January 21st, 2015
by Keith Jurow, Capital Preservation Real Estate Report
My previous article examined the dangers of widespread euphoria and optimism. In this article, I will focus on an important question few analysts are raising: Is the so-called recovery in commercial office markets real or a mirage?
According to Marcus & Millichap's Third Quarter 2014 Commercial Real Estate Investment Outlook, optimism for those investors surveyed has never been higher.
Take a good look at this chart showing the intention of these investors over the next 12 months.
You can see that less than 5% of those surveyed plan to decrease their commercial real estate portfolios. More than 70% intend to increase their holdings.
The crash that was cut short
Let's first examine the post-financial crisis history of the commercial real estate market and the supply and demand forces now at play.
After Lehman Brothers failed in the fall of 2008, the entire banking system was in danger of a complete collapse. Federal regulatory authorities and the Treasury Department decided that something drastic had to be done to stabilize the banks.
The solution provided by the Federal Accounting Standards Board (FASB) was to rewrite the standards for when banks had to write down impaired loans. Banks were required to write down only those loans that were suffering "other than temporary impairments." Who decided which loans met this standard? The banks did of course.
In late 2009, the FDIC modified its policy to encourage what it called "prudent commercial loan workouts." The banks understood what this meant and began a policy of loan modifications that contemptuously became known as "extend and pretend."
One could argue that the regulators had no choice. The total commercial loan portfolio for all US banks stood at $1.55 trillion at the peak of the bubble in 2007. Hundreds of billions of dollars of the worst underwritten loans of 2006-2007 quickly went underwater. Because smaller and mid-size banks had loaded their portfolios with commercial real estate, an imminent collapse of hundreds of those banks was a real possibility.
This "extend and pretend" policy was, in retrospect, a brilliant strategy. When investors saw the banking system stabilizing, they were enticed back into commercial real estate. This helped to halt the decline in real estate prices. Although much of the renewed buying in 2010 and 2011 was by all-cash purchasers, the market did seem to stabilize.
For the appearance of normalcy to return, one essential piece was absolutely necessary. Most key players in commercial real estate had to develop amnesia about those allegedly performing loans that borrowers could not really pay back. If no one talked about them, that would also help. This is what has happened. The servicing banks took advantage of the opportunity to avoid having to foreclose and liquidate delinquent properties.
In its Big Picture report for 2013, Real Capital Analytics reported that the total distressed commercial loan portfolio of all banks at the end of 2013 was a mere $33 billion. That was 18% lower than 2012. Only 8% of all commercial real estate sales in the final quarter of 2013 were forced liquidations. That was sharply down from 20% at the end of 2010.
Since then, liquidations of distressed property have plunged even further, as this latest graph from Real Capital Analytics depicts.
Source: Real Capital Analytics
Commercial real estate sales are soaring again
Driven by growing optimism, investors have been pouring money into commercial real estate for the last two years. Take a good look at these figures from Real Capital Analytics.
Through November 2014, sales had already exceeded all of 2013. By the end of 2014, sales should approach $400 billion - very close to the total for 2006. It was only higher during the total madness of 2007. These sales figures suggest that major commercial real estate markets are strengthening around the country. Unfortunately, these aggregate sales figures hide what is really occurring.
In 2013, sales volume in the office sector was $104 billion, a robust 17% increase over 2012 levels. This growth was greater than any other commercial real estate category.
CoStar Group reported that this increase in sales was concentrated in five metros - Austin, Dallas, Atlanta, Houston and Denver. For those hot markets, more than 10% of their total office inventory changed hands. Austin led the pack with a turnover of 13%.
According to the most recent Big Picture report from Real Capital Analytics, this same concentration of office sales continued in 2014. Through November, office sales nationwide were on track to exceed 2013 levels. Office investors focused on five major markets - Manhattan, Boston, San Francisco, Los Angeles and Washington, DC. They accounted for 48% of the dollar volume for office sales in the entire US.
The reason for this concentration of investment dollars is not hard to find. Investors are prepared to spend more in these major metros. Manhattan was far and away the most expensive market. According to Cassidy and Turley's US Office Trends Report for the third quarter of 2014, the average price-per-square-foot for properties sold in Manhattan between January and August was $731. San Francisco was the next highest at $465, followed by Washington DC with a cost of $359.
What about other major markets besides these three? Only 14 other major metros tracked by Cassidy Turley averaged more than $200 per square foot. The average cost for Minneapolis, for example, was a mere $99. In Pittsburgh - a city that has transformed itself almost entirely since the disastrous recession of the early 1980s - properties sold at an average price-per-square-foot of only $62.
What about office vacancy rates? Cassidy Turley showed a nationwide average rate of 14.8% in the third quarter of 2014, down slightly from a year earlier. As I indicated in my previous article, averages are quite useless. Let's look at the metro level.
Of the 79 major metros tracked by Cassidy Turley, 18 actually had higher vacancy rates in the third quarter of 2014 than a year earlier. This included markets like Washington DC, Long Island, San Diego, Suburban Virginia and Northern New Jersey. Notwithstanding the higher vacancy rates in these five metros, Cassidy Turley showed higher average asking rents for all of them. How could that be?
The answer is not obvious. Asking rents increased most in those large, newer buildings attracting investors and tenants. In a report issued in mid-2013, Cassidy Turley emphasized that all of the office space absorbed nationwide since 2010 consisted of offices either newly built or newly upgraded since 2007. Tenants have been pouring into these newer buildings. Since 2010, the vacancy rate of these offices has been cut in half.
That sounds like a pretty strong recovery, doesn't it? But it would be wrong. Cassidy Turley pointed out that the vacancy rate for the vast majority of what it labeled "traditional space" was languishing at the highs reached during the post-bubble collapse. We are talking about roughly 80,000 office buildings throughout the country that are more than 20 years old and comprise roughly 60% of the total office inventory.
By focusing on the slight decline in the average nationwide vacancy rate, analysts completely overlooked what has been occurring below the surface in major metros. The investment and leasing action has focused on the small sliver of newer offices in the strongest metro markets. This tells you nothing about the vast majority of older office buildings and their continuing desperate search for tenants.
Massive problem of commercial office loans coming due
Morningstar's CMBS Delinquency Report (available via subscription from Morningstar) for December 2014 revealed the serious problems facing securitized office loans. Its "watchlist" tracks commercial real estate loans that Morningstar considers in danger of default. The chart below illustrates changes in watchlist volume by property type.
The office sector has the largest dollar amount of loans. Although the amount of delinquent loans has been steadily declining for three years, don't be fooled. It is due to the enormous volume of delinquent loans that have obtained "workouts" by the special servicers enabling them to avoid foreclosure and liquidation.
In this December report, Morningstar made it clear that the major issue over the next three years will be the huge number of maturing office loans which will need to be refinanced. In 2015, $67 billion in performing office loans will be maturing. In the two years after that, the problem will peak. The 10-year balloon loans that financed the craziest bubble-era purchases of 2006 and 2007 will mature in 2016 and 2017. The total for just those two years is nearly $230 billion.
Properties purchased in the bubble years of 2005 - 2007 had been financed when underwriting standards were steadily deteriorating. By 2006 and 2007, interest-only loans and minimal down payments had become commonplace. Loans were approved only because rent increase projections were insanely unrealistic. Furthermore, because of soaring prices in 2006 and 2007, many of these properties are still underwater. That is why more than 85% of all delinquent loans were underwritten in the years 2005 - 2007.
The commercial mortgage market probably cannot accommodate the $300 billion in bubble-era commercial mortgage-backed security loans (CMBS) that will need to be refinanced. This amount includes only those considered to be still performing. They will be competing with an even larger amount of commercial real estate balloon loans on the balance sheet of banks that will also be coming due.
What advice should you give clients?
In mid-2005, an article about the growing real estate bubble pointed out that investor money had been pouring into equity REITs. The author wrote that savvy private investors had been selling their commercial real estate at a frantic pace. He cited a key person at Real Capital Analytics who told him that the smart money was starting to get out.
Once again, the smart money is now unloading their commercial real estate in the major metros. There are many wealthy investors who understand risks and treat their hard-earned assets with great care. They are able to discern when real estate markets lose touch with the fundamentals. They understand that this herd-like buying is driven by money managers willing to take great risks on behalf of their institutional clients.
For more than two years, I have written about the growing bullish advice investors have received from financial advisors and Wall Street about commercial real estate. It will take great discipline for advisors to resist this herd thinking.
It also requires an appreciation of history - especially recent history. The overwhelming majority of advisors and their clients were caught completely flatfooted as 2008 unfolded. In the first half of that year, there was still time to unload their direct real estate holdings as well as private equity, REITs and ETFs. Six months later, it was too late.
Disregard the persistent plea of Wall Street to buy commercial office investments. With a common refrain, they have been trumpeting that it is safe for investors to take more risks. No - the coast is not clear. There are dangerous minefields waiting to explode and punish your clients.
My advice to you and your clients is simple. Now is not the time to buy commercial office investments. Let others venture into the minefields. Instead, be a seller while markets are still liquid and buyers are plentiful.
This article also appeared at Advisor Perspectives dshort.com, 13 January 2015.