Saturday, January 24, 2009

Commercial Real Estate's Perfect Storm: What Lies Ahead?

By M H Ahssan

"For the last few years we've enjoyed a perfect storm in commercial real estate," said Brian Lancaster, head of structured products research at Wachovia Securities, the brokerage group within Wachovia, a financial services firm with more than $541 billion in assets. "There has been a simultaneous occurrence of stabilizing rents, improving fundamentals, and really, really cheap money."

The commercial real estate market has been on a tear in the last few years. Banks, insurance companies and institutional investors funneled money into the market because its returns, in an environment of low interest rates, exceeded those of alternative asset classes. This segment of the broader real estate market typically includes office, retail, multifamily and industrial properties.

Lancaster observed that the commercial real estate market remains strong, although "not as great as it has been in the last few years." More than 10% of Wachovia's assets are in commercial real estate.

Lancaster made these comments at a conference last month on Innovation and Risk Management in Real Estate Markets, sponsored by the Wharton Financial Institutions Center and Mercer Oliver Wyman, a financial services strategy and risk management consulting firm. He took part in a panel discussion about the emerging risk profile of commercial real estate lending. The other industry experts were Caroline Blakely, a vice president in multifamily housing and community development at Fannie Mae; Richard Edelstein, a professor at the Haas School of Business at the University of California at Berkeley; and Bradford Case, an economist with the Board of Governors of the Federal Reserve System.

Fannie Mae's Blakely agreed with Lancaster that investments in commercial real estate continue to be strong, adding that in the multi-family sector, "real estate fundamentals are on the mend." U.S. demographic trends and steady job growth bode well for apartment rentals. In line with that, "vacancies are declining and asking rents are climbing," she said. Fannie Mae is slightly less optimistic about rent growth than other institutions in the real estate industry, but nonetheless expects it to be in the 2.5% to 3.5% range over the next year.

The mortgage financing giant also does not see the expanding supply of multi-family rental properties as a threat. "We're not concerned right now about an increase in multi-family construction, although we're certainly watching the condo conversion market and the oversupply in condos," Blakely said. Last year, Fannie Mae helped finance more than $25 billion in multi-family rental apartments in the U.S. The company's portfolio of multi-family commercial real estate assets totals more than $124 billion.

Low Rates
After the 2000 dot-com crash, Wachovia's Lancaster noted, commercial real estate revenues declined, vacancies rose and rents decreased. But since late 2001, revenues have steadily increased, with investors pouring more money into the sector. The key was the Federal Reserve flooding the market with liquidity through low interest rates, enabling commercial real estate investors to enjoy "phenomenal returns in the face of poor fundamentals," he said. One result was extremely low levels of delinquencies and default for Wachovia's and other banks' commercial real estate portfolios.

While Lancaster said he remains bullish on commercial real estate returns because fundamentals have improved in recent years, he also expects to see a "significant slowdown" in price appreciation for real estate. He added that the high prices still being paid in some areas of the apartment sector are "worrisome." However, property transactions overall have already slowed this year and buyers have been holding out for better prices, Lancaster said. In his view, this "cooling" is rational and a sign that some of the effects of higher interest rates are percolating through the system.

Lancaster noted that Wachovia's views on the commercial real estate market are predicated on its positive economic views. The firm expects the 10-year Treasury note to rise to about 5.40% by the end of the summer, with inflation concerns easing later this year. However, he said, "all bets are off in a stagflationary scenario or if job growth tanks, or if we get real significant increases in interest rates."

Fannie Mae's Blakely, while also positive about prospects, sounded a further note of caution. Commercial mortgage debt outstanding as a percentage of GDP crept toward 16% in the fourth quarter of 2005, surpassing the record set in 1988, she said. In addition, 70% of conduit loans (loans that are securitized) are partly or fully interest-only loans, triple the level two years ago. With interest rates continuing to rise and more capital seeking commercial real estate deals, Fannie Mae's worry is that debt underwriting standards could decline. The company is also "a little worried about stress levers" in the interest-only and low debt service coverage markets, added Blakely.

Edelstein, a real estate professor at the University of California at Berkeley's business school, was less sanguine about prospects for the commercial real estate market. He agreed that commercial real estate is currently in a good position, and that the U.S. economy's strength and resilience will benefit the industry generally. But he pointed out that the world we live in now is more global than it was 10 or 20 years ago and that capital can be rapidly pulled out of markets because of events that occur thousands of miles away. That makes commercial real estate's status as a favored child more precarious, he said.

"Capital market integration and securitization is going on and is inevitable," Edelstein observed. Securitization refers to the pooling together of relatively illiquid assets into more diversified financial products, whose securities are then sold to investors. This enables markets to develop by expanding their investor base and providing lower-cost financing. However, investors can now respond to new information more quickly than ever before -- and in Edelstein's view, this has the potential to create more volatility, not less.

"There has been a capital tsunami and that's likely to continue for a while, but there's nothing so mobile as capital," Edelstein said. "The tsunami could flow out very, very quickly." Events in other parts of the world could affect demand for many U.S. assets, including real estate. At the same time, the commercial real estate market's shift in the last year or two into higher-risk and leveraged assets could exacerbate any problems that develop, he added.

What could cause this to happen? China could revalue its currency faster than expected, Edelstein said. That would translate into higher prices in the U.S., which would impact the real estate market. An unanticipated jump in U.S. interest rates could also cause investors to shed real estate very quickly. "All you need is a few performance failures, because a lot of real estate is being bought with the notion that there will be growth in fundamentals," Edelstein noted. "I think we're at a very high risk point in real estate," he said.

Institutional Interest
Despite the rise of interest rates, institutional money from pension funds and other large investors continues to flow into the commercial real estate market. The robust commercial mortgage-backed securities (CMBS) market shows little sign of cooling off. CMBSs are securitizations backed by mortgages on commercial properties. Last year, U.S. CMBS issuance was a record $169 billion, up from the previous record of $93 billion in 2004, according to the Commercial Mortgage Securities Association, an industry trade group. In the first four months of this year, U.S. CMBS issuance was higher than it was during the same period last year.

Another market that has gained steam on Wall Street is the commercial real estate CDO market. A commercial real estate CDO, or collateralized debt obligation, is typically backed by a wide range of real estate debt assets, including riskier and shorter-term debt. Traditional CMBSs are usually backed by long-term fixed-rate mortgage loans. Since 2004, numerous actively managed commercial real estate CDOs have also been issued. These enable new collateral to enter and exit the CDO and have a shorter average life than the other bonds in the pool.

The result is that these CDOs have opened up narrowly financed parts of the commercial real estate market to new investors, said Wachovia's Lancaster. Various forms of debt -- such as mezzanine loans, B-notes and preferred equity -- can now be included in a managed real estate CDO vehicle, which is then sold to investors all over the world. Real estate risk is thus transferred to more players in non-U.S. geographic markets, Lancaster said.

Fannie Mae's Blakely noted that CMBS issuance forecasted for this year totals $182 billion, while commercial real estate CDOs are forecasted to reach $34 billion. She added that the growth of the CMBS market over the past 15 years has clearly benefited the commercial real estate market. Indeed, as it has grown it has also become Fannie Mae's chief competitor for apartment building mortgages, aside from Freddie Mac. Blakely pointed out that the CMBS market views multifamily rentals as one of the stronger real estate classes -- and therefore a class that CMBS issuers seek.

Analyzing Correlations
Bradford Case, an economist with the Board of Governors of the Federal Reserve System, focused his comments on the quality of data in the commercial real estate market. He noted that as the institutional market continues to expand, insufficient data could take a toll on both investments and risk management. In particular, the paucity of key performance data about markets and market segments could make managing the risk associated with a portfolio of commercial real estate assets more difficult.

Unlike the stock and bond markets, which produce a stream of intraday data, the commercial real estate market is often lucky to have monthly performance data, Case said. He noted that national real estate data sources mainly cover the larger markets, while smaller markets may or may not be included in local or regional data sources. Consequently, researchers and real estate portfolio managers tend to "analogize" between a market for which they have data and those they think are similar.

However, this can be risky since the markets may not behave as similarly as expected under all circumstances. Case noted that his comments did not necessarily reflect the views of the Federal Reserve.

"Good information comes from really deeply knowing the market," Case said. He referred to this as "unsystematic local expertise," since it is expertise particular to a local segment of the market. An example may be the apartment rental market in Tallahassee, as opposed to the overall commercial real estate market in Florida, which comprises many market segments that could have different characteristics and performance results. Without this local-level expertise, Case said, lending can be risky and inefficient because of the existence of an "information asymmetry problem" -- a situation in which the person with better local knowledge has a leg up on a lender who is less familiar with the price and performance dynamics in that particular market.

Case also noted that managing a portfolio of commercial real estate assets requires investors and analysts to understand how asset classes within the real estate market move in relation to one another. This could involve knowing how and when asset classes in various areas are affected by factors such as unemployment and population growth -- and when they're not. He suggested that the dearth of detailed and uniform performance data in commercial real estate should also cause investors and others to question how they define a particular real estate market.

For example, the Boston office properties segment of the commercial real estate market may have a similar performance pattern to the office market in other Northeast cities, or it may be similar to the office market for large cities across the country. Alternately, it may have more in common with other real estate market segments in the Boston area than it does with office markets in other geographic areas. Too often, Case said, assumptions about how various market segments are correlated reflect seat-of-the-pants views but lack empirical support.

The Federal Reserve economist stressed that without knowing which segments of the larger market move together and which are affected by the same supply and demand shocks, it is hard to estimate correlations among returns within a portfolio, as well as default probabilities and portfolio loss distributions. He added that once various correlations are better understood, it will also be possible to make better predictions for markets that lack data -- or, at least, there will be a stronger basis on which to draw analogies between markets for which information exists and those for which information does not exist.

Case said he has conducted preliminary research into correlations within segments of the U.S. commercial real estate market in more than 50 metropolitan areas. But his research is tentative and he hopes economists within the financial industry will generate better and more thorough data in the near future. As became clear at the conference, this additional knowledge -- whether it confirms or refutes existing assumptions about market segments -- can only help real estate investors risk-manage their portfolios better.

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