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Can "Delay and Pray" Save Commercial Real Estate?

By Jeremy Myers, CFA – Updated Apr 6, 2017 at 11:20AM

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It's a toss-up if we can bank on it for the long term.

Dare I say it ... could the commercial real estate (CRE) market be turning or at least stabilizing? I think it's fair to say that the punditry has been incredibly negative about the state of CRE over the past year, but commercial real estate service providers Jones Lang Lasalle's (NYSE: JLL) and CB Richard Ellis's (NYSE: CB) recent quarterly reports, in which both companies reported double-digit revenue growth, have finally given me some reasons to be hopeful.

In the Americas, JLL reported that transaction volumes are up 54%, and Europe and Asia are posting solid numbers as well. CB reported that it's seeing a strong increase in transactions and leasing, especially in the U.S.

On the leasing side of the business, this was the first in 10 quarters in the U.S. office market where we saw a negative net absorption rate (that's a net decrease of square footage on the market). While the decrease was only a miniscule 3.2 million square feet, it indicates that the rental market is at least reaching equilibrium, a solid indication for rents. JLL says it's seeing large companies taking advantage of low rents to consolidate space, upgrade their digs, or lock in long-term rents. Additionally, there's an expectation that when rents do stabilize, and eventually tick back up, there will be a lot of tenants that were sitting on the fence who will be clamoring to lock in reduced rents.

JLL is seeing institutions and local buyers picking up "core" properties, and in many cases paying relatively low-cap rates (i.e., they're generating low returns). These "core" deals are usually fully leased buildings in prime locations, which of course makes it a little easier to get loans. I'm assuming some of these institutional buyers are pension funds chasing yield in what they assume are "safe" assets.

There are also opportunistic deals taking place, such as the agreement JLL recently announced with General Growth Properties (NYSE: GGP), the mall operator that is restructuring to leave bankruptcy in near future. This was a large transaction in which JLL will take over the management of 18 shopping centers, totaling 11 million square feet.

Additionally, it seems that troubled bank assets are still slow to come to market. This is probably the result of the "lend and extend" or "delay and pray" strategy that many banks have been using to avoid foreclosure.

What's kind of crazy is that this strategy of kicking the can down the road a couple of years might actually be working -- at least in the short term. Still, many regional banks are still in trouble, and more than 100 have already gone bust this year, but there seems to be enough interest from institutional money to prop up prices in key markets.

Research firms Moody's (NYSE: MCO) and CoStar (Nasdaq: CSGP) are verifying the recent increases in price, albeit over a relatively low number of transactions. Moody's saw commercial real estate prices increase 3.6% in May, the second consecutive month. CoStar has also confirmed that institutional buying has increased in the large metropolitan areas, pushing up prices.

However, CoStar's proprietary Commercial Repeat-Sale Indices are indicating a slowing down of investor activity. The company believes this slowdown is likely caused by a weakening economy and housing sector, as well as financial reforms that have slowed the commercial mortgage markets as banks sort out the regulations.

It's been surprising to see REIT indexes outperforming most asset classes year-to-date, but I think we're starting to understand what's been going on. Fund managers raised a lot of money in the wake of the credit meltdown hoping to pick up a flood of distressed properties on the cheap. If these managers can't put the money to work, they'll need to return it to investors. As a result, these institutional investors are chasing deals and pushing up prices.

By multiple accounts, market fundamentals are improving and the consultants, like JLL and CB, have had the luxury of capturing fees on multiple sides of the transaction. In the short term, brokers like JLL and CB who make their living off commissions should benefit from a market that may have found a bottom.

Jeremy Myers does not own shares in any company mentioned. Moody's is a Motley Fool Inside Value recommendation and a Motley Fool Stock Advisor selection. Jones Lang Lasalle is a Motley Fool Hidden Gems pick. Motley Fool Options has recommended a stock repair position on Moody's. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Moody's Corporation Stock Quote
Moody's Corporation
MCO
$254.69 (-0.24%) $0.61
Brookfield Property REIT Inc. Stock Quote
Brookfield Property REIT Inc.
GGP
CoStar Group, Inc. Stock Quote
CoStar Group, Inc.
CSGP
$69.57 (-0.76%) $0.53
Jones Lang LaSalle Incorporated Stock Quote
Jones Lang LaSalle Incorporated
JLL
$153.34 (-1.65%) $-2.58

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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