Wednesday, June 24, 2009

CRE Indicators

At CRE Financial Advisors, we never stop underwriting. With countless years of Commercial Real Estate risk analysis between us, our firm’s “risk sensors” are never switched off as we monitor and assess rapidly changing Commercial Real Estate market conditions.

Some of the key CRE Indicators CRE Financial Advisors is watching closely:

Constrained CRE Capital Markets: there is nominal origination activity and most, if not all of the activity, is occurring by way of guarantees or funds issued by the government. The important market test will be if and when CRE capital markets can once again stand up without government support. We believe the reconstruction of the private CRE capital markets will take a long time and may not return to historical levels for at least 5-10 years.

Rapidly Rising CMBS Default Rates: The rise in default is occurring due both to the inability to refinance and the erosion of asset performance and quality. Looser underwriting based on aggressive growth assumptions in pre-2008 pools means these complex capital structures are unraveling rapidly. Addressing the interests of competing bondholders is new and treacherous territory for workout professionals.

CMBS Appraisal Reductions: Plunging values are prompting servicers to cut back on liquidity loans to securitization trust affecting interest payments to below investment grade bondholders. This trend is creeping up the credit curve. This downward trend (spiral) is self-reinforcing.

FDIC Sales Activity: The FDIC has conducted 1st Q 2009 of whole loan sales of bank assets totaling approximately $2Billion face value, selling at $.51 on average. A new FDIC portfolio, totaling $6 Billion in a structured loan offering, is expected to hit the market in July/August 2009.

CRE Asset Spot Market Sales Activity: We are hearing that in the private CRE asset sales market (mainly offered by banks), many deals are not closing. The bid/ask gap is still too wide and the prevailing approach by selling financial institutions may be that if price targets are not met via portfolio sales, it is better to wait for economic recovery to restore or shore up asset values.

CRE Financial Advisors’ Macro-market Monitoring and Micro-market Analysis

The New Normal Economic Utilization Rates:

One of our overriding concerns is that economic activity is going to run at a significantly lower level in the new, less leveraged economic environment both in the near and the long term. The core economy will keep working (at an 80-90% utilization rate) but the economy on the margin will continue to suffer. The government has been the major economic support and has financed the reconstruction of much of credit market and some productive capacity via credit enhancement and economic stimulus. The government support will not continue indefinitely. The devastation and destruction on Wall Street has eliminated many marginal players, allowing the strongest Wall Street institutions to gain share and recover quickly.

For us, one interesting example of the New Normal is the drop in US car sales from the “bubble” level of 17 million vehicles per year to possible sustainable sales of 10-12 million units in the more constrained credit environment. Lots of marginal human capital will need to be redeployed and relocated as production levels adjust to new, lower levels and production shifts to new locations thereby affecting many micro-markets. Production housing, a historically strong job-creating machine in many US markets, is also re-aligning itself to new demand levels in response to the still evolving economic and financial landscape.

The Inevitable CRE Value Reset to 1995 or 2005 Levels:

In CRE, cash flow is king. We believe that in many markets, CRE Net Operating Income will deteriorate slowly but surely. Due to the economic downturn, a significant rental rate reset is occurring and will flow to the commercial property bottom line, ultimately realigning commercial values over the near term. Just because it is occurring slowly does not mean it will not occur or can be avoided. As we have seen in the past year, there will be some spectacular failures and many more subtle, long term re-adjustments.

The banks have every reason to wait as long as they possibly can before unloading CRE assets. We believe, at minimum, we are facing a 10-30% commercial value downward adjustment. Some asset classes, such as raw residential land in outlying areas, may be hit much harder.

Some of the smartest people in the room are forecasting massive debt destruction (in fact, many are banking on it). According to some experts, the lack of true incremental productivity (not speculative financially engineered growth) of underlying assets is the force requiring the dramatic reset of debt levels. We believe that finding and valuing productive assets realistically is the key, where value is driven by solid and sustainable demand.

Debt destruction will eventually occur at banks and other financial institutions. An emerging strategy to access discounted bank debt is to simply buy the whole bank. Acquiring banks presents an “opaque trading opportunities” for various funds. In these transactions the government often assumes much of the downside risk.

The Old School Burnt Down but New School Fundamentals Have Yet to Emerge:

It has been reported that the rate of economic decline may be slowing. We firmly believe that new incremental demand and growth will be slow in coming and that we must be aware of false positive indicators in the CRE market. CRE is currently a lagging indicator and will not hit the floor for at least one to three years.

One of the questions we are asking ourselves is: what if consumer confidence is no longer an accurate indicator of the direction of the economy because the consumer demand algorithm (historically 70% of GDP) has shifted away from the consumer in a new, thriftier economic environment. Consumers may not get to call the next economic recovery. Loss of jobs, lack of savings and credit scarcity (for consumers and small businesses) means empty pocketbooks.

New demand can only derived from new incremental productivity. In this viscous cycle, credit providers are waiting for improved household productivity and stability. Households are waiting for job creation and the return of credit.