Commercial Real Estate: A Market of Ironies

The commercial real estate investment market is dealing with two major ironies at this point in the cycle.

The commercial real estate investment market is dealing with two major ironies at this point in the cycle. Elizabeth Warren, the chair of the Congressional Oversight Panel reviewing the financial markets, noted in February that half of all commercial real estate loans will be under water by year-end.

At the same time, there’s too much capital, primarily equity but also debt, chasing too few deals, either core assets in primary markets at one end of the quality spectrum or deeply discounted REO and distressed assets at the other end. The pace of foreclosures has been sluggish because banks are working hard to keep properties in the hands of borrowers and off their REO roles, and also because it takes a long time to unwind CMBS loans, which were not designed to move in reverse easily. Given the elevated level of distress in the system, it seems highly incongruous that there’s too much investment capital chasing too few opportunities, but that’s where we are.

The second irony is that commercial real estate investors are once again reaching for risk just as banks are shying away from risk due to fears over the potential restructuring of sovereign debt – Greece and Spain today, but the U.S. and UK tomorrow? In the last few months, low yields on cash have encouraged investors to assume more risk in search of higher returns across all asset classes. In commercial real estate, this trend is evident in investors’ willingness to compete aggressively for core properties in primary markets, driving down cap rates. Perhaps the commercial real estate industry hasn’t gotten the message yet that risk premiums are rising once again, or perhaps we’re hoping that rising levels of risk aversion overseas won’t have a big impact in the U.S. There is no way of knowing at this point whether financial contagion from European sovereign debt fears will push capital targeted for commercial real estate investments back to the sidelines.

If I had to guess, I would say that the current episode of credit tightening will have a minor effect on commercial real estate investors in this country who, after all, are targeting two very select slices of the property markets with the least amount of risk – high quality and high distress. If eurozone countries follow through on their commitments for budget cuts and financial support, I think domestic commercial real estate investment markets will continue to attract capital at a decent pace.