which are yet to inevitably come, these are two perfect examples of the collapse of credit availability.

Marty Schiffman
Managing Director
Carl Marks & Co. Inc.
New York, NY

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Talking Ourselves into a Problem
I completely agree with your assessment. I have been in the CRE lending business for nearly 20-years and I think that we are "talking" ourselves into a problem. The real "tragedy" of this "movie" is that the residential lenders never bothered to learn from us commercial lenders. 20-years ago (during the last banking crisis), CRE was to blame for doing unrealistic and over-aggressive loans. Since then our underwriting has NOT changed, with max-LTV's of 75%, 1.25x DCR's, etc. This conservative approach should carry the CRE business through these difficult times.

Yes, consumers are cutting back and feeling less "wealthy" due to falling home prices, lack of available consumer credit, and higher gas/food prices. But, there would also have to be a much larger increase in job losses to coincide with a significant pullback and that has yet to materialize. During the last major downturn of the late 1980s and early 1990s, unemployment was well over 8-9%. We are not there yet.

Lastly, I also agree with several of your quotes from other professionals about the "wall of money" sitting on the sidelines, they all seem to think (in mass) that the old RTC/REO days are going to return and that they are going to be able to buy CRE projects again for pennies on the dollar. I do not see that happening. Again, if you look at the 1980/90s crash, there were over 200 bank failures, per year. So far in 2008, there has been only nine. Therefore, I think something (probably the election) will "shock" the market back into reality and money will come pouring back into the market like a "biblical" flood before CRE investors realize that either their tax rates or interest-rates will be going up under a new presidential administration and Congress in 2009.

Mark D. Hunton
VP, Commercial Loan Officer
Community Bank of Arizona
Phoenix, AZ

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The View from the Auction Trenches
We are seeing consistent interest and participation for sales of commercial properties. As other readers have commented, money is still available and buyers who had pulled back during market expansion are once again re-entering the marketplace. However, for all but A-class property, buyers are aggressively seeking "bargains" and their economic analysis has become downright conservative. Cash buyers feel they are in the drivers seat and are negotiating appropriately. In our industry the general consensus is that the large volume deal flow we are currently experiencing will continue unabated for at least another 12 months and possibly longer - our workout clients are "overwhelmed" with the amount of files on their desk and it will take lenders months to sort through what is there now.

Michael B. Carey
National Account Coordinator
Tranzon Auction Properties
Portland, ME

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Prolonged Stagnation
A financing risk often overlooked is the inability to refinance at loan maturity due to increased interest rates, changes in underwriting standards or terms, and limits on loan-to-value ratios. The accumulation of high asset appreciation rates during the period 1997 to 2007 first from net operating income gains and then cap rate compression was inked onto a tremendous volume of acquisition and refinance activity that occurred in the last few years of that cycle.

When short- and medium-term loans that were originated in 2004, 2005, 2006 and 2007 on those high asset values start to mature, owners are likely to find higher interest rates, more stringent debt coverage tests on amortizing payments, and loan-to-value (LTV) ceilings such that they will not be able to size enough refinance proceeds to pay off the existing loan and therefore be forced to either sell prior to the maturity date or raise new equity to refinance. Even though not over leveraged today on debt service coverage, many assets are over leveraged for the capital markets of tomorrow.

Most owners can still pay their debt service today, frequently interest only, because operations are good enough in most markets. Default rates on pooled, traunched, and securitized commercial loans are indeed still low, though on the rise. So, we are not going to purge the system of over leveraged assets quickly, as we did with the RTC when loans and assets were in whole chunks. The potential multi-year duration wave of maturity date forced sales and defaults has the potential to prolong the value stagnation even if we find the value floor relatively quickly.

Lane Jorgensen
MG Properties, Inc.
San Diego, Ca

(See related comment It May Not Be Pretty above).

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No Steep Dropoff
Thank you for a nicely balanced article offering broad perspectives and a good blend of angst and realism. Commercial values will not drop like residential values because most commercial owners have deeper pockets, because of the huge volume of investment capital ready to step in when prices begin to fall, because deal volume and velocity is lower resulting in a smoother cycle, and because higher market transparency and tighter credit is limiting new construction.

Steve Collins
Commercial Development Company
St. Louis, MO

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Don't Discount the Elections
In Los Angeles, the market was stagnating in the early part of the summer, due to the subprime fallout. Now, investors are looking for deals from motivated sellers, yet sellers are reluctant to drop their prices, harkening back to the strength of the 2004-2007 marketplace. A market condition that doesn't get acknowledgement is the fact that it's an election year, and trends show that the market softens before an election. Clues indicate that we won't see strengthening in the marketplace until after the election.

Jodi Summers
Sotheby's International Realty
Los Angeles, CA

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Still Tenants and Buyers in the Market
We are whipsawed by our mindset and that of our clients. During "good times" the impetus is to move forward with deals, during the credit crunch, sub prime crisis and oilflation people have more objections to overcome making the selling process harder and longer (surprise - you have to be a salesperson not an order taker!).

The good news is that there are still plenty of interested tenants and buyers. During real bad times those leads dry up. The problem is that in the past you worked on 100 deals at a time to close 10. Today with all the "maybe" clients and their objections, you have to work on 150 to get to those 10 closed deals. Good sales skills and efficiency will get us through the market. When the post election fog raises, we'll be off and running again!

Don Zech
CDC Commercial
San Diego, CA

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Near the Bottom
I think the office market is healthy by and large because we have been in a long recovery since 2001. Counter to other cycles where supply gets built up during strong economic times, the lenders were pretty conservative on the new construction side. Most projects required significant preleasing, so it was a sector that stayed in balance.

This is the first economic slow down that I've seen where vacancies are down over all. So as an asset class I would say it's a pretty safe place to be.

The replacement cost issue is becoming a big factor today. A new office building is to a great extent 60% above sale prices, so I think we will see rate growth even as we move through this recovery.

It's the front end of the game that's so difficult right now. Construction costs and loan-to-value ratios have narrowed the field of developers out there building office buildings, so even though vacancies in our market are down in a range where most would be building, the number of players is limited to those with capital.

I see confidence in the business community that is just not reflected on the financial pages, our clients are adding staff and taking on new space.

I think sublease levels are a great place to look in terms of the overall health of a markets business environment although there are aberrations such as large companies moving out of leased space into owner occupied buildings. We haven't seen companies put sublease space on the market here to any significant extent, so I think that's a sign of health.

I do think there are opportunities for us in the REO side coming up in 2010. Banks still have not written down the bad loans they've made to the level required to move properties off their REO and I think there are a number of smaller properties out there in our market that are upside down that are going to become a problem for banks as we work our way through this. I think we should be near the bottom by first quarter 2009.

Tim Schaffer
Red Brokerage
Kansas City, MO

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The Gun Is in Fact on the Table as is the Ammo
Fortunately, the gun is in a dis-assembled state and some fidgety actor is trying to read the instructions. For now the balance sheet lenders have been able to maintain capital, albeit expensive. The endogenous shock factor will be if the collective super and regional commercial banks need to wholesale assets for the sake of new capital formations. Since many have already played out other capital strategies, like dividend cuts, preferred issuances or sale of minority interests, for now, with just a few exceptions, one of the last arrows in the quiver, - the loan sale market - is muddling as well with the bid ask ratio keeping most opportunists on the sideline…

Charles A. Giska
Partner
Perimeter Properties
Dublin, OH


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It's the Same with Debt
A very interesting article on where we are going with values. I see the same thing with distressed commercial real estate loans. Lots of talk, some greater discounting, but not an avalanche and lots of money in the wings.

James H. Ross
Rossrock LLC
New York, NY