Wednesday, 5 September 2007

Commercial Real Estate

The strength in US commercial real estate has been one of arguments used by economists in support of a strong US economy. The argument goes that the strength in the Commercial real estate market has to some extent offset the decline in residential. Below is an excerpt from a Bloomberg article that came out today forecasting drops in commercial real estate prices. Click on the link below for the full article.

Commercial Real Estate in U.S. Poised for 15 Percent Price Drop
By Hui-yong Yu and David M. Levitt

Sept. 5 (Bloomberg) -- U.S. commercial real estate prices may fall as much as 15 percent over the next year in the broadest decline since the 2001 recession as rising borrowing costs force property owners to accept less or postpone sales.

``People aren't willing to do deals right now,'' said Howard Michaels, the New York-based chairman of Carlton Advisory Services Inc., which has arranged financing for real estate purchases including the Lipstick Building in midtown Manhattan. ``The expectation is that prices will come down.''

Investors in July bought the fewest commercial properties since August 2006 and apartment building acquisitions were down 50 percent from June, data compiled by industry consultants at New York-based Real Capital Analytics Inc. show. Archstone-Smith Trust in August postponed its $13.5 billion sale to a group led by Tishman Speyer Properties LP until October. Mission West Properties Inc., the owner of commercial buildings in Silicon Valley, said on Aug. 13 that the company's $1.8 billion sale may fail after a bank withdrew funding.

``There are so many deals falling apart,'' said David Lichtenstein, chief executive officer of Lakewood, New Jersey- based Lightstone Group, an owner of more than 20,000 apartments and 30 million square feet of office and retail space. ``People who can get out are getting out.''

Higher Costs

About 930 commercial real estate transactions valued at $5 million or more closed in July, preliminary data from Real Capital show. That count could climb as much as 15 percent when all of the month's deals are tallied, which would still be the lowest this year, said Dan Fasulo, director of market analysis for Real Capital.

Average prices for commercial properties might drop 5 percent to 15 percent in the next two years depending on the type of property and its quality and location, said Matthew Ostrower, an industry analyst at New York-based Morgan Stanley, the second-largest U.S. securities firm by market value.

Commercial mortgage rates have climbed as defaults rose in the subprime part of the residential real estate market. About six months ago, a 30-year commercial loan with 5 to 10 years of interest-only payments would have cost the borrower about 120 basis points more than the yield of the 10-year Treasury note. A similar loan would now cost about 160 to 200 basis points more than the 10-year Treasury's yield of 4.6 percent, data compiled by New York-based Cushman & Wakefield Sonnenblick Goldman show.

Yield Spreads

The increase has halted a rally that lifted prices for office buildings, apartments and hotels to records this year. The average price paid for high-quality office properties in city centers reached $291 a square foot, up from $188 in 2005 and almost double the average $152 in 2001, Real Capital reported.

Real estate investors typically purchase properties with the expectation that the yield will outstrip conventional investments and make their financing affordable.

When prices for prime urban office buildings fell in 2002, capitalization rates, or a property's net operating income divided by the purchase price, rose to an average 9.25 percent, according to Chicago-based data provider Real Estate Research Corp.

That was almost 500 basis points more than the average rate of 10-year Treasury bonds at the time. Such yields attracted investors and by this year's first quarter, the average cap rate had fallen to 6.5 percent.

New York-based Blackstone Group LP, manager of the world's largest buyout fund, purchased Sam Zell's Equity Office Properties Trust for $23 billion in February to gain about 540 office buildings in the U.S. That worked out to a capitalization rate of about 5.3 percent, a record low for an acquisition of a real estate investment trust, according to Green Street Advisors Inc. Including debt, the price was $39 billion.

`Fear in the System'

Regency Centers Corp. lost an equity partner in May for the $80 million purchase of four shopping centers in Florida because financing costs exceeded the projected cash flow, said CEO Martin ``Hap'' Stein in an interview. Jacksonville, Florida- based Regency is the third-largest company by market value in the Bloomberg REIT Shopping Center index.

``You've got a lot of fear in the system from the capital markets,'' Stein said. ``As far as the pricing of credit, it was greed six months ago and it's fear today.''

A lot of the arguments sound the same as those that precipitated the fall in Residential real estate. Funding was cheap, greed took over and risk considerations took a back seat. Is there any reason to believe that commercial real estate is not just another bubble waiting to be pricked?