Must Read: PIMCO’s CRE Project

One of the most interesting research articles we’ve read this month is the PIMCO U.S. Commercial Real Estate Project.

As the Wall Street Journal just reported back-to-back months of Moody’s CPPI increases, PIMCO’s view is that the index is virtually meaningless.

National price indices such as the Moody’s Commercial Property Price Index (CPPI) can provide misleading indications of a recovery in CRE asset price levels. Since November 2009, the index has rebounded 3%.

While it is natural to draw comparisons between the CPPI and the S&P/Case-Shiller index used to gauge residential home prices, we caution that indexes such as the CPPI are relatively meaningless in today’s limited transaction environment – commercial real estate transaction volume fell nearly 90% from 2007 to 2009.

Our ride along meetings highlight another limitation of the CPPI. Based on repeat transactions, the index excludes the truly distressed or overpriced properties acquired in the past few years that have yet to trade, and is instead skewed by the high proportion of trophy asset and Agency-financed multifamily transactions.

In fact, for every broker story regarding a bidding frenzy for a trophy asset or multifamily property, our team heard of multiple instances of owners embroiled in workouts on properties they believe to be worth less than 50% of peak valuations.

When these distressed properties finally do trade, they will have a disproportionate effect on the CPPI. For example, the CPPI index price change in March 2010 was based on only $1.7 billion of transactions.

By contrast, a single deal, the highly publicized Stuyvesant Town property in Manhattan, sold for $5.4 billion in 2006. If this property were to liquidate today (the property is currently in default), many estimate that it would sell for 60% less than its 2006 purchase price.

What is PIMCO’s outlook?

Higher Cap Rates Here For the Long Term
We expect that the spread between cap rates and 10-year Treasuries will remain above its average of 265 basis points seen since 1995, as the litigious deleveraging process leads to a sustained period of risk aversion in the sector.

As shown in the accompanying chart, the 10-year forward curve implies that 10-year Treasuries will approach 5% over the next several years. If cap rate spreads remain above their average, the market can expect long term cap rates near or above 8%. In this case, even if properties with floating rate debt can successfully avoid defaults in the short term, rising longer term rates will create a floor for cap rates and limit recoveries.

A summary of their “Key Findings” include:

1. Capital is clearly returning to commercial real estate, helping to stem the value decline in the sector. But optimism should be tempered, because national price indices are misleading when transactions are limited and fail to reflect the significant uncertainty around property valuations.

2. Changes in the structure of capital markets – notably the proliferation of complex securitizations since the last CRE crisis in the early 1990s – will lengthen the deleveraging process and suppress a recovery. The impaired ability to transfer CRE risk out of the banking system relative to previous cycles makes a stable, let alone a V-shaped, recovery unlikely. Instead, many CRE assets likely will not return to 2007 prices until the end of this decade.

3. Macroeconomic headwinds such as limited GDP growth in the U.S., elevated unemployment, potential re-regulation and a secular increase in the savings rate will force the market to re-evaluate the assumptions it has used to price CRE. These trends severely affect the outlook for rents, vacancies and capitalization rates, highlighting the downside risks that remain in CRE.

Hat tip to Calculated Risk for their mention of this research report.