Case for Distressed Commercial Real Estate

The commercial real estate ("CRE") market is beginning to look attractive relative to other real estate investments. During 2004-2008, the U.S. CRE market, driven by record levels of capital inflows, increased by 50%. In the subsequent collapse prices have fallen 42% nationwide from their peak, according to the CPII index. Capital has been slow to return to many parts of the real estate market. MBS issuance reached only $40 billion in 2010 and is expected to increase, but remain at low levels. Investors, in a flight to quality and in search of yield, have poured capital into core CRE, which has caused prices to return to near record levels. However, less capital is available for assets with high vacancy rates, over-leveraged balance sheets, and bankruptcy situations. An abundance of income producing, distressed assets are available at favorable prices for investors with the ability to turn around poor performing assets.

The current supply-demand trends in CRE provide an opportunity to earn attractive returns. Below is a list of factors that contribute to the current opportunities that exist within CRE:

·         The CRE market appears to be in the very early stages of a recovery and now faces favorable supply and demand trends. Absorption rates have been positive for three consecutive quarters, which has lead to a better vacancy picture nationwide. Vacancies appear to be slowing, and in some areas improving after increasing 35% since 2008.  Commercial vacancies across the U.S. are currently estimated at 16.4% which is well below the long-term U.S. average of 14.6%. New CRE supply is near an all-time low, because rents in most areas do not justify new construction. New construction represented only 1.2% of the total CRE stock in the first quarter of 2011. Increasing demand and favorable supply trends is producing a rebound in NOI, thus increasing valuations.

·         Roughly $250 billion of CRE mortgage debt is currently distressed; an upcoming wave of maturities should push the amount of distressed mortgage debt higher. An estimated $2.5 trillion of commercial mortgage debt will mature over the next seven years. Lower NOI and CRE valuations will make refinancing difficult for CRE that was originally financed at historically high valuations and with significant leverage. On a weighted average basis, 34% of all CMBS loans originated during 2003-2007 are on a watch list or are delinquent. Some private equity real estate funds, such as Blackstone Real Estate, are positioned to provide the necessary capital for restructuring, recapitalization, and refinancing. Distressed property sales increased from $5 billion in 3Q 2010 to $12 billion in 4Q 2010. Lenders have been generous with distressed properties often extending loan maturities or providing some other form of restructuring, but as property values have appreciated many lenders have begun looking to remove CRE from their books.

·         Limited debt capital is available to fund over-leveraged, distressed assets. Only $11 billion in CMBS was issued in 2010, down from its peak of $230 billion in 2007. CMBS is an important source of debt capital and is necessary to support a sustained recovery. Early this year the CMBS market showed signs of improvement; in the first quarter of 2011, approximately $10 billion of new CMBS issuance was in the pipeline and analysts expect total issuance for 2011 to top $35 billion. However, new CMBS issuance has recently slowed as the market has become more volatile. REIT and Private equity capital has returned to the CRE market as well, but the majority of funds have focused on core properties. REITS raised $26.24 billion in 2010 and $23.72 through the second quarter of 2011. A significant portion of this capital was used to shore up balance sheets, but REITs have also increased acquisitions. A total of 439 private equity firms are attempting to raise $160 billion for new real estate funds compared to approximately $40 billion in 2010. Capital inflows will provide some support to valuations despite unfavorable global economic conditions.

·         Core real estate prices have enjoyed a strong rebound; for example, the vacancy rate in New York City's prime office market is approximately 4%. Distressed properties have not participated in the rebound, which has created favorable valuations. Stabilized core CRE often attracts several buyers; however, far fewer investors have the capital and experience to purchase distressed assets, which often requires complicated capital intensive workouts. The lack of buyers for distressed assets has created an opportunity to earn outsized risk premiums. A strong core market is good for opportunistic real estate funds because once the distressed properties have been stabilized they can be sold to core buyers for large premiums.

Despite the favorable trends in CRE, substantial risk still exists. General economic conditions, interest rates, and changes in supply and demand pose risks to CRE. Economic growth and employment are of particular importance to CRE due to the reliance on office property demand, retail spending, and hotel demand. Investors are also dependent on the availability of mortgage funds to finance the portfolio. Lack of financing and/or rising interest rates can negatively impact returns.

Comparatively, private equity opportunistic CRE looks more attractive than REITs. REITs have rebounded strongly from the great recession, gaining approximately 130% since their 2008 lows. The rebound in REIT prices is worrisome; many REITs now trade at a premium to NAV. Core real estate prices have been pushed up by REIT and private equity buyers. Core properties are selling for capitalization rates that historically have not produced outsized returns.

Why S&P's Downgrade of the U.S. Means Little

The media has made a ruckus over the U.S. debt ceiling and S&P's downgrade, but the markets are not responding with the same hysteria. In fact, the market has not had much to say about the downgrade. I think S&P's action will have little impact on the economy and financial markets. However, if over the long-term the reasons driving S&P's downgrade continue, the U.S. would be headed for trouble.

Why do I think S&P's downgrade doesn't really matter? First, Moodys and Fitch confirmed a Triple-A rating on the U.S., which means financial institutions that are mandated to hold Triple-A paper do not have to sell Treasuries. Also, the Federal Reserve and the Federal Deposit Insurance Corp. issued a statement saying banks would not have to increase bank capital that was backed by Treasury or other federal-government-backed obligations. Financial institutions could be negatively impacted if S&P's downgrade of the U.S. leads to downgrades of financial institutions. S&P has yet to take any action on this front.
Second, S&P's ratings are just a label; supply and demand still determines the rates the U.S. will pay on its debt. Through this whole debt debacle and subsequent downgrade, Treasury yields have gone down which means the cost for the U.S. to borrow has actually gone down! Treasury yields have fallen because of recession fears, but even before the recent poor economic data was released Treasury yields (except for near term T-bills) were not going up.

The true concern is what will happen over the long-term if the U.S. continues on this path. S&P's downgrade is a first step towards higher borrowing costs. If China and other large holders of U.S. debt decide to diversify away from Treasuries the dollar will slowly lose its reserve status and the cost of financing our debt will go up. This process will play itself out over several years because large holders of U.S. debt will not want to dump large quantities onto the market thus decreasing the value of their Treasuries.

Investors are currently flocking to Treasuries in a "flight to quality" which shows that for now, U.S. Treasuries are still the preferred safe haven for investors.

My Investment Pick for a Slowing U.S. Economy

The DOW is down around 8% in the last two weeks mostly due to concerns over an economic slowdown. Major economic indicators are pointing towards a slowdown in U.S. growth, which has given rise to fears of another recession. I believe large cap stocks are set to outperform in the coming years. Specifically, I recommend Vanguard's Mega Cap 300 Growth ETF (MGK). In general, I am a value investor, but I like MGK because of the reasons outlined below.

First, I like large caps over small caps because they have the ability to generate revenue overseas, which could cushion a downturn in the U.S. economy.  The top 10 holdings of MGK are in order: Apple, IBM, Coca Cola, Oracle, Microsoft, Google, Phillip Morris, Schlumberger, Pepsi, and Wal-Mart. All of these companies have strong balance sheets and many generate a significant portion of their revenue overseas. Historically, large caps have performed better than small caps during periods of slower growth. Small caps have also performed very well since the recession and they look expensive relative to large caps. For example, Vanguard's Small Cap Growth ETF sells for 31 times earnings, while MGK sells for only 17.7 times earnings.

I like growth right now because the price of growth relative to the broad market is attractive. In comparison to Vanguard's Mega Cap 300 (MGC), MGK offers strong growth potential without a large premium. MGK is currently selling for 17.7 times earnings with a growth rate of 12.7% and return on equity of 25%. In comparison, MGC sells for 15.4 times earnings with a growth rate and return on equity of only 6% and 21.1% respectively. If the U.S. economy slumps, companies that can grow revenue and earnings will receive a large premium.

I am not attempting to predict the direction of the U.S. economy, but MGK provides downside protection in the event of continued slow growth and positions investors to benefit from a surprise upswing.