June 4, 2009

Commercial Real Estate: Some Observations

I have taken a beating on my commercial real estate holdings (CRE). So it is time to reevaluate my position on the sector.  

My original buys of these names were in late 2008 on the premise that unlike previous down cycles in CRE, office real estate is not overbuilt and will not experience any thing close to late 1980 collapse in prices. I guessed that the market had overreacted to CRE and the market though a repeat to the  collapse in residential housing will occur in CRE.  I expected cyclical down pressure on their operation to be mundane. You can see my earlier views here:  post 1, post 2, post 3, post 4.

What is the status of CRE, here are few observations:
  • Credit underpins the valuation in all capital markets, including commercial real estate. To that extent lack of credit have downward pressure on CRE prices. The fact that CRE did not overbuild dampen that downward pressure.
  • As deleveraging occurs, credit for CRE will not be available. Private equity and investors are not rushing to pour money into CRE.CRE upleveraged and needs to deleverage, while debt value are constant it follows that asset values came down so equity is wiped out.
  • As property owners have no equity in their holdings they have no incentive trade or sell their assets. They will hang on in hope of something to happen. For example, GGP did not want to trade with Simon Property even in bankruptcy because they do not gain on these sales, so they will hang onto their properties in bankruptcy in hopes of something happening.
  • No transaction will occur for few years so valuation will not be visible. Valuation will decline but will be mundane at least in what is reported in indices. 
  • Transaction will occur in two instances:
    • loans come due and the majority will occur in 5- 8 years. Lenders will extend loans rather take loses.
    • transactions will occur when there is growth prospects of leasing, rental agreements..etc. so far the prospects of performance is not visible so highly likely no transactions to occur.
  • The 20% drop in values are for small properties and not indicative of values in CRE space. publicly traded CRE companies have gone some 55-60% may be that is more accurate for CRE values.
  • REITS that have announced equity sales have gone up and when completed have gone up even more. These REITS Ent. value has expanded as it reduced its debt/ equity ratio. Raising more equity will increase value rather it will dilute ownership as earning are decompressing.
  • office will hit hard as unemployment will be high for few years so demand will go down although no overbuilding happened. 
Am I to abandon the space? I think not. But I will reduce some exposure as I take advantage of this rally. There are interesting development in some areas that can lead to opportunities especially on debt and distressed debt front. Still my preference is to buy long term assets in supply constrained markets, Like Brookfield Properties and Boston Properties. 


Anonymous said...

Can someone please translate this sentence into English?

"Raising more equity will increase value rather it will dilute ownership as earning are decompressing."

Sami said...

the Entp. value that is as you replace debt with equity it is more valuable in this cycle of deleverage. That is all.

if you have two identical businesses, A with 80% leverage to assets and B is 40% leverage to assets, B is more valuable now as earnings dilution takes back seat to solvency.