As I prepared for my morning, I opened my email inbox to find an article on commercial real estate (CRE) defaults. According to the article on GlobeSt.com, CRE delinquencies are declining, and that segment of the real estate market is approaching a healthy state. Even troubled construction loans have fallen by about half vs. this time last year. Commercial property loan default rates are down to about half the peak level reached in 2010, as well.
Meanwhile, loan demand for CRE appears to be picking up, and prices in some markets are showing strong improvement. In the past year, CRE has not attracted as much attention or buying interest as has multifamily and single-family residential real estate, and it appears that this marketplace is improving and my present an opportunity.
I downloaded some information from Real Capital Analytics and looked at the markets as measured by the RCA/Moody's indices. As I was sifting through the data, this much became obvious: With the exception of central business district properties in hit markets, a recovery is under way -- yet there is still a tremendous amount of upside potential ahead.
The premier office properties in downtown markets have rebounded, and the relevant index is sitting near the 2008 highs. On the other hand, suburban properties have not done as well -- and, although they are off the lows, prices are at just 70% of the 2007 peak. The index of retail properties is at about 80% of peak 2007 levels. Major markets on an all CRE basis are near the peak pre-crisis levels, while non-major market prices are at 80% of peak levels. The CRE markets are improving, prices are climbing and transaction levels are slowly increasing.
The improvement in CRE markets has very positive implications for the Trade of the Decade in small banks. Many of the smaller banks possess extensive commercial real estate loan portfolios and an increase in loan volumes, while default and charge rates are declining dramatically. This is good for their bottom lines.
When it comes to banks that have heavy CRE exposure, two that come readily to mind are Eastern Virginia Bancshares (EVBS) and Alliance Bancorp of Pennsylvania (ALLB). These could be very attractive acquisition targets for larger regional banks. Midsized regionals like First Merit (FMER), Associated Bancorp (ASBC) and Bancorp South (BXS) could themselves become targets of larger banks looking to acquire more exposure to the recovery in CRE.
As CRE improves across the country, another sector will also appear attractive: the real estate investment trusts that finance these properties. If demand is increasing and credit risk is contracting, these are very attractive long-term investments. My favorite in the sector remains Apollo Commercial Real Estate (ARI). I have an affinity for vehicles associated with the large private-equity firms, as these REITs seem to have access to better deal and information flow as a result of their relationship with their parent company.
As an example of this, the REIT is investing alongside several other Apollo (ARO) entities to buy 21% of Belgium-based KBC Bank. This bank specializes in corporate banking and financial services for medium-sized German companies, and is active in real estate financing, acquisition finance and institutional asset management. In addition to anticipated profits from the investment in the bank itself, Apollo Commercial management expects it will be able to invest alongside KBC in income-producing commercial real estate financings in Europe.
The shares currently trade right at their asset value and yield 9.77%. Management raised cash earlier this year, and it expects to pretty much fully deploy that capital by year's end -- and this will support the dividend. Apollo Commercial also said on the last conference call that the focus remains on protecting and growing book value. I think you can buy a little of this REIT at current levels and look to add to the position on any declines.
Although that is my favorite pick, there are several other REITs with high CRE exposure that are worth considering at the current share prices. Arbor Realty (ABR) stock trades at 86% of book value and yields 7.96%. Ares Commercial Real Estate (ARCC) trades at 90% of book value and yields 7.61%. Colony Financial (CLNY) has strong exposure to CRE loans, as well as a large portfolio of single-family homes. The shares trade at 87% of book value and yield 7.71% right now.
Commercial real estate does not get the headlines that the housing market does, but it is still a huge market. There are many ways to profit from the long-term improvements in this marketplace without sacrificing the principles of safe and cheap. Investors should be looking for ways to invest in the sector for the next decade.