The Other Building Sector

Commercial real estate isn't on housing's perilous path. Still, slower growth lies ahead in demand for offices and other business properties.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

September 26, 2007

Will commercial construction follow housing into slump territory? No, but the nonresidential side won't emerge entirely unscathed. Clearly, there are carryover effects -- some merited, some not -- from housing's woes. Notably, less home building has cooled interest in the development of new shopping centers, though this hasn't been the case so far in Houston, Phoenix, Los Angeles, San Francisco and Washington, D.C. Meanwhile, a housing-led slowdown in job creation is sure to temper demand for offices. Overall, however, commercial property will remain in decent health in the coming year.

In most areas, nonresidential property is not a bubble about to burst. On the contrary, deepening housing problems since last year have actually helped to prevent commercial-sector froth from forming in many locations, as banks and other financial backers became generally more circumspect about all types of building projects, housing or otherwise.

That caution, however, is also slowing down some worthwhile deals due to a lingering distrust over the value of asset-backed debt that had come to represent a large percentage of real estate transactions. Gregory Leisch, chief executive of Delta Associates, says, "We need faith again in the valuation of the collateral. That will take time, perhaps well into the first quarter of 2008."

Even before the housing mess, builders and lenders in the office sector were acting more cautiously than they did during the 1980s, when towers were often financed and built without tenants signed up. That led to a huge oversupply of space when the economy slowed in 1989 through 1991. Dennis Yeskey, national director of capital markets for Deloitte & Touche LLP Real Estate, says, "[The commercial market] is going to cool down a little bit, but no bust. We didn't overbuild this time."

Investment returns to buyers of prime office space are likely to hold up, though the pace of sales price gains for office buildings will ease from the frenzied pace of the past three years. Robert Bach, senior vice president with Grubb & Ellis, says, "Prices of buildings won't be bid up as they have been. But real estate investment will be very attractive."

The upside of a less-frenetic market and less bidding up of prices for buildings is that buyers actually have greater scope for improved potential returns. Notably, the closely watched capitalization rates -- the first-year return on investment for rented office buildings -- are likely to climb to an average 6.3% by year end from 5.8% last quarter. Five years ago, the average was 8.5%. Outperformers will include Manhattan, downtown Boston, Charlotte, N.C., and Salt Lake City. Weaker markets will include Miami, Las Vegas, Phoenix, Detroit and Cincinnati.

Gains from nonresidential building won't be enough to offset housing's drag in coming quarters. Housing contributed to the gross domestic product every quarter from the beginning of 2003 through 2005. Since 2006, housing has subtracted from economic growth. And while business spending on commercial structures advanced a whopping 28% from early March through June, we expect the gains in the next four quarters to be more modest, most likely in the mid-single digits.

Commercial construction's strongest suits: Hospitals and other health care facilities plus energy projects, especially power plants. Also, brisk foreign trade will boost demand for warehouses in coastal areas near ports, but otherwise, demand should ebb somewhat. The average warehouse vacancy rate, which is currently at 9.4%, will creep up to about 9.8% by the middle of 2008.

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