Is The Commercial Office Market Recovery A Mirage?

by Keith Jurow, Capital Preservation Real Estate Report

My previous article examined the dangers of widespread euphoria and optimism. In this article, I will focus on an important question few analysts are raising: Is the so-called recovery in commercial office markets real or a mirage?

According to Marcus & Millichap's Third Quarter 2014 Commercial Real Estate Investment Outlook, optimism for those investors surveyed has never been higher.

Take a good look at this chart showing the intention of these investors over the next 12 months.

Change in Real Estate Holdings

You can see that less than 5% of those surveyed plan to decrease their commercial real estate portfolios. More than 70% intend to increase their holdings.

The crash that was cut short

Let's first examine the post-financial crisis history of the commercial real estate market and the supply and demand forces now at play.

After Lehman Brothers failed in the fall of 2008, the entire banking system was in danger of a complete collapse. Federal regulatory authorities and the Treasury Department decided that something drastic had to be done to stabilize the banks.

The solution provided by the Federal Accounting Standards Board (FASB) was to rewrite the standards for when banks had to write down impaired loans. Banks were required to write down only those loans that were suffering "other than temporary impairments." Who decided which loans met this standard? The banks did of course.

In late 2009, the FDIC modified its policy to encourage what it called "prudent commercial loan workouts." The banks understood what this meant and began a policy of loan modifications that contemptuously became known as "extend and pretend."

One could argue that the regulators had no choice. The total commercial loan portfolio for all US banks stood at $1.55 trillion at the peak of the bubble in 2007. Hundreds of billions of dollars of the worst underwritten loans of 2006-2007 quickly went underwater. Because smaller and mid-size banks had loaded their portfolios with commercial real estate, an imminent collapse of hundreds of those banks was a real possibility.

This "extend and pretend" policy was, in retrospect, a brilliant strategy. When investors saw the banking system stabilizing, they were enticed back into commercial real estate. This helped to halt the decline in real estate prices. Although much of the renewed buying in 2010 and 2011 was by all-cash purchasers, the market did seem to stabilize.

For the appearance of normalcy to return, one essential piece was absolutely necessary. Most key players in commercial real estate had to develop amnesia about those allegedly performing loans that borrowers could not really pay back. If no one talked about them, that would also help. This is what has happened. The servicing banks took advantage of the opportunity to avoid having to foreclose and liquidate delinquent properties.

In its Big Picture report for 2013, Real Capital Analytics reported that the total distressed commercial loan portfolio of all banks at the end of 2013 was a mere $33 billion. That was 18% lower than 2012. Only 8% of all commercial real estate sales in the final quarter of 2013 were forced liquidations. That was sharply down from 20% at the end of 2010.

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