Summary
Based on public equity valuations, where P/E ratios based on projected "E" are at all time highs it is hard to envision a scenario where Commercial Real Estate equity returns achieve positiive levels. Fundamentals remain weak, availability of debt financing remains constrained, and all expect a surplus of REO properties to hit the market over the next few years. The tree legs of the valuation stool - supply, debt financing, cash flow growth - are broken; not a pretty picture for valuations.
Analysis
The 3 legs to the valuation stool will remain broken for some time - too many properties on the market relative to investor demand, not enough debt financing available, and weakening fundamentals:
Reviewing recent commercial bank releases, and rating agency reports on CMBS highlight the building issue(s) impacting the commercial real estate space. Specifically, non performing/REO balances at commercial banks and increased special serviced loans in CMBS markets are leading indicators to the supply of distressed properties expected to hit the markets over the next few years. Commercial banks ratios will only deteriorate further as the recent round of appraisals result in an increased number of loans with LTVs (Loan to Values)>100%; as LTVs pierce the 100% level, non performing loans will increase putting pressures on banks to unload. Commercial banks and special servicers will seek to unload foreclosed properties over the next few years in an effort to put the problem behind.
Debt markets remain broken; while, on an isolated basis banks and insurance companies are providing financing, the majority of financing fueling the last value binge - CMBS - remans broken. Until the securitization market recovers to some modest level, availability of debt financing - which ultimately drives value - will be constrained.
Fundamentals remain weak. In a jobless, slow growth recovery, real estate space demand will remain anemic - particularly non core retail, non core office, and luxury/destination hospitality. Real estate fundamentals will not improve until job creation kicks in.
One ray of sunshine does exist - private equity/opportunity funds are focussed on the area. While supply of capital is limited, it does indicate that there is a "bid" for real estate at some level, albeit at levels materially below those of 2007.
