INVESTORS waiting for repeat of the distress in the early 90s and deeply discounted transactions in the United States commercial property markets could be waiting for an opportunity that may never arrive.
According to Pramerica Real Estate Investors’ US principal Phillip Conner, the market continues to have an uneasy “Waiting for Godot” feeling about it.
He said the credit crunch is hampering the orderly flow of capital and growing uncertainty about the near-term outlook for the economy, bid-ask spreads have widened as activity throughout the commercial real estate market, from lending to leasing to transactions, has slowed to a crawl.
And distress is working its way through the capital markets and inflicting losses on investors who are either overleveraged or who need to refinance in the current environment.
“And if the economy continues to weaken and vacancies rise, there undoubtedly will be more instances of distress in the transaction market for assets whose cash flows cannot support the debt service.
“But we have yet to see much evidence of properties trading at prices that would qualify as “distressed,” even in transactions involving highly motivated sellers,” he continued.
“It is clear that debt and mezzanine capital have repriced since this time last year. Commercial lenders responded to the credit market turmoil and the departure of the most aggressive sources of debt capital by widening spreads and tightening underwriting standards, most notably with lower loan-to-vale ratios.
“While falling benchmark interest rates have partially offset the impact of the wider spreads, the downward trend in LTVs has shifted a larger share of the capital stack to higher-yielding tranches, namely into the mezzanine and equity segments,”
But Conner said the repricing in the debt should produce a proportionate repricing of equity, but he conceded unless sellers lower their asking prices, it does not appear that equity investors are being compensated for the additional risks they bear in the current environment.
“Ordinarily, equity returns should be higher than mezzanine returns. However, if we assume property level returns have not changed materially, the implied equity return (cost) clearly is not sustainable.
“Either property level returns (and cap rates) must increase to accommodate a higher cost of equity, senior debt and mezzanine returns must decrease or, most likely, some combination thereof.
Meanwhile Conner said although signs of distress remain largely confined to highly leveraged deals consummated at the peak of the investment cycle, in late 2006 and early 2007, there is an undeniable and growing sense of anticipation among investors that
And so far, he said property values already appear to have fallen 10% or more from the pricing at the peak of the market, and they may continue to decline over the near term.
“The implied correction is still more modest than the cap rate analysis suggests, especially if inflation is taken into consideration. While the corporate bond market lacks an inflation-protected yield series similar to TIPS, we can construct a “real” yield series for corporate bonds based on inflation expectations derived from the Treasury bond market.
“The implied correction in property values (assuming 3% NOI growth and spread reversion over 12 months) would range from about –15% to –20% across the major property types, or about midway between the cap rate and Treasury spread analyses,”
However, Conner said there are now opportunities as property market fundamentals remain relatively balanced, a modest supply pipeline, soaring construction costs, and a wall of capital waiting in the wings.
But he added investors looking for a repeat of the capital-starved distress in the early 1990s and the deeply discounted transaction market it produced may be disappointed.
“That does not mean, however, that distress will not create opportunities along with the risks. As those who are familiar with Beckett’s play will recall, although Godot never appears onstage, his off-stage presence, whether real or imagined, and his expected arrival largely dictate what does and does not happen in the play.
“To be sure, more distress will surface in the transaction market before the credit market normalizes, and the combination of higher capital costs and lower rent growth will depress asset values in the near term,” he continued.
“Though it’s hard to generalize, it would not be surprising if property values decline 15% to 20%, on average, from peak-to-trough before values stabilize, which, if property values are already down by 10%, would mean that the correction is about halfway done, if not more. But most of the distress – and opportunities for investors – should remain “offstage” in the capital markets,” Conner concluded.
Australian Property Journal
