Slump Hitting Commercial Property

The pain will vary widely geographically, but the overall outlook will deteriorate as recession sets in.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

October 21, 2008

The commercial property market is icing up, and the outlook is worsening. Deals are way down. Over the past year, total dollar volume of transactions in offices and hotels has dropped about 75%; retail, about 70%; and industrial, about 60%.

Doubts about the value of property have shut down deals financed through mortgage-backed securities. Investors, including pension funds and insurance companies, are extremely wary. Suzanne Mulvee, senior real estate economist with Property & Portfolio Research, says, "Investors have the cash to buy, but they think the economy could deteriorate a lot further" from here.

Developers as well as investors say lenders are becoming increasingly tightfisted. Banks and other financiers are raising standards and insisting on more cash up front from borrowers. "A year ago it could have been 90% borrowed. Now it's about 60%," says Frank Liantonio, executive vice president of global capital markets for Cushman & Wakefield.

Sales of property at risk of default will rise as some building owners find themselves unable to refinance adjustable rate loans. Some will go bankrupt, having paid top dollar at the peak of the market a couple of years ago. Moreover, recent Wall Street events haven't played out yet as the now defunct Lehman Brothers and other failed firms wend their way through bankruptcy, putting office and retail projects on hold in New York, Washington, D.C., and other cities.

Rising unemployment adds to the squeeze, resulting in more empty offices, less rental income and falling property values. Because vacancy rates lag joblessness, the problem will linger even after the economy begins to recover and employers start to add jobs again, which is at least a year off. Meanwhile, vacancy rates have started to creep higher. Robert Bach, senior vice president with Grubb & Ellis, says, "The leasing side is just getting hit."

Retailers will shutter more stores in the near term as consumers continue to pare their spending. And that means less demand for warehouse space, aggravated by a weakening global economy that will reduce both imports and exports.

At least there appears to be less toxic debt involving commercial real estate than in housing. Until 2006, a few years after lax lending inflated the residential market, lenders didn't dish out much easy credit for offices and warehouses.

The degree of pain in the commercial real estate market varies widely. Among the areas hit hardest: Las Vegas, Orange County, Calif., Phoenix and Orlando, Fla. -- places where property values and construction soared during the recent boom. Cities doing relatively better: Washington, D.C., which is aided by government jobs, and Houston, Denver and Seattle, though activity even in those better-off cities is slowing.

Staffers at the Federal Reserve noticed evidence of a widening commercial real estate slowdown when they scrutinized a Fed survey of economic conditions nationwide. The latest survey, through early October, says that "increases in vacancy rates were noted in Chicago, Boston, New York, Atlanta and San Francisco. Several districts reported project delays and cancellations due to tighter credit conditions and increased economic uncertainty."

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