LaSalle Investment Management: Commercial property, mind the liquidity gap

Jacques Gordon, Global Strategist at LaSalle Investment Management, comments on the current status of the commercial property market and the challenges posed by the liquidity gap.

"Investors' appetites grow and diminish. How and why this happens is a mysterious process in all asset classes. In property, talk of "risk-on" and "risk-off" can be heard from traders as a new year unfolds. A year ago, the "risk-on" real estate trade was the thing to do and investors of different stripes returned to real estate in larger numbers than any time since early 2008. A broadening band of private equity assets and products gained popularity after the risk off trades of 2010 and the year of nearly no trades in 2009.

"Now, in early 2012, the risk-off trade is dominant again. In real estate parlance, only "core" assets (fully leased, dominant buildings in major markets) have full access to liquidity. Risk averse money seeks safety in the most expensive property markets in the world. Like investment grade bonds, core properties have traded up in price, even though fundamentals are weak. But the low risk reputation of these assets may be illusory. Investors seeking a safe haven in property have bid up the prices, and driven down the yields, to levels that may be unsustainable, especially if and when interest rates rise again. In London's West End a luxury retail flagship store traded recently at a record low yield of 2.9%. In North America, mid-rise rental apartment buildings in trendy neighborhoods routinely trade at a 4% yield or lower and in Shanghai, while the government tries valiantly to reduce the pressure on luxury residential prices, office buildings trade at 5% yields - lower than government bonds.

"At the same time, risk-on trading has found a home in the world of real estate debt. The mountains of real estate debt accumulated during the credit bubble era are starting to crumble. NAMA, the Irish government's bad bank for property development debt, is auctioning large chunks of its €72 billion pool of performing and non-performing loans across Europe and North America. In December large portfolios of discounted real estate loans were sold by RBS and Lloyds. Barclays and HBOS have already exited their North American and Asian loans through secondary market trades. The French and German banks are next to start selling, as the Euro crisis and Basel III force these institutions to pare back to domestic, conservative senior debt. American banks face a similar mountain of expiring debt and are steeling themselves to start packaging it up for sale. Meanwhile, the smart money is moving into "mezzanine" real estate finance, where yields can be twice, thrice or even four times as high as the yield on senior debt or on direct equity.

"How will trading in discounted real estate debt affect the underlying commercial property market? Non-performing, barely performing, and "zombie" debt rarely has prime, core assets as collateral. Many of the debt purchasers hope to wrest control of the collateral from the original borrower. As they do so, more of these "not-quite-core" assets will start to trade, as they are pulled out of limbo land. Investors willing to take on a degree of complexity, or who are willing to shift focus from Knightsbridge to Hammersmith, or Madison to Third Avenue, will find much better value in these "core-plus" properties, as we in the trade call them.

"Commercial property is clearly divided into the "haves" and the "have-nots" when it comes to liquidity and pricing and returns look quite different on either side of this liquidity gap. In geographic terms, the West End of London, Mid-town Manhattan, Central Paris and La Defense, Hong Kong-Central, and Shanghai's Pudong and Puxi districts are all firmly in the "have" category. They exert a strong pull, accounting for an extraordinarily high proportion (by value) of all activity that took place in major markets in 2011 according to Jones Lang LaSalle research.

"Yet, there is a great, wide world of real estate beyond these Über-expensive, low-yielding dist

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