August 22, 2008

Commercial Real Estate: The lost Cycle

If you read some of my posts and tracked some of my investments you will notice that I am betting on Commercial Real Estate. Commercial real estate (CRE), I mainly focus on retail and office spaces, cycle has been lost amid the residential housing crash. In this post I want to look more closely to the CRE sector and outline my investment thesis that will assist me in picking and assessing investment opportunities.

Along with general economic conditions, valuations in commercial real estate are driven by the following factors:
  1. Capital availability: Real estate is a capital-intensive industry, and its health rises and falls with capital availability. Capital, relatively cheap, fuels investors demand for CRE projects in the hope of earning future cash flows.
  2. Supply: Boom times typically engender oversupply of product.
  3. Interest rates and the economy: The lone head wind for commercial real estate is higher interest rates and their potentially negative effect on economic growth.
Actually the factors move in cycle and it goes something like this:
  1. Tenant's demand in good economic times for CRE will drive rent prices up making yields very attractive, as a result CRE prices start to go up.
  2. builders start increasing their investment in new developments therefore flooding the market with more supply that demand can absorb causing rent prices to start dropping due to competition over tenants. Please note that this takes few years as new supply do not materialize suddenly as projects take few years to complete.
  3. CRE prices start to decline as a result of the new supply.
  4. Lenders panic and put the breaks on loan refinancing and originations as their collateral is being devalued and realize they are heavily exposed to commercial lending.
  5. Developers can't get new financing to finish their projects or refinance existing properties so they default causing banks to take title and liquidate their holding causing more decline in CRE prices.
  6. Recovery begins when excess inventory is cleared and rents start to stabilize.
The previous steps are present in almost every real estate boom and bust. But the universal truth in every CRE bust is overbuilding. Then it is followed by system deleveraging of some sort. Currently, residential overbuilding has caused severe price drops followed by a liquidity crises as banks try to clean their balance sheets from bad loans and defaults as result of overzealous lending.

The slow economic environment, the disruption in capital markets and the shutdown of CMBS market will no doubt weight on CRE prices, no questions about it, prices have to come down. Owners have to refinance at some point and when they can't they have to sell at any price to allow them to repay their loans. However will CRE go by the same way as housing and suffer a collapse in pricing? That question can be answered by finding out: if developers overbuild in this CRE cycle. Answering this question have many implications to banking write offs and the severity of CRE price decline.

In the late 80s and early 90s CRE has endured a similar fate to what housing is going through right now. You can argue it was exactly the same but the current crises is much more severe due to the large size of residential mortgages and housing construction compared to commercial lending and construction.

  • The amount of investment in CRE the current cycle is mundane compared to the late 80s and early 90s as percentage of GDP. That suggest that the current cycle of CRE did not terribly overbuild to create excess supply that could lead to a bubble like environment, however still since 2003 non residential investment has picked up a bit, see chart 1 from Wall Street Journal.
  • Most of the construction investment happened in secondary markets, take the example of office construction as in the graph 2, courtesy of CB Richard Ellis research.
  • Construction prices have skyrocketed due to natural disasters and rising commodity prices, which has tempered new building in all property types. That lack of new supply increases rental pricing power and occupancy levels in existing properties. New developments will incur higher costs so they have to charge higher rents to earn good returns giving an advantage for existing buildings to charge less rent. That dynamic will limit new developments and construction a bullish sign for CRE valuation.
  • Most recent construction happened in suburban locations or B and C locations. Downtown real estate saw little change in construction levels over the past few years as you can see in chart labeled office construction. Further evidence is the available sublease space is also low compared to previous cycles as seen in chart labeled available sublease space. The limited construction and further decline in construction in the downtown office market will lead to higher rent growth once the US comes out of this rescission and employment starts to grow again.
  • Real estate funds are flushed with cash and new ones are being formed to take advantage of the dislocation in capital markets
  • Retail space will face tougher outlook than office due to retailers bankruptcies and slow down in consumer spending. Space vacancy is highest in retail space in a decade. Take for example some of the recent events for retailers:Two retailers on the brink of collapse with strong potential to announce major store closings over the next six months include Steve & Barry's, which operates 276 stores, and Circuit City, which operates 696 U.S. stores. Add to this the likelihood that Linens 'N Things will liquidate the remainder of its store fleet (382 stores, as it already announced 120 closings in May and another 87 this week) and Whitehall Jewelers, which just filed bankruptcy, will liquidate its 373 stores, and there is already another 1,721 possible closing announcements over the next six months. Foot Locker is closing 140 stores; Wilson's Leather is closing 160; Ann Taylor, 117; and jeweler Zales has closed 105.
  • For some chains, times are even more desperate, and the drumbeat of retail bankruptcies grows louder by the day. So far this year, 15 retailers with assets of $100 million or more have filed for Chapter 11 bankruptcy, up from seven for all of 2007, according to, which tracks such filings.
  • Property & Portfolio Research expects the final tally of store closings for the year to climb to more than 6,000, compared with 4,600 closings in 2007. As of mid-August, Boston-based PPR reports 5,300 closings. Of the store closings tracked by PPR, 46% are located in malls and about 43% in strip centers, with the remaining stores tied to big-box retailers. The current retail vacancy rate nationally is 11.8%, according to PPR. The firm forecasts the vacancy rate to rise to approximately 13% by the end of 2008 and 14% by late 2009. Apparel stores accounted for about 35% of the 2,831 store closings tracked by the International Council of Shopping Centers (ICSC) in the first half of 2008. About 6.5% of the store closings through the first half of 2008 tracked by the retail industry trade group were in the home furniture and furnishings niche, one that moves in tandem with the housing market. However, this is an improvement considering that this niche accounted for more than 14% of store closings in the first half of 2007, and about 34% of the closings in the second half of 2007, according to ICSC.
  • Lack of liquidity: CRE market still have good fundamentals as no overbuilding occurred in this cycle, but distress in CRE will come from lack of financing. Owners have refused to sell in the last 2 quarters due to low prices but they have to sell some time if they can't refinance. My thesis is condos and single home developers will be the one doing most of the selling but income producing properties like offices and retail are in a better situation completely. Banks have been reducing commercial loans and taking reserves against commercial loans because they lump single home and condo development loans with all commercial real estate loans. Financing for this type of assets have dried up but for an owner of an office building that have available property will be able to get refinancing.
Conclusion and CRE investment thesis
One of the good things about the recent economy is that in most sectors--excluding the residential sectors--there was relatively little overbuilding. High oil prices, high commodity prices and fierce competition for construction equipment and material in other parts of the world--China, India, and the Middle East--tempered the market's tendency to overbuild and will make new space less competitive. The lack of over-supply in the US commercial real estate market will help to support and speed the recovery in the market. I will focus on companies with portfolios of downtown office space like Brookfiled Properties and Boston Properties as they own unique assets with high barrier to entry. The slowdown in lending and capital market activities has put the breaks on new developments making new supply in the future virtually non existent therefore allowing existing office space to command higher rent due to limited supply in the future. I will avoid companies with large development business or pipeline as they will get chocked in this current environment and their prospect of earning good return is outweighed by risks involved. I will avoid retail properties due to significant risks to their ability to increase cash flows. Supply in retail properties is abundant at the moment due to string of bankruptcies. But in general these vacancies are a function of economic slowdown and the same thesis for office space applies to retail. unique assets will command a premium due to higher replacement cost and the drying up of financing for new developments.

1 comment:

Anonymous said...

I have a question related to CBG. It appears CBG's margin is very thin, with 1.3 billion revenue, the income is only 16 million. Is there something terribly wrong with this company's business model? The company appears to have very thin margin, and they are not able to reduce cost when revenue shrinks. Do you know why their margin is so think? Is it because they pay high commissions to employees and their employees are overpaid? Very thin margin and mindset of growing big with acquisitions even at the cost of profitability are big risk factors for stock investment. I want to know why you think CBG is a good buy given their high fixed cost nature and habit of big costly acquisitions. I think from investment perspective, this is the kind of stock one shall try to avoid. In good time it's hard to tell the true risk of a business, but in bad time, one can clearly see the risk factors of a business. With so many choices in real estate market, I don't see any compelling reason to buy CBG. It doesn't pay a dividend, the management is not prudent and make big acquistions at the top of the market, fixed cost is high, has a bankruptcy history.

Another big negative factor is that they have 29000 employee and only less than 3 billion market cap, something is not right about this company. I typeically don't like company with large number of employee and low market cap, that only means the true productivity of the company is very low. There are so many employee want to share the wealth created by the company, how can this be a good investment if so many people need to share the upside. Google has less employee and much big market cap, that means either cbg overpaid their employee or the productivity of their employee is very low. In the long run, I don't see how one can make decent investment in this company unless they are very good market timers.