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A REIT Recovery, With a Catch

Analysts say rosy assumptions are already baked into stock prices. 

Philip Guziec, 08/16/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

Everybody knows about the problems facing residential real estate, but what's going on in commercial real estate? I sat down with real estate analysts Todd Lukasik, Jason Ren, and Philip J. Martin to get the scoop.

Q: How was commercial real estate affected in the recession, and how has it fared in the wake of the recession?

Philip J. Martin: This downturn in real estate wasn't really supply- or oversupply-driven; it was more financial-crisis-driven. This should allow underlying commercial real estate cash flows and valuations to recover more quickly coming out of this downcycle. It's much different than coming out of the late 1980s or early 1990s, when we saw significant oversupply in commercial real estate, largely driven by a lack of lending discipline throughout the 1980s. The result was oversupply and an associated commercial real estate recession. The commercial real estate sector required at least five years to recover, and it wasn't until the mid- to late-1990s that underlying commercial real estate operations, rents, and valuations began to recover. That would compare to residential real estate today, where we arguably have a one- to three-year oversupply of residential real estate.

Q: You said that we don't have the kind of oversupply that we had in the 1980s, but we did have a bit of a banking cycle and some pretty loose lending practices. Did you see some oversupply in commercial real estate?

Martin: We didn't really see significant overdevelopment heading into this. Any oversupply experienced was generally at the local level as opposed to being more widespread or national. However, we did see some aggressive commercial real estate pricing in 2005-2007, which may require some time to digest and justify from a return perspective.

Q: There was no excess square footage that we would see normally when heading into a recession; we had a price spike, collapse, and recovery.

Martin: We had the price spike, but we didn't have oversupply. So, the fundamental underpinnings are a bit better. Coming out of the late 1980s and early 1990s, most commercial real estate was in the hands of private owners and operators. The Resolution Trust Corporation took over a significant portion of real estate owned by the savings and loans, much of which was sold to professional commercial real estate owners and operators. Coinciding with that, we saw the publicly traded equity REIT sector begin to grow significantly. So, all of a sudden, a significant portion of commercial real estate was being owned in a publicly traded structure, where there is more discipline. Who's underwriting and financing a big chunk of the sector from this point forward? It's not just a bank--it's an institutional investor. The broader public equity and debt markets are financing a larger percentage of the commercial real estate business, where there is, arguably, better underwriting discipline, transparency, and corporate governance and structure requirements.

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