Experts: Commercial real estate market at too high a gear

After driving into a ditch during the worldwide economic meltdown, commercial real estate has taken to the comeback trail way too quickly and could end up crashing again, real estate veterans warn.

Industry executives are concerned that rising real estate prices and easing loan terms — at least for stable properties — are higher than real estate fundamentals, which include measures such as occupancy and rent rates.

Commercial real estate has had a history of highs and lows but in the past, the industry has taken much longer to recover, said Jacques Gordon, global strategist at LaSalle Investment Management. After a recession that economists have compared in severity to the Great Depression, it should have taken more time than usual, not less, for the real estate market to rebound, he said.

And this isn’t solely a U.S. market phenomenon but also a worldwide one. Prices around the globe are outstripping real estate fundamentals, Mr. Gordon said.

“Investment managers need to be cautious and thoughtful,” he said.

The National Council of Real Estate Investment Fiduciaries’ Property Index has been positive for six quarters in a row.

The total return for the 12-month period ended June 30 was 16.7%, with much of that coming from the increase in the value of the properties. A year earlier, the return was -1.48%.

“There are a lot of clouds on the horizon for commercial real estate,” said Scott Minerd, chief investment officer in the Los Angeles office of Guggenheim Partners LLC.

There are warning signs leading money managers to factor in a double-dip downturn in their commercial real estate investment scenarios.

For example, Mr. Gordon said, there is little reason that office buildings in good locations should be selling at high prices when unem- ployment is still high.

According to the NCREIF Property Index report, the one-year return for the period ended June 30 for properties located on the West Coast was 15.7%, with 8.7% appreciation.

The seasonally adjusted unemployment rate in California in June was 11.8%; Oregon, 9.4%; and Washington, 9.2%, according to the Bureau of Labor Statistics. California’s unemployment has been in the double digits since 2009.

“We’re getting an earlier-than-expected return to development, value-added real estate investment and leasing,” Mr. Gordon said. “We’re shifting back to value-added ahead of real improvement in the economy.”

Real estate is an aggressive market, Gregory Walz, a managing director for real estate lender Northwestern Investment Management Co., said during a panel at the NCREIF summer conference in Chicago last month.

“It’s too frothy, too quickly,” he said.

At the same time, the loans in commercial-mortgage-backed securities issued before the crisis are starting to come due.

Those loans generally are the less stabilized, B-class properties that aren’t performing well, Mr. Minerd said.

“Given these loans are coming due in the CMBS conduits, it’s really starting to raise serious questions about the ability to refinance CMBS,” he said.

If CMBS loans can’t be refinanced, that could cause all commercial real estate prices to plummet, Mr. Minerd said.

“The world has not fully awakened to the refinancing risk yet,” he said. “The implications could be another setback of commercial real estate prices, especially in the B-class buildings, which by the way, are the majority of the buildings.”

Even managers who don’t expect a second real estate market crash are factoring the possibility of one into their investment plans.

The old, precrisis world was influenced by Yale University chief investment officer David F. Swenson’s model, “where it is OK to embrace illiquidity and get the premium from appreciation,” said Katherine Burr, chief executive of Loja Group LLC and president and chief operating officer of subsidiary Loja Real Estate LLC. “It turned out that the only valuable asset was the one that was ignored the most — and that was cash.”

In today’s world, the focus is on income.

“Institutions have to look to make sure that the income is there,” Ms. Burr said. “Everyone should at least be factoring a double dip [in real estate] into their thinking.”

Mr. Gordon, meanwhile, said: “LaSalle Investment Management is trying to stay ahead of the game. We’re trying to avoid too much capital chasing too little product.”

Arleen Jacobius is a reporter at sister publication at Pensions & Investments.

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