The Problem Is Distressed Borrowers Not Distressed Properties

An interesting comment on CNBC regarding commercial real estate caught my attention. The guest (I wasn’t paying close enough attention to catch his name) suggested that the problem with CRE isn’t so much distressed properties rather it is distressed borrowers.

This makes a lot of sense, though I think it might be a mistake to extend it to the entire CRE market. For instance, I suspect that there are a lot of properties in the retail sector that are truly distressed and will remain so for the foreseeable future.

But back to the subject. While outside of retail, CRE is showing strains, objectively the decline in fundamentals hasn’t been that drastic. Vacancies are up and rents are down but not viciously. In normal times it would be a manageable situation. A few tweaks in capital structure, a little more equity and maybe some concessions from the lender would normally have been sufficient to put the situation right.

Unfortunately the excess utilization of leverage, overly ambitious cap rates based on proforma NOI growth and the difficulty of renegotiating securitized loans have combined to create a problem that requires massive tweaks. It’s not that the properties are performing that poorly in relative terms, it’s that the borrowers are massively under water with little prospect for restructuring.

The end result is still likely to be significant foreclosures of CRE with resales substantially below the prices the properties fetched several years ago. Put more simply, CAP rates are going to come back to reality. If you buy the argument that the fundamentals aren’t that bad then it could be one of the best buying opportunities since the early 1990′s.

An aside here. If this interests you look for B- or C+ properties in close proximity to core A office properties. You’ll attract a lot of tenants that want the prestige of the area or that need to be close to clients that locate in the A buildings. Your rents will be at a discount to the A property rents but will be substantially above rents in more remotely located sub-A markets and you may not have to pay much of a premium over them.

So if you’re looking at a real estate play, CRE might be something to keep an eye on. Sooner or later a lot of properties are going to come back to the financial system and they’ll have to be disposed of.

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