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September 01, 2009

The "Other" Real Estate Issue - Revisited

The "Other" Real Estate Issue - Revisited...It was in early February of this year that we penned a discussion about the state of the commercial real estate markets. Of course at the time the Street's eyes were collectively glued on the near free fall in residential real estate values and general activity. Our suggestion at the time was that CRE (commercial real estate) was about to make a very prominent guest appearance on the economic stage as being yet another meaningful real estate related issue for the financial sector, the economy, and for those holding significant investment positions in the asset class such as institutional pension funds. You know what has happened since, but the reality is that CRE will continue to be a problem child issue for some time to come. As we'll see in just a minute, relative to prior historical CRE reconciliatory cycles, we're just getting started. Will this be yet another "challenge" for the banks ahead? You bet. But the miracle of the eraser the government allowed the banks to invoke sidestepping mark-to-market activity may delay the true realization of asset value declines. As you'd guess, we have a lot of charts that together tell quite the story of deflation in values and activity, both now and we expect also yet to come in the current cycle. And why is this issue important to really the broader US economy as we look ahead? Simple - its implications for bank lending and normalized functioning of credit markets ex the massive baling wire and duct tape support of the financial sector the Fed/Treasury/Administration (none of which has been removed as of yet, or can be if asset values such as CRE continue to deteriorate) has engineered. We believe the CRE issue will forestall a return to credit flows from the banks as they privately (no mark-to-market) continue to nurse balance sheet wounds for some time to come. Let's get started.

We want to kick off this analysis with some data we have never shown you before. But it is certainly very timely right now. Why? Because this data is both current and market value based. We're NEVER going to see this type of data coming from the banks as they will lie as long as they can about CRE values on their books. They have the blessing of the government, so don't hold your breath in terms of trying to find truth coming from the financial sector. Alternatively, and very importantly, the institutional investment community still marks their real estate assets to market each quarter in terms of keeping integrity in calculating ongoing total rates of return for their funds. Thank God someone is willing to tell the truth, right? It seems there's less and less of it around each day.

The National Council of Real Estate Investment Fiduciaries (NCREIF) is an association of institutional real estate professionals who share a common interest in their industry. They are investment managers, plan sponsors, academicians, consultants, appraisers, CPA's and other service providers who have a significant involvement in pension fund real estate investments. They come together to address vital industry issues and to promote research. The NCREIF was established to serve the institutional real estate investment community as a non-partisan collector, processor, validator and disseminator of real estate performance information. Now you know what we are talking about in terms of integrity of the data. No tier I, II and III assets for these folks to manipulate and massage in terms of values, just honest third party actual quarterly appraisals of real properties. The NCREIF publishes a National Property Index (NPI) on a quarterly basis that gives us some very good insight into what is happening quarter by quarter with the value of institutionally held commercial real estate investments. And you can be darn sure they are much closer to the truth of what is happening with CRE values than the banks in this country will ever let on. The NPI covers all "classes" of institutional investment in CRE including, office, retail, hotel, industrial and apartment properties.

The NCREIF Property Index is a quarterly time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only. All properties in the NPI have been acquired, at least in part, on behalf of tax-exempt institutional investors - the great majority being pension funds. As such, all properties are held in a fiduciary environment. NCREIF requires that properties included in the NPI be valued at least quarterly, either internally or externally, using standard commercial real estate appraisal methodology. Each property must be independently appraised a minimum of once every three years. Because the NPI is a measure of private market real estate performance, the capital value component of return is predominately the product of property appraisals. As such, the NPI is often referred to as an "appraisal based index." At the moment there are roughly 6000 individual properties in the index whose value approaches $300 billion. Sorry for the knock down drag out description as to who these folks are and how the index is calculated, but we believe it is one of the most "transparent" pieces of data regarding ongoing CRE values we can find. Of course it seems the government alternatively believes that by wiping away mark to market we can just go back to lying to ourselves and everything will be just fine. That worked out really well in the prior cycle, no? In terms of honesty and integrity, we'll take the NCREIF data any day of the week, thank you.

Finally to the point, below is the three decade-plus history of quarterly returns for the NCREIF property index. Get the picture as to current trends?

Of course you do. We're currently looking at the most significant period of consecutive quarterly drops in value in what admittedly is the short history of the data (going back to 1978). Although we do not detail the quantitative numbers in the chart, over the last four quarters (3Q 2008-2Q 2009) the index has recorded a 22.5% contraction in value. And just what does this infer about bank holdings of CRE loan paper? Thanks to the current Administration's financial sector "don't ask, don't tell" policy for bank assets, we're not going to really know any time soon. Good thing the US banks can simply move forward reporting record earnings and ignore the current inconvenient truth of declining CRE values, no? We only see some glimpse of the truth in asset values every Friday when we see that week's US bank failures. Did you catch how BB&T wrote down Colonial Bank asset values by 37% after Colonial's essential failure and melding into BB&T? The write down never happened until Colonial hit the tarmac nose first, yet asset values had vaporized long ago. And this is the "transparency" we've been promised?

In the next chart we've taken CRE individual asset class quarterly returns from the NCREIF data and produced a compound rate of return series for each asset class since the beginning of the current decade. Please be aware that the NCREIF rate of return data includes two components - an income return and capital price change. Although we will not drag you through the specific quantitative data mud, you'll just have to trust us in telling you that income returns have been positive each and every year. That means the capital return (price change) both primarily drives the direction of the data in the chart below plus is a bit worse than the actual numbers in the chart show due to the positive influence of the income flows.

In short, we are looking at some very substantial price declines to produce these compound annual rate of return trends for each property type. In the table below we delineate the NCREIF pure prior four quarter rate of return by property type for the period ending 2Q 2009. Again, it is the true reality of actual property price appraisals that is driving these numbers. C'mon, can't we allow the pension funds to simply make up "fair value" numbers like the banks do? It just doesn't seem fair they should have to take these types of asset value hits, right? They can't convert to bank holding companies, can they?

Certainly the numbers you see above are breathtaking, especially given that they only cover the prior four quarters through 2Q of this year. And to be totally honest, value declines in the third quarter of last year for all property types were less than 1%. Meaning that 95% of the price damage you see in the table above has occurred since September month end of last year to the present. Just how meaningful is this historically? How does the present CRE down cycle compare to historical cycles? We only wish we had the very long term data. But what we do have is a copy of a presentation done by Ken Riggs, President and CEO of Real Estate Research Corp. (RERC) given at the summer 2009 conference of the very same NCREIF. RERC bills themselves as "one of the first, and one of the most recognized, independent and objective commercial real estate research, valuation and consulting firms in the nation. For more than 75 years, RERC real estate research, publications, market studies, property valuations, investment criteria and trends analysis have proven visionary". Anyway, the following is some data Mr. Riggs presented to the NCREIF crowd literally seven weeks ago in terms of prior CRE cycle character.

As you can see, his numbers for current magnitude of decline are not too far off what the NCREIF property index tells us. As we look at the data above, what is most striking is that it has only now taken really three quarters in the current cycle to produce 41% of the decline seen in the 24 quarter down cycle of the early 1990's. And of course the early 1990's CRE collapse was in good part driven by the vaporization of the S&L industry. Seven quarters of CRE decline early this decade produced a "rounding error" of price decline magnitude relative to the present cycle. And unfortunately, as we see it, we're still in the first few innings of the current CRE cycle reconciliation game for now. And as far as the banks and their CRE assets are concerned, the national anthem has not yet even been played. We'll just have to see how it all unfolds from here.

Final chart from the good folks at the NCREIF. As is often the case in any asset class where a very meaningful decline in values takes place over a very short period of time, activity simply dries up. You may remember our personal near and dear mantra courtesy of Ray DeVoe - "Liquidity is a coward. There's always too much when it's needed the least and it's never around when it's needed the most." Please be aware that the 2009 number in the chart below has indeed been annualized. Quite the collapse in activity, right? In no way will this help "price", quite the opposite.

It's a shame all the buyers have vanished, because as you may remember close to $300 billion-plus of CRE mortgage loans are up for renewal or reset this year. And as of now the asset backed market for commercial real estate loans is contracting as opposed to expanding. Much like the residential asset backed markets, the commercial asset backed markets are no longer open 24/7.

That really leaves the banks as the potential saviors for commercial real estate finance. But here unfortunately again, the banks are nursing their CRE wounds in the privacy and blackness of their non-mark to market balance sheets. What we do know is that per the most recent bank loan officers survey, over 65% of banks were still tightening standards for commercial real estate loans when these folks last answered the phone (a quarterly survey).

So just where does that leave CRE owners who need to refinance this year or early next? In trouble, that's where. And if this were not enough, we can tell you from first hand knowledge that bank regulators have been crisscrossing the country examining bank CRE loans intently. They do not want another mortgage debacle as was residential real estate on their current watch. Like they have a choice, right? In many cases current CRE appraisals are being conducted against existing bank property loans and capital calls are going out to CRE owners who have always been model credits and have never missed a payment in their lives. And CRE values will improve in this type of a regulatory and available capital environment? Quite the opposite, as you already know.

Taking The Lead?...So just where does all of this lead us with CRE ahead? When will we begin to get some "green shoots" or signs of "stabilization" in CRE values? We wish we had the answer. But we do have yet another data point from an industry source we hope can help in terms of timing ahead. The wonderful folks at the National Association of Realtors have put together what they call the Commercial Leading Indicator (CLI). The Commercial Leading Indicator for Brokerage Activity is a tool to assess market behavior in the major commercial real estate sectors. The index incorporates 13 variables the NAR believes reflect future commercial real estate activity. The index is designed to provide early signals of turning points between expansions and slowdowns in commercial real estate. We like it in that it is comprised of the NCREIF price index, the NAREIT price index, industrial production, labor market data, retail sales, personal income and capital spending data factors. As much as we distrust most data or comments from the NAR, the CLI appears a very reasonable indicator. In fact, this is what it is telling us right now.

Admittedly it's not looking too wonderful, especially as a "leading indicator". Sorry for the small print in the chart above. It covers the 1990 to present period and, of course, it's the direction that's most important. Directly from their latest report comes these comments.

"The sharp fall in the CLI implies that commercial activity, as measured by net absorption and the completion of new commercial buildings, will likely contract quite severely over the next six to nine months. Commercial real estate construction spending (i.e., non-residential structural investment) had held on relatively well in the current economic recession, but is anticipated to tumble in commercial real estate building construction in upcoming quarters. Commercial practitioners can also anticipate a much weaker net absorption in the office and industrial sectors later in the year and a far fewer number of new commercial buildings reaching the market."

"We now expect office vacancy rates to rise very sharply, surpassing 20 percent in 2010. Office rents will fall 7 percent in 2009 and further fall an additional 1 percent in 2010. Industrial and retail sectors will face deteriorating conditions as well. Only the multifamily sector looks to squeeze out positive rent growth, though at a slower rate of increase than in the past."

Comforting, right? Sure it is. One final comment in terms of the commercial real estate cycle and how that cycle relates to residential real estate. The following is simply an update of a chart we have shown you the past. Directly from the GDP data, we are looking at the year over year change in residential fixed investment (residential real estate) set against the same year over year change in non-residential fixed investment (a loose proxy for CRE).

Important point being that at least as per the historical message of past cycles, the rate of change in the residential markets turns up before the rate of change in non-residential activity does. And at least as of yet, residential construction/investment activity is not turning up. As we said a few minutes ago, the CRE down cycle is unfortunately still young. We hope we can anticipate the eventual turn when we see the NAR CLI reverse up and the annual rate of change in residential fixed investment bottom and begin to move higher.

That Vacant Look...And we'll close with a bit more data from the super folks at the National Association of realtors. In conjunction with the production of their Commercial Leading Brokerage indicator, they also project forward vacancy rates for office, industrial and retail property types. Here's what they think is coming down the pike for the remainder of this year and looking into next. Maybe we're colorblind, but it seems even the NAR can't find any "green shoots"? We never thought we'd see the day. The numbers for this year and next are certainly sobering.

There you have it. We suggested in February of this year that CRE would be an important issue before the current year had run its course. The numbers, analysis and industry commentary tidbits suggest the down cycle is far from complete. The ultimate impact on the financial sector remains an open question mark at this point. Will banks simply ignore the issue, as they continue to do with many a residential real estate foreclosure situation by simply not sending out notices of default? Will the Fed/Treasury/Administration devise yet another taxpayer funded bailout scheme for their very close friends at the banks and in the US financial sector at large? Without question, the regional and community banks are most at risk with current and to come CRE issues. We do not expect death and destruction as excesses in CRE lending were NEVER as egregious as what we witnessed in residential lending. But these folks will need time to heal. They will need time to earn their way out of their current and to come CRE problems. This simply tells us their will be less aggregate systemic risk taking and credit availability from this crowd of regional and community bankers ahead. It can be no other way. And yet equity investors continue to attempt to discount a "V" economic recovery, as is implicit by the recent vertical action in equities? They certainly know something we do not. They do know something, don't they?

Market Observations
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