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Commercial real estate market has bitter pill to swallow

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To say that commercial real estate and capital markets are in disarray is understating the obvious.

Today's commercial real estate markets are hurting badly, largely because of banking and capital market problems compounded by the national recession, with its historically high unemployment rates. Banks are under tremendous regulatory pressure to raise equity capital, increase loan loss reserves and tighten underwriting criteria. Only politicians and borrowers are pushing banks toward making more loans, not regulators or banks' boards of directors. The overhang of CMBS due to be refinanced in 2010-'13 is huge, with few if any clearly identified sources of capital prepared to offset that calamity-in-waiting.

Wall Street is the best hope, but investment bankers are not entirely in the clear and ready and capable of taking on that challenge. Moreover, foreign investors were burned badly by rating agencies' failure to assess risk properly. Others, of course, share this blame as well; faulty assessment and pricing of risk was rampant leading up to the crash in 2007. Foreign investors are sticking primarily to U.S. Treasuries, not real estate-related assets, financial or otherwise, for the foreseeable future.

The wide-ranging federal stimulus program seems to have fallen well short of its intended objectives with respect to spending, job creation and capital injections. Unfortunately, its legacy includes a huge overhang of investments in banking and corporate America without a clear-cut exit strategy. Banks using future capital infusions from investors to pay back the Federal Reserve or Treasury will delay further their ability to expand lending and investing. Corporate America's payback of federal assistance will occur at the expense of slowing or reversing future job growth and investments with economic benefits.

The foregoing problems are like foul-tasting medicine that ultimately cures the sick patient if it doesn't kill them first. Future real estate, bank lending and capital markets behavior eventually will recover, chastened, more realistic about pricing risk and generally more conservative behaviorally. It will not be a zero-sum game. There will be winners -- those with access to capital -- and losers -- those with diminished or no access to capital. The cost of capital will be higher for all, but more prudent risk assessments will direct capital flows and costs more efficiently than in the years leading up to the crash of 2007.

The assessment of real estate valuations, currently plagued by uncertainly, will sort itself out and eventually facilitate the narrowing of bid-ask spreads as sellers of real estate and financial assets reluctantly become more realistic about pricing. Unfortunately, the second shoe will drop as two things happen: First, maturity defaults on CMBS in 2010-'13 will depress values and heighten losses for investors. Second, those who buy distressed real estate assets will be able to reduce rents/lease costs and thereby strain the cash flows of those real estate owners whose cost basis is much higher.

All in all, commercial real estate markets appear to be in for a rough time for several years to come. As developers and current owners of real and financial assets struggle to survive, perhaps their most important priority should be a laser focus on new and existing sources of capital. This must be coupled with tenacious attempts to communicate with lenders and prospective investors who are either too busy with their own challenges or simply do not have the access to capital that we expect they have. The Burnham-Moores Center for Real Estate's 14th Annual Real Estate Conference, headlined by Sam Zell, will address many of these critical issues. To register for the Jan. 29 event, go to www.usdrealestate.com.


Riedy, Ph.D., is executive director at the University of San Diego's Burnham-Moores Center for Real Estate.

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