March 7, 2008

Retail Real Estate Economics vs Credit Availability

Although the "de-leveraging" of credit from the system has put downward pressure on residential housing prices, commercial properties have fared much better in terms of asset values as opposed to REITs prices. However can commercial properties values hold given the lack of credit for long?

US REITs as a group have declined by more than 33% from their peak in the current market. Since 2000 to their peak in early 2007 they were up some 161% in price appreciation. In this post i will review some of the economics of commercial real estate and try to asses if the downward pressure on commercial properties reit is justified.

The retail commercial real estate fundamentals remain in relatively good shape. They posses a low vacancy rates, growing rent, and no huge construction overhang, unlike residential housing. Moreover there is not a huge development pipeline of future available space that can depress rent rates. even delinquencies on commercial debt is still very low compared to previous crises.

Granted that commercial and retail real estate metrics are lagging indicators. So you should see some decline in properties values, rise in delinquencies, and increase in vacancies following an economic activity slowdown. But is the calls by media for commercial real estate collapse in similar fashion to residential housing justified? I see these calls for the imminent commercial real estate crash as an overstretch right now. However, if this rescission is deeper and longer than your average recession then commercial real estate will suffer.

I always want to asses supply and demand for space to analyze values rather than credit availability, as credit adjustments are volatile to predict and eventually will stabilize allowing for deals to happen.

Supply & Demand
Commercial construction will add 125 million sq. ft. to the national retail inventory this year, down from 145 million sq. ft. built in 2007, according to Marcus & Millichap. Much of that space under development is pre-leased, with big-box retail and build-to-suit accounting for 40% of construction. The 125 million sq. ft represent 8% of the top 25 retail operators owned retail space and less than 4% of all available stock.

However there is increasing risk that can disrupt this picture as demand will decline as retailers pull back on expansion plans due to week economy. Some retailers like Lowe's, Wal-mart and others have reigned their expansion plans, others are closing under performing stores. But retailers are still demanding space although at slower pace. Wal-mart is opening new super centres almost on monthly basis, Lowe's are planning an additional 100-120 new stores in 2008; Target added 15 million sqr. ft. in the last quarter. Again retailers will cancel any plans for expansion if the economy deteriorates significantly.

Commercial Real Estate Deals

The question is does lack of availability of credit will put downward pressure on properties value? So far commercial properties are holding their values due to lack of deals. Sellers are holding out for better prices. January and February deal volume has almost came to a halt across all types of properties due to lack of availability of debt. Buyers are requesting lower prices to compensate for lack of leverage, while sellers are holding out for higher prices. So who will blink first: sellers or buyers?

My bet is sellers will agree to lower their prices, as they continue to put properties on the market. More than $10 billion of properties were put up for sale in January, the highest amount since September 2007. And based on listings so far, the volume of offerings in February will be even higher. There is a lot if capital to do deals from pension funds and other institutional investors that were shut out by Private Equity overbidding over the past few years. This capital is waiting to be deployed given some support for commercial real estate values as well.

In conclusion I do not think that REITs deserve this huge discount to asset value. The discount to net asset value prices the worst case scenario in terms of the economic outlook. The space will present certain opportunities in the future to invest for the long term. There will probably be a general 10% correction just because of the liquidity factor. But in the urban centres where it have favorable demographics, the unique properties will probably experience no more than a 5% to 10% drop in value. The real problem will be in the second- and third-tier cities where there will be a real absence of financing.

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