While it has been widely assumed that the bulk of the damage from the devaluation of commercial real estate would hit properties purchased at the peak of the market in 2006 and 2007, Wall Street is now worrying about the deals completed in 2005 and earlier. If its concerns are right, tens of billions of more dollars in commercial mortgage-backed securities are at risk of credit downgrades; and future property transactions and loan reviews are subject to greater scrutiny from investors and banks.
According to analysis using CoStar COMPS Analytic, today’s average cap rates are now higher than they were in 2004 and the average price per square foot or per unit being paid today are either at or less than 2004 price levels.
· Office properties are approaching the average price paid in 2004 ($168.05 now vs. $164.02 then);
· Industrial properties are already 13% less than the average paid in 2004 ($70.66 vs. $80.90);
· Shopping center properties are 23% less than the average paid in 2004 ($83.79 vs. $108.71); and
· Multifamily properties are 19% less than the average price per unit paid in 2004 ($70,352 vs. $86,487).
Today’s average property sale prices are now 22% off their peak in 2007 for industrial property, 29% for multifamily and shopping center properties and 31% for office buildings. And the projection is that commercial real estate values likely face further pricing pressure.
Bond rating agency Fitch Ratings said it expects that real estate fundamentals will continue to deteriorate over the next 18 to 24 months, even as a recovery begins in the broader economy. That deterioration is likely to cause rating downgrades for seasoned U.S. CMBS deals.
Fitch plans to close out 2009 with a thorough review of its rated portfolio of older U.S. CMBS deals (originated in and before 2006).
“Large loan floaters, pre-2000 vintage CMBS, and deals originated in the latter half of 2005 will be most susceptible to downgrades,” said Mary MacNeill, a managing director at Fitch. “It should be noted that the magnitude of these expected negative rating actions will not be as significant as that of recent actions already taken on later vintages.”
While Fitch expects these older vintage transactions to perform better from a ratings standpoint, “it is now evident that all CMBS vintages are susceptible to the severe economic conditions of the past two years,” MacNeill said.
Fitch’s third-quarter review of 2006-2008 CMBS deals, which concluded earlier this month, resulted in rating affirmations on 80% by balance (totaling $186.1 billion), and downgrades for the remaining 20% ($44.3 billion). Fitch expects few additional near-term negative rating actions among these 78 deals.
Fitch currently has $10.8 billion from pre-2006 vintage fixed-rate transactions and $3.3 billion of the $30 billion of outstanding large loan floating-rate transactions on ratings watch negative. Fitch said it expects that operating cash flows will continue to weaken across all sectors.
While the economy has recently shown some positive momentum, Fitch said it does not expect that this momentum will translate into near-term stabilization for commercial real estate. Fitch’s current outlook on every major property type is negative.
The hotel sector has demonstrated the most volatility due to the daily resetting of rates and the discretionary nature of the operating business. Demand from both leisure and business travelers remains low. With travel concentrated at hotels with lower price points, the luxury segment has faced the greatest declines. Across the larger markets, revenue per available room has declined approximately 20% during the past year. Fitch said it expects the largest market value declines, of up to 50%, to occur in the hotel sector.
Though delinquencies remain low, the office sector will see stress in the coming months, as unemployment climbs through the coming year and longer term leases come up for renewal. Vacancies have reached 15% nationwide and are expected to rise higher in the coming year. Though larger central business district markets continue to outperform suburban markets, landlords are facing a swift decline in base rents, significant concessions, and vacant sublet space, now that tenants have gained the upper hand.
The retail sector continues to struggle due to cautious consumer spending, increased vacancies, and limited store openings, which have pressured rents. Owners are struggling with vacant big box spaces, as retailers across the country review their lease agreements for co-tenancy clause rent reductions or rights to terminate.
Rising unemployment and slowed household formation continue to affect multifamily loans, which have the second highest rate of delinquency. Vacancy has risen to 8% nationwide and is expected to reach 10% by next year. Falling rents won’t rebound until the supply overhang and shadow space are absorbed.
Fitch said it anticipates CMBS delinquencies will hit 6% by first-quarter of next year and double digits by 2012.
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