Commercial Real Estate's Uneven Rebound

Commercial real estate deals can be found around the U.S., but only a handful of markets interest big investors

By Venessa Wong

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In October, an investment group that included Blackstone Group (BX), Paulson & Co., and Centerbridge Partners purchased Extended Stay, a bankrupt U.S. hotel owner, for more than $3.9 billion, less than half what previous owner Lightstone Group paid for it at the peak of the real estate boom in 2007. While it is the biggest commercial real estate sale so far this year, according to CoStar Group (CSGP), a Washington (D.C.) real estate information and analytics company, it is also a reflection of the current U.S. commercial property market: distressed assets and struggling owners selling at a loss to investors with plenty of cash who can afford to wait for the economy to rebound.

Extended Stay was the victim of overleveraging by Lightstone and a drop in demand as the economic downturn dried up business for the midprice chain, which is based in Spartanburg, S.C."Nothing is wrong with the properties," says Bruce Ostly, an analyst in Portland, Ore., for Integra Realty Resources, a commercial real estate valuation and consulting firm. "The ownership got in trouble," Ostly says, "by buying and financing at the peak of the market based on inflated price."

In order for the market to pick up again, new owners must buy the properties and "make [them] work at today's price," says Brian Glanville, Integra's managing director and chairman of the real property board of RICS (Royal Institute of Chartered Surveyors) Americas. "What you're seeing is an opportunity to buy properties for less than what you can build them for today."

Obstinate Gap

In real estate, "you take risks, and you're rewarded if you're right," Glanville says. In the boom period from 2005 to 2007, many investors such as Lightstone bought at the wrong time and at the wrong price. The problem, he says, is that the market has not been allowed to function.

Commercial real estate values have fallen—by as much as 20 percent to 30 percent from peak levels in some markets—and a gap persists in most of the U.S. between what commercial real estate sellers want and what the buyers are willing to pay, says Glanville.

Banks have modified loans, through a practice called "extend and pretend," to prevent owners from defaulting, but "the banks are no longer willing to carry them," he says. Owners "have to face reality now and see what they can get."

In August 2010 more than one in four sales involved distressed real estate, according to Moody's. During that month, U.S. commercial property prices also fell to their lowest level since June 2002, according to the Moody's/REAL Commercial Property Price Index.

Looking Up: Trophy Buildings

The situation is expected to get worse: More than one-third of the $270 billion in U.S. commercial real estate loans maturing in 2010 will be under water (or have mortgages greater than the value of the property), reported trade publication National Real Estate Investor. It expects the rate to grow to 63 percent by 2012.

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