Fighting the last war

At the ULI meetings, I am hearing that banks are not willing to repeat their behavior in the last down market (the early 1990s): they are afraid that if they sell their assets--commercial real estate loans--at a discount, they will miss out on upside opportunity. Instead, they are "extending and pretending," in the hope that values will rebound to levels above mortgage balances. I overheard one person say, "cap rates have to go back down again. right?"

Not necessarily. This paper by Phillip Connor and Yougo Lang shows that cap rates tend to stay in the eight range over the long term--to think they will return to the fives is almost certainly unrealistic. Even if net operating income had stayed constant--and it has fallen--the increase in cap rates from 5 to 8 implies a 37.5 percent reduction in value. It is going to be a long time before loans with LTVs at origination in excess of 75 percent will be right-side-up again.