Is The Foreclosure Wave Over?

A forecast on distressed commercial real estate in the United States

Randy D. Podolsky, Managing Principal

It is no secret that the state of world economics can be described, at best, as uncertain and tumultuous. Slow economic growth following the financial crash in 2008 has led to the stagnation of rent growth in the industrial and office sectors of the commercial real estate market and held back the rise in property values.

Although some Chicago area and Midwest submarkets have shown signs of two consecutive quarters of increased occupancy, the amount of space being absorbed is woefully short of what is necessary to experience sustained, positive growth. Further, the amount of foreclosures is still increasing, the result of which can only be continued growth in other real estate owned (OREO) properties by financial institutions.

This has two significant implications. First, most banks and institutional lenders have little tolerance for owning real estate acquired through adverse proceedings. They generally do not staff real estate departments, forcing them to move the assets from REO to the market at a faster pace, and at lower prices, than an experienced real estate owner or operator.

Second, the ownership of these same assets forces restrictions upon the financial institution owner, which reduce available lending limits, force added reserves and cause greater scrutiny from more recent extensive federal regulator oversight. Coupled with the fear of the unknown market recovery timeline, lending appetites remain substantially reduced from those necessary to provide for growth and stability.

Further exacerbating the problem is the amount of anticipated commercial real estate debt restructuring of industrial and office properties still coming down the pipeline — $16 trillion worth — according to some estimates. For almost five years, lenders and borrowers alike have been kicking the can of devalued assets, and refinancing them, further down the road.

While financing rates today are very attractive for all intents and purposes, the revaluation of the underlying assets in need of refinance causes hundreds of millions of square feet of real estate to require additional equity, often times simply not available from the current owner.

The uncompromising economic conditions that prevail post market crash and slow market recovery mean there is no immediate end in sight for this conundrum. Increased employment and pent-up demand for products, and space, will ultimately provide stability and growth to the industrial and office spaces markets across the country. Clearly absorption is trending up, vacancies are starting to decline across many property types, affordable debt is available to credible, well-capitalized sponsors, and companies are now hiring at a moderate rate. However, these economic drivers do not translate to immediate changes in the commercial real estate market. Therefore, I believe that my timeline is an accurate reflection of things to come.

Patient investors will prevail

If commercial real estate owners invested in office and industrial properties can hold onto their properties in the short term, say another 18-24 months, they will likely be rewarded in the long term, say three to five years, as pricing stabilizes and vacancy decreases. This is particularly true for Class B and C properties as well as those properties with multiple tenants and/or less than institutional credit tenants. Unlike the apartment market, which is experiencing unusually high demand in a majority of markets, the valuations of most product types (office, industrial and even single-family residential) are 30 to 40 percent below their valuations prior to 2008, largely due to vacancy and stagnant rental rates.

In the second half of this year and throughout 2014, the signs of economic recovery will start to positively influence the glut of space and depressed pricing that hangs over most commercial real estate submarkets. Demand for quality assets, as well as the repositioning of all classes of commercial assets to today’s market conditions and valuations, will prove to reduce market vacancies on a more rapid path that currently exists and will help bolster valuations through the appraisal process.

Investing is relative

Until then, investor appetite for real estate, even under less than ideal conditions, will falsely increase property values as prices being paid rise due solely to the comparison of real estate valuations to other asset classes and investments, particularly fixed-income asset classes. While the stock market is at a five-year high, it remains volatile and unpredictable.

The return on investment (ROI) for real estate assets, particularly in a market where prices for these assets should see growth going forward, will look very attractive against other investments, including fixed-income assets and the stock market.

Savvy entrepreneurial investors and institutions holding real estate that can be leased, stabilized and carried short to near term (18 to 24 months) will benefit from increasing prices over the next three to five years.

Certain commercial assets are very attractive to the huge institutional pools of money already streaming into the market for the acquisition of commercial real estate assets. Institutional quality industrial investments, meaning those with long-term triple net leases, institutional credit tenant(s), as well as similar grade Class A office and medical office properties, are in high demand today with acquisition prices already returning to sub 7 cap rates, the same level as in 2007. Though not appealing to the “value-added’ buyer, these investments offer a greater ROI to institutional investors when compared to other asset classes, particularly fixed income.

A plea for prudence

Provided there are no further material setbacks to the U.S. or global economy, we can expect to see all real estate values, rents and occupancies increase over the next five years. All we can hope for is that the former 10-year cycles, now shortened to five to seven years, do not eclipse the three-year memories of lenders and investors. That is the only way to avoid another collapse of commercial real estate valuations in the next decade.

Wouldn’t it be nice if for just once, while other investor markets decline, real estate values hold their own due to discipline and prudence on the part of investors? Stay tuned, as only time will tell.