Small-Cap Performance Leads Lagging CRE Market Recovery

Fears of a commercial real estate market collapse in bigger proportions than what we have already seen in the residential side are now making way to renewed recovery expectations especially in the smaller-cap segment of that market.

According to research firm Boxwood Mean Inc., Stamford, Conn., the small-cap commercial property market is ticking up as prices for small CRE properties “are gradually recovering after a slump lasting three years,” as private investors expect “a space market recovery in 2011.”

The Boxwood Small-Cap Price Index shows prices for CRE at under $5 million increased for the fourth consecutive month in October, up 41 basis points compared to September and 2.2% compared to the previous three months.

And that is very good news for commercial banks with large distressed or nonperforming loan portfolios, says Boxwood principal Randy Fuchs, since these banks hold an estimated $1.5 trillion in CRE mortgage assets most of which are small-balance commercial and business real estate loans. “Bid-ask spreads are tightening and after substantial writedowns.

Boxwood data on small cap CRE sales activity and fundamentals in 120 U.S. markets also show that these assets feature “lower price volatility than larger, investment grade properties,” primarily due to its more diverse mix of property types and “heavy concentration” of owner-occupied buildings.

Fuchs says another advantage is their lower sensitivity to the ups and downs of the CRE market cycle and higher flexibility in the ability to respond to local economic changes and the business performance of creditors.

In addition, he argues, smaller-size properties are not as attractive to the news headlines as their much larger-size counterparts and are “easy to overlook” even though this much larger in size market segment “has proved to be more resilient” and continues to outperform the larger CRE asset market “since the onset of the down cycle in 2007.”

Other research findings indicate overall market improvements are under way.

Standard & Poor's reports a slowdown in the rate of commercial real estate delinquencies, improvements in property fundamentals, a higher flow of investment capital back into the market, increased volume of commercial mortgage originations and an uptake in demand for CMBS issuance.

S&P's credit analyst Larry Kay says he is confident “the current momentum in the commercial property and credit markets” will continue into 2011, at a recovery rate that will depend on the level of job growth and consumer spending.

S&P's analysts recognize that CRE recovery signs tend to lag those of the larger economy when coming out of a recession, which is why it is important to recognize that while delinquency rates in commercial mortgage-backed securities remains high, “the rate of growth has slowed considerably from recessionary levels.”

In Kay’s view, loan modifications, “particularly maturity extensions are also relieving some of the stress in the property markets by reducing the number of liquidations at distressed prices."

In 2010 data through Sept. 30, “delinquency growth has slowed appreciably” compared to the dramatic delinquency growth in 2008 and 2009.

S&P's defines several converging factors have contributed to improvements in the delinquency rate.

They include a decrease of the pace of new delinquencies while resolutions rise. Although delinquencies are expected to drop, Kay warns, “the increase in the number and amount of loans maturing in 2011 and 2012 will continue to pressure delinquency rates."

Kay says the fixed-rate loans maturing in the coming two years “will, to a large extent, include five-year term loans from the 2006 and 2007 vintage years,” which as a rule featured high leverage and aggressive underwriting, so compared with 2010, in 2011 “the amount of floating-rate loan maturities will spike 290.7%.”

S&P’s report, “Delinquencies May Be Moderating, But Downgrades Are Expected to Remain High in 2011,” also states that as property sales are increasing, loan modifications also are expected to stay at high levels as “property fundamentals are improving and mortgage originations are picking up.”

Analysts caution, however, that these signs of improving market conditions should be viewed within a larger context as “the advancements are, to a large degree, relative to the depths that the property markets and CMBS credit performance sank to” during the recession.

Examples from office and retail, which represent two of the largest CMBS property segments and 61% of outstanding CMBS, show they have experienced “significant rent declines” over the last few years, and according to S&P credit analyst Eric Thompson are not expected to have any rental growth until 2011 or 2012.

The reason why “debt service coverage impairment and lower property valuations are expected to keep downgrades at high levels in 2011” is that it cannot happen without rent recovery and property equity buildup.