Commercial real estate industry should expect a bumpy ride

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Paula C. Squires

The pain isn’t over. As the country tries to recover from a credit crisis that required massive government intervention, the commercial real estate industry should brace itself for a bumpy ride.  Sales of retail and commercial properties are down, and price corrections are expected to continue as the country heads into a recession this quarter.

That was the overriding message yesterday by capital market experts who spoke during the 18th annual Real Estate Trends Conference.  Sponsored by Virginia Commonwealth University, the event drew 800 real estate professionals, breaking previous attendance records. “What a difference a year makes,” quipped conference chair Bruce A. Kay. “Last year we were talking about new urbanism … Today, it’s all about the money.”

Or, more precisely, the lack of it.  Now that the superhot, over-leveraged subprime market has burst its bubble, the cost of capital for real estate projects is high and availability is low, noted keynote speaker Sally Gordon, managing director at BlackRock, the country’s largest asset management firm. “The CMBS [commercial mortgage-backed securities market] is history. What we’ll see going forward will be different than in the past.”
Gordon said covered bonds, used widely in Europe, might be one way to help restore capital flows. These debt securities are backed by a pool of assets that “covers” the bonds if the issuing financial institution becomes insolvent. Since originators must hold the bonds on their balance sheet, they are responsible for ensuring that the pool consistently backs the bond. 

Asked about the government’s actions to shore up the banking industry — which moderator John Levy referred to as “The No Banker Left Behind Act “— Gordon responded that a more systemic approach was needed. The challenge now, she added, will be to take finite sources and decide how many banks can be helped.
The federal government announced yesterday that the U S. Treasury Department will use up to $250 billion of the $700 billon bailout deal to buy non-voting shares in some of the nation’s banks as a way to help restore lending.

Meanwhile, a lack of capital for real estate deals has caused a big drop in transaction volume. For the first nine months of 2008, the number of commercial real estate sales in the U.S. was down by 74 percent compared to the same time last year, said speaker Robert M. White, president of Real Capital Analytics of York, a company that tracks commercial real estate markets around the world.  “Of $20 billion in office properties that was supposed to close by September, less than $7 billion has closed,” he said. Plus, 3 percent of the deals that closed in the third quarter came from distressed sales, according to White, with more sellers than buyers across the board for all commercial real estate categories. “No big group of buyers has stood out to get the market going again.”

On the equity side, there are still some pockets of capital available from pension funds, said speaker Geoffrey Dohrmman, president and CEO of Institutional Real Estate Inc. in San Ramon, Calif.  However, real estate companies shouldn’t look to the funds as a big source. For the near future, Dohrmann portrayed a grim picture. He said an additional 1,000 regional and community banks are poised to fail, while increased defaults on home mortgages are driving down U. S. property values.

To help the capital markets, Dohrmann offered several possible solutions, including:
• Reinstating a provision of the 1933 Glass-Stegall Act (repealed by Congress in 1999). This would once again separate commercial and investment banking.
• Eliminating the mark-to-market accounting method, which critics say is worsening the credit crisis. Under this standard, a wide range of assets are valued at current market prices. So the value of mortgage securities — even those carrying AAA ratings — has to be written down on the balance sheets of financial institutions that hold them, shrinking capital bases and the amount available for lending.

Moving forward, Dohrmann said, “We’ll have to go through this deleveraging and feel some pain.” Cash will be king, he predicts, and people in a position to buy reduced-price assets will be able to make a lot of money. “The real lesson here is not that the world is falling apart … but that the base underneath us is shifting.” 

The speakers did have some good news. As a capital city in a state experiencing population growth, Richmond is well positioned for commercial real estate projects when the market recovers. In fact, Richmond was one of 120 cities worldwide last year that saw more than $1 billion in commercial property acquisitions. In 2008, only 20 cities are expected to hit that level. 


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