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Charting a Bottom in Commercial Real Estate

CoStar Group CEO Andrew Florance says the Fed will manage a soft delevering of commercial real estate, and while it bottoms, investors may have a rare opportunity.

Todd Lukasik: Hi, I'm Todd Lukasik, equity research analyst at Morningstar covering commercial real estate services firms and real estate investment trusts. Today I'm very lucky to have with me the CEO and founder of CoStar Group, Andy Florance. Andy, thank you for joining me.

Andrew Florance: Thank you for having me, Todd; it's a pleasure.

Lukasik: Obviously with the data and the customers that you have, you've got a good pulse of the commercial real estate market in general. Do you have any insights or thoughts that you can share with our viewers about when we might see transactions turn around, when we might see some of the fundamentals for the landlords turn around in what is so far been a difficult economy?

Florance: To make sure we don't end on a negative point here, I'll start with the negative and then go to the positive. Certainly there are some significant issues. Commercial real estate experienced exactly the same asset bubble that residential experienced. It's identical. If you do the Case-Shiller Index and you do a Repeat Sales Index in commercial real estate, it mirrors perfectly.

It was an asset bubble driven by the availability of risk-insensitive, super cheap credit. That problem exists, and I believe there's a massive delevering that has to occur, you've got to refinance trillions of dollars of debt, banks are going to be held to lower loan to value ratios, and there's going to be a big gap. That's going to put significant downward pressure on values, and I think a lot of debt will default.


There will be a lot of defaults, and we're already at default levels in commercial debt that have not been seen since 1993, a period which was historically a very bad downturn. I think that the Fed having possibly mitigated the damage in the residential real estate world is actually beginning to turn a lot of attention to how they're going to solve the commercial.

So roughly 35% of all the real estate in the United States is commercial; there's a big problem there and I think the Fed has put roughly $700 billion into solving the residential problem and $6 billion into the commercial problem.

I think they're going to have to continue. The TALF and PPIP programs that have been useful, but the Fed's not done, and I'm optimistic that they'll respond to the issue and manage a soft delevering of commercial real estate.

If you look over the leasing side and the future investors' side, it's pretty good. So the typical tenant in the United States has been delaying any leasing decisions because they're not dumb, they know that rents are falling, and they don't want to sign a 10-year lease when they know rents are going to be 30% lower next year.

That is beginning to reach a bottom. So probably we're forecasting that in the end of 2010, you'll begin reaching a bottom. Corporations can't time things too closely; they'll need to start moving into longer-term leases in the middle of 2010, no later than the beginning of 2011.

That will send transaction volumes up and push money out to the brokerage firms. CB, Cushman, Jones Lang LaSalle will see their revenues climb, I believe, in mid- to later 2010. It's a great opportunity for tenants to take advantage of the landlords' misfortune here and go long on leases.

On the investing side--only once or twice in a generation do you get an investing opportunity that you may have in commercial real estate over the next three years.

If you had brought new capital into commercial real estate and bought office buildings or multi-family back in '93 when blood was running in the street after that down cycle, if you bought at that time period you would have seen a 10% real return over the next 14 year in the capital appreciation and you would have seen about a 3%-5% income yield.

You don't get returns like 14%--after-inflation return--over a long haul like that. If you can pick up distressed real estate now or vehicles that invest in distressed real estate and are not hindered by existing debt that's a problem, that might be a tremendous opportunity. So there are a lot of opportunities out there right now.

Lukasik: Great. Well thanks a lot for joining us today, Andy, I appreciate it.

Florance: Thank you very much, Todd.

Lukasik: I'm Todd Lukasik with Morningstar, and thanks for watching.

Todd Lukasik does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.