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Commercial Real Estate's Death Knell May Have Been Premature

In the face of some otherwise-daunting obstacles, commercial real estate is proving to be an attractive area for investors looking for bargains as loans come due and foreclosures mount.

Analysts have been warning for months that commercial real estate could be the next shoe to drop in the subprime mortgage collapse that came to a head in 2008.

But with signs of thawing in the securitization markets and indications that investors are ready to come to auction when properties are on the block, the idea that the industry represents a major looming danger for the economy is losing traction.

Prudential Financial executives, speaking at a market outlook discussion Tuesday in New York, said they are "reluctant optimists" on the space. Marc Halle, the firm's managing director of real estate investments, compared the industry to a "fly wheel" that likely will accelerate in the years ahead.

"As it cranks up, it's going to start going pretty quickly in the next three, four years," he said. "We think the recovery is going to be very different this time."

Halle acknowledged that distressed conditions are likely to intensify in the market but does not expect to see "wholesale foreclosures." Instead, real estate investment trusts could become a more attractive asset class in a slowing economy as interest rates stay low and REIT dividends remain solid.

For instance, theVanguard REIT IndexETF , which tracks the Morgan Stanley Capital International US REIT index, is up in price about 7.6 percent in 2010. But perhaps as importantly, the fund is paying a healthy 4.64 percent dividend, providing allure as the stock market grinds through the summer.

The Dow Jones REIT IndexETF is up about the same amount and pays a 4.26 percent dividend.

Broadly speaking, REITs have gained about 7.75 percent in 2010 while the major stock indexesremain mired in negative territory, according to FTSE/National Association of Real Estate Investment Trust data.

Halle said Prudential has been a slow buyer of commercial real estate, but has found surprisingly high pricing in the market and strong bids.

"We think the recovery is going to be very different this time." -Prudential Financial, Marc Halle

"When we sell a property, the number of bids is phenomenal," he said.

Big banks also are seeing opportunity on the commercial side.

JPMorgan Chase, Goldman Sachs and Citigroup are all making forays back into the securitization market, which is the lifeblood of commercial deals.

The banks are expected to launch $1.4 billion in two offerings of commercial mortgage-backed securities, according to a report Wednesday in the Wall Street Journal, which cited sources familar with the planned sales.

The offerings pale in comparison to the more than $1 trillion coming due in maturing debt over the next five years, but offer some glimpse that Wall Street may be getting back on board.

"There are select opportunities," said Paul Sobrera, president of Alliance Consulting in New York. "The opportunities are in deeply distressed foreclosures and bank-owned properties. However, I still feel those properties haven't been discounted enough to accommodate the discount in rents."

Indeed, there remain obstacles, among them whether prices will continue to fall and if banks will become more open with lending practices.

Many banks these days, in the face of stronger regulation including more stringent capital requirements, are eschewing the typical longer-term mortgages and instead are forcing buyers to take five-year balloon plans, forcing them to refinance down the road and face an uncertain future with interest rates.

Uncertainty among borrowers regarding whether banks will go back to more normalized lending practices is at the root of criticism against the Frank-Dodd financial regulations that President Obama signed Wednesday.

Banking analyst Dick Bove, at Rochdale Securities, said there is a persistent rumor that the Federal Reserve is looking at loosening capital requirements. Bove, a harsh critic of the new law, said that would be a welcome development.

"It demonstrates that the Fed understands that it must help the banks so that the banks can help the economy," Bove said in a note to clients. "It implies that the Fed will not be very hasty in putting into effect the onerous rules being mandated by the banking legislation. If the Fed truly understands this, the outlook for banking and, more importantly, the economy is beginning to change in a positive manner."

Banks themselves have been voicing some slightly encouraging sentiment regarding the direction of commercial real estate.

Most institutions issuing their second-quarter results have been indicating that commercial loan losses either are reversing or leveling off.

US Bancorp delivered perhaps the best news of the bunch, noting that it had seen "strong lending activity" totaling $46.3 billion in the quarter that included $11.4 billion of new commerical and commercial real estate commitments, as well as $17.9 billion of renewals.

Wells Fargo reported $1.3 billion in commercial real estate losses but noted that it was a "significant reduction" that it expects to continue.

Even Comerica, which reported a decrease of $641 million in average loans, more than half of which came from commercial loans, said the total decrease of $1.1 billion in average earnings assets bettered the previous quarter's mark of $1.4 billion.

Prudential's Halle said he expects banks, which normally don't like to keep foreclosed real estate on their books for long, will be changing their approach.

"Banks don't like to hold real estate. They want to sell real estate off their books," he said. "This time they may want to hold real estate because they see the value out there."

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.