This is not my headline, but I wish I had written it. It comes from REBusinessOnline which recently published a story about Ethan Penner and his perspective on the commercial real estate market. Penner’s comments are consistent with my view that the stampede into primary markets and core assets is overdone, just like the stampede into the Sunbelt was overdone in 2007. To be sure, San Francisco (where I live) is seeing strong rent growth across the four major food groups, but some investors are paying up for Daly City and Santa Rosa as if they were Pacific Heights and Telegraph Hill.

The article, which you can read here, follows:

Today’s extremely low interest rates pose a danger to commercial real estate investors, particularly those with billions of dollars to deploy such as pension funds and sovereign wealth funds, warns Ethan Penner, founder and president of CBRE Capital Partners. In order to receive a reasonable rate of return, these investors are being “crowded out” of low-risk investments and forced into high-risk investments.

The 10-year Treasury yield, a benchmark for commercial real estate finance, currently is hovering around 2 percent, not far from its record low.

“There is almost no way to invest large amounts of money in today’s market — specifically in today’s real estate market — and not be set up for a major disappointment sometime soon,” remarked Penner during his keynote address at the Commercial Real Estate Investment & Finance 2012 conference. Law firm Morris, Manning & Martin along with France Media’s InterFace Conference Group hosted the day-long event at the Grand Hyatt in Atlanta.

“The major disappointment may take the form of economic non-recovery, it might take the form of very, very high interest rates, which will render your returns very, very inadequate,” explained Penner. “I don’t know what [factor] it is going to be, but I can tell you the byproduct of investing money today for most investors is going to be a lot of crying going forward.”

A disconnect among investors only compounds the problem. Some fund investors, for example, seek low-risk properties that generate double-digit returns. But those returns are more representative of value-add or opportunistic deals.

Penner, a pioneer in the commercial mortgage-backed securities industry who served as CEO of the Capital Company of America/Nomura Capital from 1993 to 1998, said the federal government has engaged in a misguided effort the last few years to bail out the banking system. In his view, government has acted on the belief that in an overleveraged world saving creditors is important.

“Obviously they are wrong. [The government] should have been saving the debtors, not the creditors,” argued Penner. “If we had taken the couple trillion dollars that we wasted trying to prop up the creditors and deleveraged the debtors, we’d already be in a recovery. It’s so obvious that it’s kind of amazing that nobody figured it out.”

Penner supports the idea of providing mortgage debt relief for homeowners. “That could be something that catalyzes a recovery because it’s obvious that it’s needed.”

Who is paying the bill for the efforts to prop up the banking system through low interest rates? The most obvious group is savers, explained Penner, “because people who are older, who are retired, and who were expecting to be able to invest their hard-saved money at a very low-risk investment at a certain rate of return to live a certain way of life are screwed beyond belief.”

Not even Joe DiMaggio could have hit this change up. Just one year ago, the United States financial system stood on the brink of failure. GDP had declined by 6.25%, the most severe contraction since 1982. In November 2008, non-farm payrolls were cut by 533,000, the most severe contraction since 1974. But just a few months later, right after the ink had dried on largest corporate bankruptcy filing in American history (Lehman Brothers), U.S. GDP managed to grow at a 5.7% annual rate — the the fastest expansion in 6 years.

It’s a remarkable turnaround, but the problems in commercial real estate persist. CMBS defaults at the end of 2009 registered a five-fold increase over 2008. In two of the hardest hit sectors, hotels and apartments, almost 10% of all CMBS loans were delinquent at the end of 2009. Fitch says overall CMBS default rates could reach 12 percent by 2012.

Indeed, even God is losing money on commercial real estate. Lenders are foreclosing on Stuyvesant Town and Peter Cooper Village, which was acquired in 2006 for $5.4 billion. Stuyvesant Town is a huge property, so it’s not surprising that the acquisition set the mark for the highest price ever paid for a multi-family residential asset. What is surprising is that just four years later, the value of the property is estimated to have declined by 70%. The investor group included the Church of England, and the foreclosure completely wiped out its $250 million investment.

Since divine intervention appears to be out of the question, investors are understandably nervous about the $1.5 trillion in commercial real estate debt maturing over the next three years. Nevertheless, despite the carnage yet to come, the decline in commercial real estate prices is unlikely to cause a rain delay in the nascent economic recovery.

This is primarily because the U.S. commercial real estate market is much smaller in comparison to other important markets. Based on flow of funds data from the Federal Reserve at the peak of the market in 2007, the corporate bond market was worth $3.5 trillion; U.S. government securities $5.1 trillion, single family securitizations stood at $6.8 trillion and all single family mortgages amounted to $11.2 trillion. Meanwhile, the commercial real estate market was worth about $6.8 trillion in total, with only $3.3 trillion of that comprised of debt.

Just as important, the problems in commercial real estate have been well-telegraphed, while the full extent of the problems in single family were not clear until we were well into the crisis. Not only have the problems been well telegraphed, and well documented, but Jamie Dimon (CEO of Chase) is already declaring a bottom. “Commercial real estate is a train wreck, but it’s already happened,” Dimon said during a speech at a J.P. Morgan health-care conference in San Francisco last month.

While commercial real estate debt maturities are clearly still a problem, sophisticated investors from all over the world have lined up piles of dough for America’s distressed real estate play. Combine that with banks and special servicers that are determined not to sell into a weak environment, and the result is 30 or more bids for distressed commercial property sales in major markets, with some bids coming from as far away as Germany and South Korea.

I personally was involved in the recent bank sale of a non-performing loan for 60 acres of entitled but otherwise empty desert outside of Phoenix, and that sale attracted 26 bids. If entitled single family residential land in Arizona isn’t the absolute belly of the beast I don’t know what is, yet most of the bids for that flaccid loan were all cash.

What we’re witnessing is the market’s sometimes noisy process of converting debt to equity. That process is working, greased by baksheesh from all over the world. So why all the unrelenting gloom and doom with regard to commercial real estate and the economy? It’s pretty simple really: in this era of populist schadenfreude, people love to read about it.

San Francisco, once considered one of the strongest commercial real estate markets in the country, had one of the largest increases in overall CMBS default rates in the second quarter of 2009, up 444 basis points to 5.15% (and yes, this was even worse than Miami). Detroit was still the worst performing market, with an overall CMBS default rate of 5.62%, up 562 basis points from Q1. However, San Francisco’s multi-family sector now has a CMBS default rate of 21.7%, which is almost double the 12.93% multi-family delinquency rate in Detroit.

The amazingly high default rate in multi-family is being driven by one just one buyer and a lot of brokers in nice suits. Well known for not only paying top dollar (over 20 times gross rents) but also for pursuing, shall we say, aggressive retenanting programs, this buyer actually pocketed 75% of all San Francisco apartment properties that traded in 2007. And who is surprised? At 20 times gross rent, anybody who wasn’t selling was living under a rock. About $1.2 billion was “invested” from 2003 through early 2008, financed primarily with two year, interest-only, cross collateralized debt complete with personal guarantees who’s your daddy now?

The answer is UBS, which has already taken back about 1,500 units, and CIM, which bought the senior debt on 24 properties from Credit Suisse. This is only the tip of the iceberg though, and so far only about 700 units have actually been sold to new buyers. San Francisco apartment brokers, who were only too happy to cheer 20 GRMs on the way up, are now complaining publicly about comps that are “artificially low”. Predictably, the view on that side of the fence is not that this guy overpaid, but that he simply over-levered! That aside, I’ll give you one guess where prices in San Francisco are heading:

Despite the mess in San Francisco now, the S&P/Case-Shiller Index for Bay Area multi-family prices shows a 10.83 percent growth rate from the year of its inception (1995) through 2002. Growth in prices was strongly influenced by the Bay Area’s healthy population growth, and as a result growth in Bay Area multi-family prices far outstripped the S&P/Case-Shiller Index for the top 10 metropolitan areas over the same period.

Unlike some cities in the Lone Star state, for example, where increased supply typically rises to the occasion, Bay Area multi-family prices have been influenced by a fundamental supply and demand imbalance even before the credit/real estate hysteria of 2003 through 2006. Between 1987 and 2002, the Bay Area population increased by 18 percent. The growth was fairly evenly spread over nine Bay Area counties, with Solano County having a growth rate of 28 percent, which was the highest growth rate in the area. The largest population growth in terms of total residents occurred in Santa Clara County, which added 301,000 people, followed by Alameda County and Contra Costa County, both of which added approximately 250,000 people. Combine that with natural and political barriers to unfettered new development, and Northern California doesn’t look so awful even in you’re a Bears fan.

Granted, the current San Francisco foreclosure saga is far more interesting than plodding through Bay Area demographic statistics. But when all those “artificially low” comps get set, is there any place you’d rather be with your money?

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If you are investing in REITs right now, life is good. The US MSCI REIT index has doubled since hitting its lows in March, and in the second quarter Mid America (MAA) generated $.05/share in earnings from the sale of just one asset, a 36 year old, 96 unit apartment building in Grenada, Mississipi. Indeed, gambling on a little property in Grenada, Mississipi looks like a much safer bet right now than rolling the dice in Las Vegas, the gambling capital of the world.

Las Vegas is so volatile that 2009 transaction volume has dropped almost to zero, and prices prices appear to have declined by at least 60% from the peak. However, with virtually no sales taking place, it’s hard to know what the market is. Amazingly, sales by dollar volume in Las Vegas have plunged by 99%, from almost $2.5 billion in 2005 to just $25 million for all of 2009:

The buyer, a San Diego socialite, was somehow convinced to pay a 5.5% cap rate on trailing-three-month NOI and a 6.1% cap on a trailing 12-month NOI. Even more incredibly, because the property was only 65% occupied by the time the sale closed, no lender would touch it, and the purchase had to be an all-cash deal. Can you say no competition?

Given the crummy fundamentals in Las Vegas, this sale is yet more evidence that the distress in commercial real estate may be cushioned by patient capital much more so than some currently expect.

Apartment values in New York City have declined at least as much as in Las Vegas. As I wrote earlier this year, the yawning gap between cap rates and GRMs means that New York City apartment values are heading in but one direction: Staten Island.

The Riverton, a massive 1232 unit behemoth of bricks that was purchased in 2006 for $340 million, is a great example. The buyers purchased the property using a first mortgage with day one debt coverage of .39x, which meant that the loan had absolutely no hope of being paid through existing cash flow.

Of course, the CMBS loan promptly became delinquent and the property is now in the hands of its special servicer, appraised at $108 million barely three years after Deutsche Bank wrote a check for its $225 million first mortgage. And the REIT goes on!

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It’s summertime and the living is easy, but if you’re a distressed debt broker, this is no time to be mixing Cuba Libres at the beach. There have been 72 bank failures in the first eight months of 2009, compared with 26 in all of 2008 and just 3 in 2007. So it should be no surprise that distressed debt offerings are taking off like a teenager after a paternity test, and distressed debt traders are definitely going to have their day in the sun, whether it be by hook or by crook.

Last week, $487 million of bad commercial real estate loans were offered for sale, and $235 million of it was on behalf of just one seller. The collateral was literally all over the map: Arizona, Illinois, Wisconsin, Tennessee, Indiana, Kansas, Florida, Nevada, California, Texas, North Carolina, Missouri, Minnesota, Ohio, New Mexico and Arkansas. And this week, the Wall Street Journal chronicled the mess at Maguire, which will soon let loose another $1 billion in bad debt on the market, with collateral concentrated in Southern California.

What’s happening is no mystery. These loans are succumbing to conditions that can’t be contemplated if your stock in trade is acquiring property with OPM using interest-only debt at 90% LTV, and this is just the tip of the iceberg. While many 2005 and 2006 borrowers are still alive, the hold your breath and hope strategy they have adopted will come to an end in 2010 and 2011. And just like the mid-market loan barons at CIT, these commercial real estate contessas are pressing for an assist from Uncle Sam. However, aside from TALF and PPIP, and just like the situation at CIT, additional government assistance is unlikely to materialize.

The reason is that the magnitude of the problem is being overstated. One could produce a graph showing all commercial loan maturities through 2013, and if one were to do that, it would show that there are $1.4 trillion in commercial loan maturities through 2013, and it would also show that the majority of those loans, over $1 trillion worth, are held by banks and thrifts. With bank failures increasing at an exponential rate, these the figures are the ones that the Real Estate Roundtable would use to bully congress into smothering the grenade with tax dollars:

However, the data on commercial real estate loans held by banks and thrifts comes from the FDIC, and the FDIC does not publicly release data that is granular enough to analyze the collateral backing these loans. It’s true that all of these loans are secured by commercial real estate, but many of them are actually business loans in which real estate happens to be just one small component of a much larger collateral package. Accordingly, the data does not distinguish a $5 million loan for an office building in Topeka from a company in Topeka that obtained a $5 million line of credit secured by an office building, accounts receivable and inventory.

Notably, this chart also shows that commercial real estate loan maturities climb relentlessly through 2010 and 2011, ascending to a peak in 2012, but it’s also notable that billions of dollars have been raised in anticipation of this eventuality.

As of the end of June, REITs had raised almost $15 billion in 45 public offerings, and even the beleaguered Mortgage REITs managed to scratch together $4 billion. HCP, a Healthcare REIT, closed yesterday on a $441 million stock offering, and Starwood Capital, Barry Sternlich’s new Mortgage REIT, just announced that it was increasing the size of its IPO to $800 million, which would make it the largest IPO of the entire year.

Raising money in the private market has been less productive, perhaps another $5 billion has been coaxed from the coffers of private equity investors. However, the market is nevertheless working as it should: bad debt is being recycled into equity, and amazingly enough, prices have not dropped as much as one would expect. Should the government get even further involved, using our ever-more scarce tax dollars, when private capital already seems to be doing the job?

If the real estate exposure is overstated in the bank and thrift world, where will all this new money find a home? One place where the turkeys are definitely coming home to roost is in the CMBS market, where 2005 and 2006 vintage loans with five year maturities will have very little hope of being refinanced without additional borrower equity. Opportunities for new investments in pear-shaped CMBS deals will be especially abundant in 2010 through 2012:

So, if you’re looking for deals in commercial real estate, you’ll need to look even harder than everybody else. Barry Sternlicht is no dummy, and he’s definitely not alone. The truth is out there, and it congregates here!

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Like politics, all commercial real estate is local. The Brookings Institute has just published a study on the 100 largest MSA’s in the country, and it concludes that there actually are green shoots in commercial real estate, and many of them are to be found in over-looked, secondary markets in the middle of the country.

The report shows that in 38 of the top 100 metro areas, housing prices remained flat or actually increased over the past year, even as prices nationwide dropped. Most of these metro areas also experienced below-average employment declines, and they lie in some interesting areas somewhat off the beaten path (Pittsburgh, Rochester, Tulsa, Des Moines and Baton Rouge, among others).

All of the top metros also have below-average shares of single family foreclosures, which is not surprising. This is not also not an isolated finding, and I wrote about Zillow’s distinction between “hot” markets that were actually “not” in The Best Performing Apartment REIT for 2009.

In terms of extrapolating the findings to other markets that may have similar-recession proof characteristics, it shows that areas with heavy concentrations of education and healthcare-related jobs are performing well, and that cities with concentrations in finance jobs are not all the same. Oklahoma had two cities in ranked in the top 20: Oklahoma City and Tulsa. Other cities doing well include Little Rock, Harrisburg and Albuquerque:

“All metropolitan areas are feeling the effects of this recession, but the distress is not shared equally,” said Alan Berube, the program’s research director and report co-author. “While some areas of the country have experienced only a shallow downturn, and may be emerging from the recession already, people living in metro areas that are now performing the weakest economically should prepare themselves for a long recovery period.”

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Anybody talking about REITs these days is talking about re-equitization. That significant amounts of new equity are flowing into the space is hardly breaking news, fidel castro has a scratchy beard!! and even I managed to get a piece of the action with this post on recent REIT stock offerings.

What is the real significance of all this fresh cake? Obviously, it’s about delevering, but it’s also about 2010. These equity offerings are separating the winners from the losers drowning in debt, and the latter will be forced to sell into one of the best buyers markets in decades.

In short, 2010 will bring a flood of distressed assets to the market, and everybody knows it. Cash will be king. Accordingly, REITs with access to equity capital markets will be able participate in this smorgasbord of distress, while those without cash will be locked out. Most important: Public REITs always lead property markets out of recessions, so buying into these freshly recapitalized REITs now could lock in big gains for 2010.

But don’t make me prattle on in order to prove it – it’s Saturday morning after all. Just sit back, relax and hit the play button (batteries not included…):

When it comes to investing in distressed assets, Mike Kirby of Green Street Advisors thinks REITs will be the only game in town. In this next video clip, he discusses some of the key risks facing REIT investors, as well as the opportunities for public REITS to buy quality assets on the cheap starting in 2010. Kirby foresees a a 1990s-like consolidation, followed by a much bigger REIT industry five years from now:

While Kirby and Pire cover the institutional side of the business, Cramer, everyone’s favorite retail hyperventilator, likes Boston Properties (BXP). REIT Wrecks, however, is confused by Cramer’s enthusiasm for BXP. The Company has an NOI concentration in New York City and heavy exposure to the financial sector in New York, Boston and San Francisco. Rents are down in the latter city by 40% and are still dropping [Update: Watch this January 2010 interview with Mort Zuckerman, CEO of BXP, for his latest thoughts on BXP’s markets]. The Company has already guided FFO down by 5% for 2009. This pick could become another member of the Cramer Crap Club (alas, CNBC seems to have pulled this vid. If it doesn’t load in your browser, you can see it here. Suffice it to say, don’t stick with Cramer on this one):

In addition to BXP, Numerous REITs have recapitalized, and an increasing number of brand new REITs are coming public. In anticipation of a recovery, the Dow Jones Equity REIT Index is already up 57% since the lows in March. However, REIT Investors need to be selective.

Obviously, you still need to avoid REITs with high levels of debt (click here for a list of Apartment REITs by leverage ratio). Look for REITs that are covering dividends from operating cash flow, and most of all, look for those REITs with assets in strong, protected markets. This will provide the pricing power they’ll need to combat the effects inflation, which seems almost inevitable at this point. For a quick but by no means comprehensive buying guide, see REIT Stocks: 4 Ways to Play the Carnage.

Click here for a list of Apartment REITs
Click here for a list of Healthcare REITs
Click here for a list of Hotel REITs
Click here for a list of Industrial REITs
Click here for a list of Mortgage REITs
Click here for a list of Office REITs
Click here for a list of Retail REITs
Click here for a list of Storage REITs

Click here for a REIT ETF List
Click here for a list of REITs paying dividends in stock

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