Commercial Real Estate Digs Out, Slowly

Tenants hit by a weak economy, along with plenty of buildings and still-tight financing, put recovery a year off.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

May 20, 2008

There are hopeful signs of recovery in the commercial real estate market. Even with the small hints of improvement, however, the market won't pick up until well into next year. The well-known problems in the housing market have taken a huge toll on commercial real estate, too. A virtual freeze on buying and selling mortgage-backed bonds plus tight bank lending were key factors in deals totaling just $40 billion in the first quarter, down from $137 billion a year earlier.

Robert Bach, senior vice president with Grubb & Ellis, says, "Banks, insurance companies and pension funds who keep loans on their books are active but cautious." He adds that "sellers aren't selling" because they think buyers are bidding too low. But those who hold property may be forced to sell later this year when a fair amount of floating-rate loans reset at a higher rate.

Despite widespread woes on the financing side, supply is doing just fine. Jon Southard, an economist with Torto Wheaton Research, says: "There is more in the pipeline than is needed. We don't need new supply for a year and a half."

What's pushing down leases and rents near term is the weak economy. The shrinking growth in payrolls is pushing up the office vacancy rate, now about 13%. It will rise to 14.5% by year-end and 16% or so in 2009. All markets will feel the slowdown, even the strong ones, such as Boston, Houston, Seattle, New York City and the Bay Area in California. Among the hardest hit are Detroit, Phoenix and Las Vegas.

Rents will go up just 2% this year, well shy of last year's rise of almost 10%. No increase appears likely in 2009 as the economy improves at only a snail's pace. Expect landlords to entice tenants with offers of a couple of months of free rent on a five-year lease or cash for tenants to make improvements.

The impaired economy also will weigh down demand for warehouse space, though export strength bolstered by the weak dollar will offset the drag to some extent. The vacancy rate -- 9.3% last year -- will increase to 9.8% by the end of this year and about 10.3% in 2009. Metro areas doing the best will include Cincinnati, Pittsburgh and Kansas City, Mo., which all will benefit from manufacturing exports, and Houston, where energy activity is robust. Among the weakest markets: Las Vegas, Orlando, Fla., Indianapolis, Nashville, Tenn., and Riverside County, Calif.

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