By Fortune Editors
January 4, 2011

The forecasts are rosy for the CRE market, but systemic headwinds still exist, making this a tough sector to bank on profits.

By Kit R. Roane, contributor

Until recently, the smart money saw commercial real estate as the next asset class to do a number on the economy. Now some believe it is turning into a feather in the recovery’s cap. But every bet has its risks — and in this case, better days may be farther into the future than many investors would like.

The bullish case for the commercial real estate market is that the bad news is baked in, and what’s left will likely dissipate as the economy gains steam. Wells Fargo (DB) sees commercial real estate actually contributing to growth by the second half of this year, driven by more interest in leasing, steadying rents and increasing sales.

“Operating fundamentals for all major property types are either improving or showing signs of stabilizing,” notes the Wells Fargo Economics Group in its recent economic outlook for 2011, declaring that “the troubled commercial real estate market has turned the corner.”

Meanwhile, Lawrence Yun, chief economist for the National Association of Realtors, projects that increasing commercial leasing demand and a steadily improving economy “means overall vacancy rates have already peaked or will soon top out.” And Jones Lang LaSalle is anticipating that private sector growth will send investors flocking to apartments, as well as office, retail and industrial spaces. The global real estate company sees investment transaction volume increasing to the tune of $92 billion, which would mark “an 80% increase over the low reached in 2009.”

Economics is known as a dismal science for a reason: forecasting the economy is inexact at best. But “the signs of improvement are pretty widespread and are real,” says Professor David Geltner, who heads the Massachusetts Institute of Technology’s Center for Real Estate, adding that he’s still not among those who believe it’s time to give an all clear. “The market is on the mend, but not out of danger by a long shot.”

Even if the underlying market isn’t yet fit, investors using Real Estate Investment Trusts to bet on a future recovery have, so far, been richly rewarded. The debt of REITs returned more than 13% last year, while the FTSE NAREIT US Real Estate Index clocked in total returns of 27.4% in 2009 and 27.5% in 2010. REITs have been better performers than just about any asset, except gold.

Getting the deals done

Closer to the action, real estate deals, particularly those backed by REITs or foreign buyers, have been on the rise, helping to support prices in some segments. Geltner notes that prices for “trophy” properties — prime real estate in gateway and safe harbor cities like New York, Chicago and San Francisco — have soared, while investor interest in “distressed” deals has stabilized prices there. The consultancy Deloitte & Touche LLP says that distressed sales accounted for more than 16% of all commercial deals in 2010.

Richard Hyman, president of Triquest Financial, a Manhattan-based real estate investment and advisory firm, says he has also seen more tertiary deals in fly-over markets like Ohio, Colorado and North Carolina. A pickup in these areas could signal another leg in the recovery, with some investors looking for diversification, or just cheaper prices than the coasts can offer. But Hyman cautions reading too much into the nascent action.

The largest part of the commercial real estate market, what Geltner calls the “soft middle,” has barely budged. And Hyman’s view is that a greater number of marginal and distressed properties are moving mainly because, after sitting on them to see how the economy shakes out, sellers are finally willing to take a hit. “It just seems like people have become more reconciled to the world as it is today,” he says. “It is definitely being more realistic, than optimistic.”

One reason it’s hard to start popping champagne corks is the nation’s employment rate, says Hyman. A rough gauge is that each new hire creates about 250 square feet of economic activity. Despite some gains, the nation’s private-sector hiring has not shown enough strength to budge the unemployment rate and many companies are still planning layoffs..

Increasing and more volatile interests rates could generate other troubles for the market, making buyers skittish and leaving owners with problematic refinancing costs. Deutsche Bank (DB) recently cautioned debt buyers about both risks, explaining that investment in commercial real estate instruments of any stripe is “essentially a levered play on the economic recovery and the rates market.”

Without an ever-improving economy, two of the most important diviners of a healthy commercial real estate sector, occupancy and rental rates, aren’t going to recover. Currently they are stuck in decline and “elevated vacancies are expected to make further rent reductions necessary before a gradual improvement can begin,” says Deloitte & Touche.

Add these to the mix — the market’s oxygen, commercial mortgage-backed securities (CMBS), still find few takers; the amount of delinquent CMBS loans continues to rise; banks keep nursing along billions in troubled loans they are afraid to call delinquent; and $1.4 trillion in bubble-era commercial real estate debt comes due within the next four years. Although real estate may zoom ahead, with all these unknowns, perhaps it might be prudent to reduce expectations for the new year, at least just a little bit.

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