Priced to Perfection: CRE Values Inch Up

Downtown Chicago. Photo credit: Pedro Lastra

As the anniversary of COVID significantly impacting the U.S. and commercial/multifamily property markets passes, challenging questions about property values remain top of mind.

The answers will impact dynamics for both acquisitions and refinancing as well as recovery prospects for challenged loans. A few questions market participants are grappling with:

–How do office assets get underwritten with some unclear tenant business prospects and tenants not currently using office space much in many markets? 

–For underwriting hospitality assets, what is realistic timeline for return to pre-COVID demand levels for business and leisure travel?

–Beyond cliches of “retail is not dead; it’s evolving” or “B malls are bad, essential retail is good,” which tenants, locations and properties will be successful over the next three to five years as an overhang of oversupply works its way through the system?

–For multifamily assets, what continued impacts will economic distress, government support and economic recovery have on performance across markets and properties? 

–Across property types, is the suburban rise and urban decline narrative and its impact on performance going to outlive the riskiest chapters of the pandemic? 

–How do topics such as energy efficiency, ESG and climate risk play into property valuation over time with green premiums or brown discounts as these subjects are suddenly topic du jour in business and government? 

–How do exit capitalization rates get underwritten at the end of loan term in this low-rate environment? 

–What will the continued disparity between public vs. private market valuations be and what does this measurement and volatility in public market valuations say about the outlook for property values?

Answers to these questions will be drivers for how market participants value income producing properties going forward. 

Trading Places

It’s tough to make predictions, especially about the future. – Yogi Berra

While property values vary greatly by submarket, asset type and given the unique nature of each asset, its operations and rent roll, everyone knows crystal balls are not worth much in determining where these prices are headed. While forecasting is a challenging sport, synthesizing analysis about where markets are and what may drive their direction is helpful in providing a framework, challenging existing frameworks or simply understanding how others in the marketplace view today’s markets. 

Moody’s Analytics Head of Commercial Real Estate Economics Victor Calanog discusses the challenge of estimating value when transactions dry up with Newslink last July, observing, “There are several layers to this issue, and it’s not just the difficulty of finding appropriate comparables. There is also the physical challenge of visiting a site (still necessary in this day and age despite satellite images and other technologies) to conduct proper appraisals and inspections…When transaction activity slowed down in ’08-’09, our experience has been that valuation shifted from a focus on actual sales transactions to pillars of data that we could observe: namely, income drivers like trends in rents, occupancies, and expenses. Indicative measures like rent collection losses will be key to trying to anticipate the trajectory of incomes. In addition, closer coordination between the brokerage firms and other parties privy to the transaction will be key: for example, can we observe how many unsuccessful bids there were versus the seller’s asking price, to get a sense of what buyers were willing to pay? This was key to valuing land sales in New York when the market dried up in ’08-’09.”

Fast forward to January 2021 and observations from an MBA education webinar paint a picture of more transactions actually occurring than most expected in the second half of 2020 in the hospitality sector: 

“There was more (hospitality) transaction activity than expected during the second half of 2020. Many were expecting less volume than occurred, like the standstill that happened during the Great Financial Crisis. However, there was an uptick in the third- and fourth-quarter volume, although from a low point and at levels that remain weak.”

“There are active lenders for some hotels although transaction volume is down significantly across all categories. There is enough activity to get a sense that pricing is not as distressed as many have expected. There is lots of capital and some institutions willing to take a bet on the recovery and potential light at the end of the tunnel as vaccines are rolled out.”

“These properties carry a huge amount of risk with assumptions above recovery timeline as well as the playing out of potential secular trends that may change the industry over the long term that are not well understood yet. Harsher assumptions were being made in the second quarter of 2020, when transactions initially fell off in terms of discount rates chosen than appraisers are now using since a relatively thin market for transactions opened back up. Valuations are happening with some level of transactions to use as data points, although these are not the forced trades that may ultimately occur.”

While anecdotal, these comments point to the period of time with minimal transactions and the depth of problems with bid/ask spread experienced post-COVID being significantly less than post-Great Financial Crisis. 

In releasing its 2020 transaction volume in US Capital Trends report, Real Capital Analytics said, “volume in the world’s largest commercial real estate market tumbled in 2020 due to the global health crisis though there were signs of improvement into the year-end. U.S. sales volume fell 32% versus 2019 and for the fourth quarter dropped a more modest 19%.”

The finance market is always simultaneously impacting and impacted by property values across different property types and often tracks ebbs and flows along with transaction activity. Commercial and multifamily mortgage bankers are expected to close $486 billion of loans backed by income-producing properties in 2021, an 11 percent increase from 2020’s estimated volume of $440 billion, according to latest Mortgage Bankers Association forecast. 

Returning to pricing levels (not the same as value but certainly a data point worth reviewing), Green Street provides its latest index findings and noted the challenge of effectively observing pricing trends without a sufficient number of transactions to rely on.

The Green Street Commercial Property Price Index increased 1.1% in January. The increase reflects higher valuations for lodging properties. Pricing in other property sectors was unchanged. The all-property index is now 7% below pre-Covid levels.

“Pricing of properties where the top line is less affected by the pandemic are flat to higher versus a year ago. Property types heavily impacted by shutdowns–or where the ultimate impact from COVID is unknown–are seeing weaker pricing. The exact magnitude of price declines in these sectors, however, is unknown given little product is trading,” said Peter Rothemund, Managing Director at Green Street. “Most of the uncertainty surrounding real estate pricing should clear up over the next several months as the transaction market picks up, and when it does, we expect to see more upside surprises than the other way around.”

Distressed Debt Monitor

On the other hand, Keren Goshen, Co-Founder of Metechi, New York, highlighted various perspectives on troubled properties specifically in her article, The Distressed Debt Wave: 5 CRE Experts Discuss Trading Nonperforming Loans in 2021 and Beyond. “Brock Cannon, Head of National Loan Sales at Newmark, believes the distress created as a result of COVID will last beyond our predicted 5-year growth period. He says, ‘my team is still working on sales that originated in 2007 and 2008, thirteen years later. We will be working through this distress for at least ten years to come’,” the article said.

Trepp data tell a narrative about appraised values on distressed assets in commercial mortgage-backed securities, where appraisals have recently been ordered in connection with loans being transferred to a special servicer. While this information is telling, it leaves out of the equation value estimates for collateral on performing loans as well as those loans which are in forbearance. Further, while CMBS provides transparency for commercial real estate investors, what can be extrapolated about value drop from COVID is most applicable to banks, non-banks, and insurance companies non-performing loans. Given the GSEs and multifamily investor positions broadly have shown resilient performance numbers so far, there is not much to be gleaned there. 

	Median AV Change	Loan Count	Loan Balance	Average Starting Value
Hotel	-33.68%	351	6,170,507,675	36,824,236
Retail	-44.99%	238	7,429,485,111	77,663,055
Office	-41.53%	56	1,258,436,561	46,939,554
Multifamily	0.30%	149	3,434,952,524	35,838,221
Industrial	-41.67%	5	56,235,323	19,072,000
All	-33.12%	799	18,345,244,031	49,737,468
			Source: Trepp

The Fed’s Semiannual Report released on Feb. 19 called attention to the issue of commercial real estate prices and risk. “Commercial real estate prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand,” the report said.

In terms of pricing in publicly traded REITs, Jonathan Litt of Land and Buildings shares some interesting observations in a recent white paper:

“The Vaccine Mirage, as we have come to refer to it at Land & Buildings, is like an oasis of palm trees in the desert, fueled by excitement about the economy reopening and resulting in the most impacted real estate stocks ripping higher and higher. The rising tide has lifted all boats – but there will be winners and losers. The difference is that the losers may be obscured for a time, as the initial burst of post-vaccine activity will cause investors to second guess the likely secular headwinds for a variety of businesses.”

“Investors and management teams will be beguiled by the strong rebound in activity and revenues post- pandemic as life returns to normal. For many businesses, what was truly needed was a vaccine and a return to pre-pandemic life. For example, K-12 schools as well as universities will likely see a return to normalcy for the academic year 2021/2022. Leisure travel and social gatherings will enjoy a surge as people indulge in previously dangerous or forbidden activities before normalizing to more historic levels.”

“Yet the market does not appear to be differentiating closely enough between stocks likely to sustain a fundamental rebound from those likely to merely experience a mirage of normalcy. For example, share prices of hotel companies have rallied as much as the share prices of student housing, with the prospect of returning to pre-pandemic earnings pushed further out for lodging and much sooner for student housing.”

There are lots of interesting questions and uncertainty to be worked through in the determination of market values. Inevitably, generalizing and analyzing data at the aggregate level does not get past the fact that each asset, market and submarket is unique leaving plenty of room for variability and idiosyncrasy.

Andrew Foster is Associate Vice President in MBA’s Commercial/Multifamily Group. He is a former Analyst with S&P Global Ratings and Fitch Ratings as well as a regular contributor to MBA NewsLink. Foster can be reached at afoster@mba.org or 202/557-2740.