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Stock Strategist Industry Reports

An Upcoming Buying Spree for Commercial Real Estate?

We think conditions could favor a flurry of deals in this once-troubled sector.

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Commercial real estate purchase transactions are on the rise, and we believe this trend will have a long shelf life.

Since the beginning of the year, we've observed an increase in both the number and the size of purchase transactions across our commercial real estate coverage. The REITs we track are making acquisitions that range in size from a few million dollars to hundreds of millions of dollars, in either single asset transactions or portfolio deals.

In late 2009,  Simon Property Group (SPG) announced its planned $2.3 billion acquisition of Prime Outlets, which has yet to close. General Growth Properties (GGP) recently spurned Simon's $34 billion takeover bid.

We believe the large amount of capital that REITs, pension funds, and private investment funds have amassed for commercial real estate investment has, to date, overwhelmed the available supply of assets for purchase. REIT management teams are reporting plenty of bidding competition on available assets, which has contributed to cap rate compression in recent quarters.

A Sustained Growth Phase?
In our opinion, the environment will support commercial real estate purchase transactions, perhaps for many years to come. In its February report, the Congressional Oversight Panel concluded that about $700 billion in commercial real estate loans that come due between 2010 and 2014 are underwater. We think a sizable amount of the additional $700 billion in commercial real estate loans coming due during that time frame are loans that could not get refinanced at existing levels in the current lending environment. This suggests that there are at least hundreds of billions of dollars of incremental equity capital that need to be injected into commercial real estate to establish a "proper" leverage level. In fact, The Real Estate Roundtable, an industry group comprised of representatives from public and private real estate firms, has estimated this equity gap at about $1 trillion over the longer term.

We believe the industry's need to deleverage over the coming years will create an environment that fosters outright asset sales and joint venture transactions. We expect 2011 and 2012 to be particularly active years, as that's when many of the loans made in 2006 and 2007--years when property prices and lenders' risk appetites were simultaneously peaking--will start to come due.

REITs with reasonable leverage, well-staggered debt maturity schedules, available liquidity, and access to capital markets are best positioned to take advantage of acquisition opportunities as they arise.

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