Struggling Commercial Real Estate Helplessly Waits Around For The Slaughter Of 2010
Vincent Fernando, CFA
While many other parts of the U.S. economy are in an apparent uptrend, commercial real estate still faces continued deterioration this year.
According to Fitch ratings, the default rate for commercial real estate loans packaged within mortgage-backed securities hit 8% in Q1 of this year, up from 6.6% in December.
There have now been $31 billion of commercial mortgage-backed securities (CMBS) defaults over the last 39 months.
Shopping centers, apartments, hotels and offices make up the lion’s share of struggling properties, and default rates are highest in Texas, Florida, Arizona, and California. The data will get a lot uglier before it gets better:
Rising vacancies and falling rents in commercial real estate are squeezing landlords’ cash flow. That is making it harder for them — sometimes impossible — to pay the mortgage. Compounding the problem: Many struggling owners bought high-priced properties with excessive debt, underwritten on the assumption that buildings would be full and rents would rise.
Commercial real estate analysts suggest that defaults will continue unabated for the foreseeable future. Fitch predicts that the rate will exceed 11% by the end of this year.
While $30 billion dollars has been raised since the beginning of 2009 in order to invest in distressed commercial real estate, and future investor demand should put a floor (hopefully) under the commercial real estate market, these future buyers of distressed real estate could actually lock-in the death of current struggling owners who bought their properties at too high a price:
Opportunistic investors that are able to snatch up distressed real estate for pennies on the dollar, for example, will be able to charge lower rents vs. competitors stuck with heftier debt service.
“That’s what always kills you — the guy who builds it cheaper or buys it cheaper can undercut your rents and take your tenants,” said Conklin, who focuses on the real estate and industrial sectors at Baird. “He’ll generate the returns he needs, but you won’t be able to lower the basis in your building.”
Thus even the economic recovery won’t necessarily save many owners who simply own properties at uncompetitive cost bases. Old buyers will be culled even if a recovery is in the cards long-term.
Moreover, money on the sidelines is in no hurry:
While some of that REIT capital has gone toward paying down and restructuring debt, companies such as Simon Property Group, ProLogis and Boston Properties are among roughly a dozen that have amassed ample liquidity to aggressively pursue acquisitions, SNL Financial says.
Still, REITs haven’t bought much recently. But Pelusi predicted that more distressed assets would come to market in 12 to 18 months, amid a sluggish recovery and lackluster job growth.
“There remains a significant bid-ask gap between existing owners and the potential new owners or lenders,” he said. “But deteriorating property fundamentals will make it more difficult for lenders to continue the extend-and-pretend policies, which we believe will create more deals.”
Many distressed buyers can see the inevitable slaughter and are just waiting for the worst to play out.