Commercial Real Estate's Uneven Rebound
In October, an investment group that included Blackstone Group (BX), Paulson & Co., and Centerbridge Partners purchased Extended Stay, a bankrupt U.S. hotel owner, for more than $3.9 billion, less than half what previous owner Lightstone Group paid for it at the peak of the real estate boom in 2007. While it is the biggest commercial real estate sale so far this year, according to CoStar Group (CSGP), a Washington (D.C.) real estate information and analytics company, it is also a reflection of the current U.S. commercial property market: distressed assets and struggling owners selling at a loss to investors with plenty of cash who can afford to wait for the economy to rebound.
Extended Stay was the victim of overleveraging by Lightstone and a drop in demand as the economic downturn dried up business for the midprice chain, which is based in Spartanburg, S.C."Nothing is wrong with the properties," says Bruce Ostly, an analyst in Portland, Ore., for Integra Realty Resources, a commercial real estate valuation and consulting firm. "The ownership got in trouble," Ostly says, "by buying and financing at the peak of the market based on inflated price."
In order for the market to pick up again, new owners must buy the properties and "make [them] work at today's price," says Brian Glanville, Integra's managing director and chairman of the real property board of RICS (Royal Institute of Chartered Surveyors) Americas. "What you're seeing is an opportunity to buy properties for less than what you can build them for today."
In real estate, "you take risks, and you're rewarded if you're right," Glanville says. In the boom period from 2005 to 2007, many investors such as Lightstone bought at the wrong time and at the wrong price. The problem, he says, is that the market has not been allowed to function.
Commercial real estate values have fallen—by as much as 20 percent to 30 percent from peak levels in some markets—and a gap persists in most of the U.S. between what commercial real estate sellers want and what the buyers are willing to pay, says Glanville.
Banks have modified loans, through a practice called "extend and pretend," to prevent owners from defaulting, but "the banks are no longer willing to carry them," he says. Owners "have to face reality now and see what they can get."
In August 2010 more than one in four sales involved distressed real estate, according to Moody's. During that month, U.S. commercial property prices also fell to their lowest level since June 2002, according to the Moody's/REAL Commercial Property Price Index.
Looking Up: Trophy Buildings
The situation is expected to get worse: More than one-third of the $270 billion in U.S. commercial real estate loans maturing in 2010 will be under water (or have mortgages greater than the value of the property), reported trade publication National Real Estate Investor. It expects the rate to grow to 63 percent by 2012.
Among the most stable segments: trophy buildings, whose prices have increased by 23 percent from their 2009 trough in such major cities as New York, San Francisco, Boston, Los Angeles, and Chicago as buyers and lenders seek secure investments, according to an Oct. 19 report on Bloomberg.com.
New data from Los Angeles-based commercial property giant CB Richard Ellis (CBG) show the national vacancy and availability rates for office, industrial, and retail space all exceeded 10 percent in the third quarter. The company predicts vacancies will decrease next year, although rents are expected to remain low due to the high availability of space.
"We are starting to see the first signs of demand as tenants see more stability in their businesses and are now looking to take advantage of low rents and a wide array of occupancy choices," stated Jon Southard, director of forecasting for CBRE Econometric Advisors, in a release.
This is good news for some of the country's biggest commercial landlords, such as Indianapolis mall owner Simon Property Group (SPG) and industrial real estate company Prologis (PLD) in Denver. "The bigger owners are those who own core or premium properties, and those are generally the ones that recover first," says Raymond Torto, global chief economist at CB Richard Ellis.
Even in the slowdown, the largest commercial real estate owners have been acquiring properties. Data from Real Capital Analytics, a commercial real estate research and consulting firm based in Manhattan, show that Blackstone Group, with more than $4.2 billion in acquisitions, is the top buyer of U.S. commercial real estate over past 12 months, followed by Simon Property Group with $2.8 billion.
"We're seeing a turn for the better," says Torto, "But once you've turned, it doesn't mean you go straight up."
Click here to see a roundup of America's 25 biggest commercial property owners.