Vol. 19, Number 3 page 2 : < previous page (p1)
The Supply Side of the Market
Because commercial real estate prices had soared in 2006 and 2007, many owners of real estate decided to sell to take advantage of the high prices. As a result, there was a sufficient supply of properties reaching the market to satisfy the credit-fueled demand that existed at the time. However, when prices collapsed in late 2007 and 2008, so-called discretionary sellers withdrew from the market but, contrary to expectations, distressed sellers were very slow to appear. The ability of distressed property owners to hold on to their assets is due to several factors. First of all, as we have commented in a number of previous newsletters, the basic fundamentals of the commercial real estate market have held up surprisingly well in this recession. Occupancy rates have declined, as have rental rates, of course, but such declines have been relatively mild compared to the collapse in those rates that occurred in the late ‘80’s and early ‘90’s. As a result, many owners are continuing to receive sufficient income to service their mortgage debt. This permits them to continue to hold their property, even though its value may be less than the existing debt, in the hope that the market might improve over time.
At the same time, the banks are being very slow to foreclose on properties with maturing debt. While there are still a great many properties with negative equity positions (one estimate puts the total at close to $167 billion), the banks are not anxious to take these properties back and recognize the losses that would be involved. So all too frequently the banks use the so-called “pretend and extend” approach to dealing with maturing debt, maintaining the same value of the property on their books, and extending the loan for another two or three years. The special servicers, who handle mortgages that have been sold into various pools, also have limited incentives to force the sale of distressed assets, particularly since they frequently have investments in those properties and their own investments would be wiped out if they were to force a sale.
Therefore, discretionary sellers are on the sidelines waiting for prices to improve, and distressed sellers are under little or no pressure by the banks or special servicers at the present time so they are able to continue to hold their assets. This results in relatively few quality properties reaching the market. As a result, there is more demand than supply in many geographic markets in the US today.
The Future Trends
Several things are happening that should, on the one hand, bring more properties to the market and, on the other hand, remove some of the money that has been chasing the relatively few assets that are available. The Wall Street Journal recently reported that 19 private-equity funds were unable to find appropriate investments for their portfolios and, as a result, they are returning over $6 billion dollars to their investors. This will not only take a great deal of money out of the market, but should also act to restrain the formation of any similar funds going forward.
On the supply side, it seems inevitable that the banks and special servicers will begin foreclosing on more properties that are either in default or cannot be re-financed. Both groups will have to become more realistic and recognize their existing losses. As this happens, more properties will begin to appear on the market. This process is taking longer than had originally been anticipated, but Falcon expects that we will see increased offerings of distressed properties later this year and into 2011.
We also expect to see an increase in discretionary sellers. This group has been holding back hoping to see the market rebound and, while there has been some price improvement in some of the major markets, pressures continue to build for discretionary sellers to take action. One of the major considerations is the increased capital gains taxes that result from the expiration of the Bush tax cuts and the enactment of Obama’s health care plan. Most investors who have held real estate for any length of time will have taxable capital gains, even at the current lower price level, since they will have written down their cost bases through depreciation.
Therefore, we expect that the amount of money pouring into the commercial real estate market will subside, while there should be a slow uptrend in the number of properties coming to market. As a result, we expect to see a gradual increase in the number of transactions occurring in the US market nationwide during the balance of 2010 and into 2011.