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The 2008-2009 global financial crisis brought the real estate markets to a virtual standstill in most developed regions of the world. The causes of the collapse have been widely covered, including excessive borrowing, inflated property prices, heightened unemployment, reduced economic growth and overall contractions within many global economies. One of the most significant outcomes of the market dislocations was the negative impact on the mortgage-backed securities market, which suffered dramatically in the aftermath of the crisis.

While there is no question that the sector suffered, signs of a sustained revival in commercial real estate have emerged. As the market regains strength, we believe investors would benefit from opportunities in select commercial property, a sector that historically has led recoveries from previous downturns.

In this paper, we discuss the opportunity and the factors which, in our view, are pointing to a recovery. This recovery, however, is unlikely to be even throughout the world. In fact, we believe that the US commercial real estate market will likely provide the most compelling opportunities in the first phase of the recovery as a result of: 

• Stabilizing debt markets and the re-emergence of commercial mortgage-backed securities (CMBS) issuance;
• Property demand improvements, as shown in vacancy and absorption trends;
• Favorable commercial property valuations;
• Macro-economic tailwinds; and
• Significant level of capital ready to be deployed for US real estate. 

Many of the world's largest investment firms, institutional investors and pension plans have been increasing allocations to this asset class. Starting in 2009 and throughout 2010, institutional capital poured into core and stabilized real estate in primary US market regions in search of reliable, long-term yield. Public pension plans, such as California Public Employees' Retirement System (CalPERS), have been restructuring their real estate initiatives to include a greater allocation to core commercial property.

This investment activity has led to a meaningful recovery for these properties as yields reapproached pre-financial crisis levels. The growing liquidity has also made possible the re-opening of the initial public offering (IPO) market for real estate ventures. For example, Archstone, one of the largest real estate firms focused on the development and management of multi-family (apartment) properties, has been exploring the possibility of a US$5 billion IPO, which would be the largest real estate IPO in history. Low interest rates in the US have also been instrumental in containing the cost of capital for real estate investors and making property returns attractive in comparison to other asset classes, such as fixed-income instruments.

Meanwhile, our analysis shows that certain regions are still facing some headwinds. In Europe, sovereign debt concerns are likely to linger, which could delay the sector's recovery. In the Asia-Pacific and Latin-America property markets, economic growth has accelerated property demand, but rising inflation may be a limiting factor as it leads to potentially higher interest rates. China and Brazil, for instance, have each raised interest rates several times in 2010 and 2011.

In this light, we believe that investors may be able to take advantage of the changing real estate conditions in the US by considering the following strategies: 

• Acquire over-leveraged opportunistic US commercial property (e.g., distressed) that is favorably priced for future income growth and capital appreciation, based on expectations that economic conditions may continue to improve over time;
• Invest in income-generating valued-added commercial real estate-such as multi-family and office properties-as well as select retail and industrial assets located in regions of the US with favorable demographic growth trends. Other non-traditional (niche market) income-generating real estate may also be attractive, including senior housing, student housing, medical offices and self-storage; and
• Emphasize private real estate investments for two reasons: a) public REITs recovered from the global financial crisis first, with significant performance over the past year, and appreciating over 130% since their lows in February 2009 to the end of March 2011. This was based on both investors' desire for current yield and expectations for improving net asset values of the underlying properties; b) private real estate is typically less correlated to equity market conditions when compared to public REITs, which are usually traded on open financial markets. Incorporating private commercial real estate, we believe, can improve the risk/return profile of a diversified portfolio.

Signs of a US Revival

US real estate prices and investment returns for most properties have been in decline since the beginning of the credit market collapse in 2007. There are signs, however, that the US real estate market may benefit from a gradually improving economy (GDP growth is expected to reach 4% in 2011 measured on a Q4/Q4 basis). Major urban regions, such as New York and Washington, are already experiencing heightened leasing activity for office space, and vacancy rates have been trending lower. In New York, for example, some prime office markets are experiencing vacancy rates of only 4%, with average vacancy rates across New York office properties of approximately 12.8% in the first quarter of 2011, compared to 13.9% for the same period last year. The prospects for a commercial real estate revival have emerged consistent with the economic recovery, and are related to improving trends in commercial lending, stabilization of vacancy rates and property pricing that appears on the verge of increasing in value.

Debt Conditions Stabilizing and CMBS Issuance Rising

The availability of credit will be essential to a real estate revival. With interest rates at historically low levels and banks lending more, the favorable reversal for debt conditions, which started in 2010, is likely to continue. However, we see the road to a full recovery as somewhat volatile.

Support for lending has come from insurance companies and other financial institutions, who are once again increasing their mortgage allocations. Another stabilizer for debt markets is the revival of commercial mortgage-back securities (CMBS), with new issuance expected to triple in the US in 2011 versus last year's levels. Key recent developments in CMBS include:

• In 2010, total numbs issuance in the US rose to US$5.3 billion, up fivefold from the US$3 billion overall issuance in 2009,
• Total US issuance in 2011 is expected to top US$40 billion, which would provide added liquidity to purchasers or owners with maturing loans to refinance; and
• The first quarter of 2011 was off to a strong start with approximately US$10 billion of additional issuance in the pipeline. 

As debt has re-entered the market (largely for core properties in late 2009 and early 2010), cap rates-the income yield or rate of return of a property's income based on its purchase price or value-have begun to normalize as valuations started to recover. We believe the re-emergence of debt for real-estate transactions marks the beginning of a sustained recovery in the sector.

Positive trends in loan charge-offs (also known as write-offs), which have fallen since reaching a peak in November 2010, also indicate improved commercial-lending conditions. Loan charge offs are recorded by the lender when future mortgage payments or full payoff are no longer likely. Similar to the recent decline in charge-offs, the trailing six-month-average loss-severity trend has reversed from the 2009 peak of 70%. Lower charge-off and loss-severity rates support the case for banks to cautiously open the window to further lending.

A final consideration regarding the improving lending condition in the US is the ongoing influence of the Federal Reserve and other government bodies. First, governmental organizations have continued to pressure banks to increase the volume of lending, although the exact breakout for activity levels between residential and commercial lending remains clouded. Second, the Federal Reserve remains committed to the stability of financial markets, setting interest rate targets at historically low levels. As a result, demand for commercial mortgages, and the refinancing of these mortgages, continues to build momentum.

Based on these indicators, there is guarded optimism percolating at major financial institutions, especially as debt liquidity has emerged, and the mortgage securitization market appears to be reviving.

Commercial Real Estate Demand Outweighing New Supply Growth

The stabilization of real estate fundamentals is both a function of economic trends, as well as a favorable supply picture for commercial real estate. Unlike prior real estate cycles, the collapse of valuations in 2008 was primarily credit driven, rather than stemming from oversupply.

Indicating more robust demand, vacancies appear to have stopped rising at the end of 2010, after increasing nearly 35% since 2008. Demand for warehouse/distribution space within this sector drove the majority of occupancy gains, as the vacancy rate in this segment fell to 10.9% at the start of 2011. Overall absorption has been positive for the third consecutive quarter with annual net gains reaching 13.1 million square feet (msf) at the end of 2010.

Thus office market is showing particular strength. In the fourth quarter of 2010, and for the first time in more than three years, the US office vacancy rate decreased and net absorptions increased. Nationwide, the vacancy rate dropped 20 basis points to 16.4%, and appears to be trending back towards the global average of approximately 14.1% across 104 markets globally and 14.6% in the US.

This vacancy trend is supported by corporate cash balances and earnings, which are robust and expected to promote corporate spending on expansions. According to the Business Roundtable's CEO Economic Outlook survey, 52% of CEOs plan to add staff over the next six months (as of April 2011), the highest reading since the group started its survey in 2002. As a result, we expect shortages of quality space (Class-A properties) in 2011. Class-B and Class-C properties, however, may lag in terms of meaningful improvements, especially outside major urban areas, where employment hiring generally remains weaker. Nonetheless, the overall trend of increasing demand is positive.

- To read the complete Credit-Suisse White Paper, go HERE, or download the PDF file HERE.