RELLER: Refinancings likely to undermine prices for commercial real estate

We are witnessing the most cataclysmic collapse of commercial real estate values in modern history.

As we watch
this train wreck in slow motion, we will see buyers empowered with cash or access to a cash cow pick up properties for a song.
In some cases, buyers will make off with buildings at half the appraised values of just a few months ago.

This
has been exhilarating to watch from my safe perch as an observer.

In the past 10 years, developers and investors
climbed a valuation ladder that broke all records. Rents always increased, land parcels always sold for more than comparable
sales, occupancy rates always decreased, and capitalization rates always went down as investors paid higher amounts per square
foot in each successive purchase. Sale prices per square foot always increased, and each home builder’s share of the
market always increased at the expense of a competitor.

Unfortunately, there is an inconvenient fact of statistics
called regression to the mean, or returning to an average growth rate. It works every time, much like the laws of gravity.

Real estate is now returning—painfully—to sustainable growth.

A massive wave of refinancings
will crash onto the industry beginning in 2010, but lenders won’t want to take part because the mortgage reset amounts
are greater than the property values. Comparable sales—integral to the future flow of capital—no longer support
paper values that were based on erroneous assumptions. Each new comparable sale brought new leverage flooding into real estate.

Back when they were making loans (about 18 months ago), lenders shrewdly hedged their risk by providing commercial
real estate loans short in duration, typically five years, to allow themselves to renegotiate rates and terms in the future.
What they didn’t anticipate was underlying market values regressing to levels of 2001 or earlier.

These loan
resets are now a tsunami wave estimated to exceed $1 trillion in the next 18 months nationally. Experts have estimated that
if these resets were forced to be priced at today’s market value, lenders would go bankrupt.

Lenders agree
they mispriced risk. (Their penalty was to be given massive government assistance funded by taxpayers and forcing good banks
to prepay future fees to the FDIC for deposit insurance.)

Lenders now are withdrawing from the lending business
for fear of mispricing the risk of the next loan. It isn’t as if demand for borrowed capital has dried up; rather, they
recognize a problem of their own making that they can’t solve.

Sensing opportunity, nimble foot soldiers
are looking for capital. It is this cash on the sidelines, held in money market accounts at record levels, that will enable
transactions to occur.

But asset classes must be revalued to make it happen. What goes up must come down.

Real estate market timer extraordinaire Sam Zell remarked, “This is a demand recession and I suggest to you that as
the economy improves, it’s very likely that these buildings that are currently suffering vacancies will be full. That’s
the good news. The bad is, they’ll be full at 30-percent lower rates.”

This repricing is simultaneously
the most exciting and most destructive aspect of our cyclical business.

Our rearview mirror approach of tying loan
values to these unsustainable growth assumptions was faulty. But the ability to purchase well-constructed and well-located
buildings today for less than their reconstruction cost may be an overreaction. Yet that is what happens when cash is king.

Victors in this new battle may fall neatly into two camps: Main Street and Wall Street.

Local, unanchored
real estate and vacant buildings that aren’t occupied or owned by a national entity with access to capital will be hard
to finance. Cash buyers will acquire these properties for 30 percent to 40 percent less than their 2008 appraised values.

Most real estate, by the way, is local, so this repricing will be painful.

The second category includes
sites and buildings with a buyer or tenant with access to capital on a national basis. Think in terms of companies with a
national footprint or publicly traded companies with access to Wall Street money.

These national players will have
their properties repriced less dramatically.

Several recent transactions in central Indiana illustrate how deals
are getting done without traditional commercial debt.

• An office building owned by a large but local tenant
in need of cash sold for 55 percent of its appraised value to a cash buyer.

• Publicly traded Kroger purchased
its leased office building in Castleton from a private investor to save on future rent expenses.

• Niagara
Water, a large, California-based company, purchased its bottling facility in Plainfield from a private investor before expanding
the facility.•

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Reller is senior adviser at Resource Commercial Real Estate.
Views expressed here are the writer’s.