EVEN a cursory glance at recent events in commercial real estate would make you think the next big collapse is upon us.
First, there was the default last month by Tishman Speyer Propertiesand BlackRock Realty on billions of dollars in loanson Stuyvesant Town and Peter Cooper Village, the huge apartment complexes in Manhattan. When the deal was done, in 2006, it was the biggest of its kind in American history.
And this week, Simon Properties tried to buy General Growth Properties, its shopping-mall rival, for $10 billion, a price General Growth says is too low even though the company is in bankruptcy.
Yet in the midst of this, financial advisersare telling their wealthy clients that there is tremendous opportunity in real estate. What is equally intriguing is that these investors are looking again at something as illiquid as a building, which goes to show just how quickly people can reacquire their appetite for risk if it means higher returns.
“The trick with investing in commercial real estate is not knowing if something is bad, but knowing if that ‘bad’ is priced in,” said David Frame, global head of alternative investmentsat J.P. MorganPrivate Bank.
The next few years are expected to be bad for commercial real estate largely because the rosy predictions made when the buildings were purchased in 2005 and 2006 have not come true. First, the values of those buildings have plummeted, as much as 45 percent in some instances. That is going to make it difficult for the owners to refinance their over the next few years. Second, the recession has reduced the rents and occupancy rates on which those inflated values were based.
But what’s bad for an owner may be good for an investor.
The opportunities in commercial real estate run the gamut of risk, from buying undeveloped land to buying stock in real estate investment trusts, or REITs, which invest in property and mortgages.
Mike Ryan, head of wealth management research for the Americas at UBSWealth Management, said while there were risks in commercial real estate, they would not be as bad as many bearish analysts had predicted and certainly not on the level of the residential real estate crash.
“The notion that the other shoe is about to drop and we’ll see a wholesale liquidation of property is overdone,” he said. But, he added, “We’re not saying people should plow in.”
Yet Mr. Frame said he saw the coming refinancing crisis in commercial real estate as a continuum of what has been happening with other securities in the last 18 months. “Our job has been to look through the capital markets and identify where there’s been a scarcity of capital,” he said, meaning where investors sold their positions quickly and fearfully. The first opportunities to take advantage of a turnaround were with convertible bondsand private equity. “Now,” Mr. Frame said, “we think the opportunity in real estate is much broader than it was 12 months ago.”
OPTIONS So how are people seeking to profit in commercial real estate? This depends on whether they are passive investors, who want to allocate some money to real estate, or entrepreneurs seeking to buy buildings.
Many investors who did not make their fortunes in real estate remain cautious. “You have to help them view real estate as private equity because you’re locking up your money for some period of time,” said Joanne Jensen, a private banker at Deutsche BankPrivate Wealth Management.
But if they’re going to invest in real estate, they want the security of high-quality investments. “I’m speaking to a lot of real estate investors, and what they’ve been telling me is there’s been a bifurcation between the ‘A’ quality buildings and everything else,” Ms. Jensen said.
One intriguing strategy is to buy the underlying mortgage debt of buildings whose value was inflated. The debt is now trading at a deep discount. This may sound risky, particularly if the owner walks away from that debt, as happened with Stuyvesant Town. But Mr. Frame sees it as a way to make either a little or a lot of money.
He described one possibility: a building was purchased for $100 million in 2006. It is now worth less, but the underlying mortgage is still $50 million, and it is coming due next year. The owner is probably going to have a tough time refinancing the mortgage without putting in more money. That uncertainty is reflected in the price of the debt.
“Say it’s 70 cents on the dollar, or $40 million for the first-lien mortgage,” he said. “If, in the next year, I get paid off, I get a 12 percent return. If not, I own the building at 60 percent off the original purchase price.”
In many cases, he said, clients are hoping they do not get paid back because the return from owning the building could be far greater. But the risk is they may have to hold that property for at least several years.
Some of his other ideas carry the same caveat: they require time. In this category, he included buying land prepared for developments that have stalled or buying loans from the Federal Deposit Insurance Corporation. The agency acquired these from banksand has bundled them into packages to be sold off.
Hotels are one area in which the investment turnaround could come faster. Their occupancy rates plummeted in the recession, and many were further hurt by having too much debt. “The most upside can come from hotels, if we get an uptick in the economy,” Mr. Frame said. “But the risk is high.”
Still, he said he believed that all these seemingly risky investments were actually predicated on caution. “We’re not taking an optimistic view of the recovery,” he said. “As long as it doesn’t get dramatically worse, we’ll be O.K.”
REIT stocks are a more liquid alternative. They went through their own steep decline last year. In March 2009, REIT stocks were down 75 percent from their February 2007 high, according to the leading REIT index. The index had rebounded to half of its peak, but REIT stocks slid again after the Federal Reserve raised its lending rate to banks on Thursday. This is not necessarily a bad thing for long-term investors.
“We think REITs are trading roughly at the net-asset value” of the properties they own, said Thomas N. Bohjalian, a portfolio manager at Cohen & Steers, a real estate investment firm. “And that is not the ceiling; it’s the floor.”
What is more significant than stock price, he said, is Cohen & Steers’s prediction that dividends on REIT stocks will grow by an average of 12 percent over each of the next five years. REITs are legally required to pay out 90 percent of their taxable income annually. In flush times, they were paying out a good portion of their cash flow as well. As income from REIT-owned properties rebounds, so will the dividends.
All these investment ideas are predicated upon patience and a healthy stomach for risk. With REITs, for example, Mr. Bohjalian said he did not expect double-digit dividend growth to start until 2011.
This patience works two ways. Ms. Jensen has several clients who have made their fortunes in real estate but have struggled to find properties at the discounts they expected. “They’re not willing to do a deal that doesn’t make sense,” she said.
That may be a good mantra for any investor.