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Property Values Going in the Only Direction They Can Right Now: Down

But as Property Prices Come Down, The Cycle Will Turn and a New Group of Investors Will Come Along with an Old Set of Investment Criteria
September 17, 2008

Crisis On Wall Street, Impact On Main Street

by CoStar Senior News Editor Mark Heschmeyer


As tumultuous as Wall Street has been in the past two weeks, the historic events are not likely to have as nearly as dramatic impact on property values and investment sales, according to industry executives.

In light of extraordinary turmoil on Wall Street, CoStar Group contacted executives across the country this week to gauge what impact the historic events are likely to have on commercial real estate sales and values.

The people we contacted suggested that property prices had only one direction to go from historic highs, and that was down. Their decline has been slow and methodical compared to residential prices. The latest events only add to that model but that inevitable repricing also will set the stage for the next up in a constant cycle. What will be different will be the group of buyers and lenders.

In this story, we compile and condense what industry executives had to say about the short- and long-term impacts on the property investment sales market.

Niche Projects Will Lead the Way Back

Commercial values will continue to hold up better than single-family but the residential market will see bigger gains at some point than commercial from a value perspective but I will not be speculating as to when that happens.

Short-term, transactional velocity should pick up and the better bet from a value perspective is on niche projects catering to higher end users where price per square foot may shock but absorbency fears can be mitigated as the higher end consumer is still around, shopping, qualified, and motivated.

Bricks and mortar will always play a bigger value role in the long run than a house of cards built on bogus promises (except maybe in MI).

Cash will remain on sidelines until it makes sense for smart equity to wait it out and buy profitable pieces of the companies that fall prey to the current credit/liquidity environment?

Chuck Blessing, Jr.
Managing Director
Inter-Continental Group
Potomac, MD

Lehman Selloff Pressures Prices

I think if Lehman is forced to sell assets and mortgages this will put pressure on the value of the real estate. The bigger the deal, the harder it is to get funding and if you can get funding the leverage is less like 60% LTV. In order for investors to get the required yields, prices will need to fall.

Steven P. Miller
Jupiter Realty Group, Inc
Cincinnati, OH

Collateral Damage

The only positive light I can see is that we get to the inevitable asset re-pricing much quicker. (e.g. Lehman's toxic CRE positions are effectively marked down by the bankruptcy filing rather than a drawn out asset sale.) This will allow new money to enter and start to build a base from which we can move forward and attempt to build some form of a market / momentum. Unfortunately, the collapse creates a lot of collateral damage to many of the innocent bystanders.

Tom Aschmeyer
Match Properties
Atlanta, GA

Stagnating Deal Flow

The most immediate impact on commercial real estate markets will likely be further stagnation of both investment and leasing deal flow. Both investors and corporate real estate executives will turn to a "wait and see" strategy. Lehman, Merrill Lynch, AIG etc, will likely start to sell their commercial real estate assets to raise capital, which should increase investment supply and put downward pressure on selling prices.

Alex Kent
Managing Director
Symphonic Investments
Burlingame, CA

Why Sell?

Even if today's buyer expects a higher cap rate on Class A property, why would a self-respecting seller of the same class property, with a low risk, low LTV loan sell out at a huge discount? If they sell, what will they buy in exchange? This standstill gap between buyer and seller expectation will result in lower sales results.

Eddie Haddad
Great Bridge 1031
Las Vegas, NV

A Challenging 24 Months

What our firm (commercial real estate auctions) is seeing is the average commercial property is selling at a slightly better price (5%-10% on average) than six months ago. Our sales are all cash, so that market still sees that there is value in good deals; however our marginal buyer is gone.

Overall, our bank/servicer business is down due to unrealistic book value but the bankruptcy work has increased. The need for professional workouts of complicated deals is still needed.

It is going to be a challenging 24 months for all our businesses.

Ed Durnil
Senior Partner
Tranzon Asset Advisors
Elizabethtown, KY

Owner Landscape Changing

The difficulty in obtaining debt should lead to assets returning to fundamentals-based pricing. As unemployment and vacancy rise, rents will decrease, NOI will decrease and cap rates should increase. Well-capitalized owners will opportunistically expand portfolios and highly leveraged owners, especially publics, may be forced to sell. In five years the landscape of owners will be very different than it is today.

Matthew Ciriello
Assistant Vice President
Los Angeles, CA

Worsens the Problem

It seems apparent that for the short term, the private investor sector of the business will have trouble acquiring assets and making purchases. This is due to the banks not lending money for new projects and investments. Equity requirements on deals have increased to the point that it has become very difficult to underwrite the transactions.

This squeeze was occurring before Lehman, Merrill and AIG. This only worsens the problem.

Christopher J. Skibinski, SIOR
Managing Director
Jones Lang LaSalle
Charlotte, NC

Sleepless in Boston

In general, for the properties I review cash flow is strong EBIDAT. There is an underlying value to those flows, this is very different than 1990 when this was not always the case. All markets are based on confidence; for all real estate when people make money where they sleep, they view real estate as a sound investment. When they are losing money where they sleep, watch out.

Balance sheet buyers are looking at a lot of deals and they will have their pick of them for a while. Many participants are convinced that there is too much risk in real estate right now, however they are buying up loans at discount. I am aware of some very good "deals" being done by purchasers as originating institutions race to sell the paper which is liquid to raise cash for their reserve requirements.

John E. Ryder, Jr.
Senior Consultant
Marvin F. Poer and Company
Boston, MA

Prices Will Drop Precipitously

The impact from the Wall Street fallout will be far and wide. This upset will add to the already nervous investors, tenants and retailers as consumer confidence continues to slide south. Lenders have all but ceased making new loans for commercial deals as the warehousers of commercial paper disappear. Low leverage buyers for commercial assets will have the reign of the markets as sellers turn to "who can do the deal vs. who can pay the most." As a result, prices and cap rates will drop precipitously.

Paul L. Rogers
Senior Vice President
Inland Real Estate Auctions, Inc.
Oak Brook, IL

Some Equity All But Lost

With transactions down over 70% from the same quarter last year, prices have adjust on the seller's side as the days of underwriting at single-digit cap rates should be over (they never made sense in the first place). When banks are requiring more equity, why would anyone accept cap rates that are single-digit returns with the amount of risk they are taking on? This is on a pretax basis as well. Commercial real estate fundamentals are still strong, but I see a lot of sweat that is going to break out for those who bought at such high LTVs in '06. Their equity is all but lost in the current market.

John Tilley
Director of Real Estate
Jacmar Builders
Alhambra, CA

Will Reduce Prices, Will Reduce Buyers

The immediate impact is that cap rates will continue to decompress and at the same time vacancies will likely increase (with the exception of multifamily) and this will further devalue the properties. Moreover the continuing liquidity crisis will reduce the number of buyers capable of investing in commercial real estate, this will also contribute to sliding values.

Longer term, over the next four to five years, many of the transactions that were consummated during the peak will have their notes come due. Assuming that there isn't some wild liquidity rebound, many of these notes will not be able to be refinanced. New equity will be required or else defaults will increase.

Brecht Palombo
Auctioneer, Broker
Tranzon Auction Properties
Stoneham, MA

Downward Pricing Pressures Strong

My take -and I am probably guilty of over cutting to the chase and thus over simplifying - is that I think it is inevitable that commercial real estate values absolutely must come down - perhaps to 2004/2005 cap rate levels, maybe more punitive than that.

Assuming that investors' perception regarding the intrinsic risk from owning commercial real estate does not decrease, then return expectations from investing in commercial real estate should remain unchanged.

If equity return expectations don't change and, with regard to debt financing, LTVs are lower and costs are higher (through less or no I/O and shorter amortization periods), then something will have to give: either we must believe that future cash flows to equity from commercial real estate ownership will rise at a healthy (perhaps unrealistic) clip in spite of current economic forecasts or sale prices must go down.

Only three things could mitigate this downward pressure on commercial values and I am not so sure any of them will happen:

* Super-tight supply and I am not sure we are there given new supply financing provided over the last few years;
* Unprecedented demand by users of commercial properties (retailers, companies, etc), which I don't think anyone is forecasting; or
* A willingness of buyers to take on recourse in exchange for better debt terms, which I don't think there is.

Nick Tramontana
Managing Partner
PNT Capital Group
Denver, CO

The Next Up Will Be as Wild as Current Down

The foreclosure of America has begun! Consolidation, Consolidation, Consolidation!
Only the strong with survive, that is if you have enough cash to offset the drop in share value. Sideline capital is getting ready to enter the game. Devalued dollars will be spent for assets that have massive value. Look for the dollar to get much stronger once the assets are gobbled up and interest rates will rise. This must happen before value can be regained in real estate. The next bull will be a super sized, hormone raging, stampede to all new highs. Hope you are tied in for the ride! Only a few will be able to participate in the next Rodeo!!

Kenneth Skinner
Colonial Properties Trust
Atlanta, GA
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