Mixed signals on commercial property

Believe it or not, the commercial-real-estate market could be close to a bottom.

If so, that signals relief to banks and other financial institutions that are struggling with troubled commercial-property loans and gives a boost to frozen commercial-credit markets — as well as the economy overall.

Commercial-property prices were up 4.4% in the third quarter, according to the MIT Transactions-Based Index of Institutional Commercial Property, a widely followed measure of high-quality assets owned by institutional investors.

That is the largest increase since the market downturn began in mid-2007, said professor David Geltner, director of research at the MIT Center for Real Estate.

The price index is now 36.5% below its 2007 peak, up from a 39% deficit last quarter.

Still, “I think it’s too early to call it a turnaround,” Mr. Geltner said.

But the index was “plunging like a stone, and at least for this quarter, that’s stopped,” he said.

What’s more, econometric modeling done by the center shows a nearly 12% jump in the potential prices at which buyers are willing to trade, Mr. Geltner said. That measure had fallen for eight quarters in a row.

“There’s definitely been a change in mood” in the past few months, said Kyle O’Connor, a principal at Marcus Partners Inc., which invests in private real estate. “There is certainly a lot more demand and a lot more confidence in the marketplace,” he said.

STILL GETTING WORSE

“The question is whether this is a bump-up on the way to [a lower] floor,” Mr. O’Connor said.

Fundamentals for commercial real estate are getting worse. Rents and vacancy rates are still falling.

That will continue to put downward pressure on prices, said Ryan Severino, an economist at Reis Inc., a real estate consulting firm.

“I don’t think we’ll see values fall at the breakneck pace we’ve seen in the last 12 months,” he said, but demand and financing aren’t plentiful enough to prevent further -erosion.

A broader measure of commercial prices, the Moody’s/REAL Commercial Property Price Index, is still trending down. It was off 41% through August from its peak in October 2007.

An analysis Mr. Geltner did of distressed properties in that index shows them off about 56% from the 2007 peak, versus 33% for healthy properties.

“The proportion of distressed sales is growing,” he said.

The big unknown is the overhang of commercial mortgages coming due in the next few years.

Lower property values, combined with stricter loan-to-value ratios by lenders, will make refinancing difficult.

More than half the $1.4 trillion in commercial mortgages coming due in the next five years are underwater, said Matthew Anderson, a partner at Foresight Analytics LLC, a real estate research firm.

That means those loans finance property that is worth less than the amount of debt.

About $250 billion of commercial mortgages mature this year, $270 billion comes due next year, and $300 billion rolls over in 2011, Mr. Anderson said.

“We’re going to see mushrooming demand for mortgage credit at a time when we don’t think values will be rising,” he said.

Banks have been extending terms on performing loans. More than half the loans that were up this year were simply extended by the lenders, Mr. Anderson said.

If lenders can stretch out the adjustment process, it is possible that they could end up with lower-than-expected defaults and loss rates, he said.

Indeed, U.S. banks are being encouraged not to make distressed sales and are in no hurry to do so.

Late last month, federal banking regulators gave banks more leeway in restructuring and extending underwater loans.

But that “extend and pretend” game can’t last forever, observers said. At some point, lenders will be forced to deal with distressed commercial property.

Observers think that banks may begin capitulating and begin more forced sales in the second half of next year.

“But it won’t be this crescendo of property dumped on the market like the early 1990s,” when Resolution Trust Corp. forced savings institutions to dispose of failed property, said David Lynn, managing director of research and investment strategy for ING Clarion Partners LLC, which manages about $40 billion in commercial real estate. “There won’t be fire sale prices, because everyone is ready for it,” he said.

“Our expectation is that prices could decline another 10% next year,” Mr. Anderson said.

That estimate assumes that the economy is “showing some signs of life, but with real estate fundamentals still getting worse,” he said.

A lot of cash is on the sidelines waiting to take advantage of distressed sales, Mr. Lynn said. For buyers, quality commercial real estate provides superior cash flow to many other investment alternatives, he said.

“There’s no shortage of equity for good-quality properties,” Mr. Lynn said. “I think it’s going to surprise everyone.”

E-mail Dan Jamieson at [email protected].