The Two Sides of Commercial Real Estate

The outlook for commercial real estate is still ugly, though less so than a year ago. After a 40% decline in average property values since August 2007 and a nearly 80% drop in sales volume during the recession, more deals are finally getting done. Buyers and sellers are moving closer on pricing. And a small amount of mortgage-backed debt is again being securitized and sold, providing a trickle of new financing now and the hope of a steadier stream in the future.

In fact, the market has a bit of a Jekyll & Hyde flavor, with some segments attracting considerable attention while most property, in most places, is still being shunned. As Mitch Roschelle, a partner in the U.S. real estate advisory practice for PricewaterhouseCoopers, puts it: Investors' flight to quality has “created a greater separation between the trophy and the trash assets.”

According to a recent survey by PricewaterhouseCoopers and the Urban Land Institute, sales in major markets such as Detroit, Cleveland, Phoenix, Milwaukee, Cincinnati, Atlanta and Las Vegas have dried up. At the same time, movement in iconic properties -- mostly located in international gateway cities such as Boston, New York, Washington, Houston, Denver and Seattle, plus L.A., San Francisco and San Diego -- is brisk. There’s also interest in Portland, Ore., Dallas and Austin, Texas, Raleigh-Durham, N.C., and northern N.J., in the shadow of NYC.

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Across most of the country, landlords’ problems persist. Vacancy rates are leveling off, but will remain sky-high ’til 2012. Office buildings are now at 17.5%, retail properties at 11%, industrial space, 13% and apartment buildings, 7%. As a result, rents will continue to slide. For offices, expect a decline of another 3% over the coming year. Ditto, retail space. No change is likely for industrial space. Apartment buildings have a more upbeat outlook as foreclosures and tight mortgage lending drive more folks into the rental market. The good news is that meager development won’t add much to the current oversupply.

Real estate loans coming due are also a concern. In each of the next five years, about $300 billion in loans must be rolled over. With vacancies squeezing cash flow, many borrowers will come up short, potentially putting more property on the market and further pressuring property values. The issue is especially worrisome because it packs a double whammy, slamming not just building owners, but small and midsize banks as well. About 40% of their loan portfolios are in commercial property, so the large number of defaults still to come will put hundreds of additional banks out of business next year. That will in turn crimp the availability of credit for the small businesses that depend on them.

Fortunately, creditors will tend to be flexible. They know that foreclosures will only push values lower, worsening the problem. Instead, they’ll opt to take a haircut on outstanding loans, writing off some losses and sharing the pain of devaluation with owners as they await better days.

In addition, long-term trends spell a long, slow recovery: Permanent downsizing of businesses in the wake of the recession and a similar move in state and local governments, if not in Washington, will curb demand growth for office and business space. Similarly, the growing popularity of job and office sharing and telecommuting means fewer employees to permanently house. Online shopping will continue to cut into demand for retail bricks and mortar.

For investors with cash, great deals are available, especially in raw land and finished lots. Warehouses near ports and downtown full-service hotels will also do OK. But avoid suburban offices and retail, which remain burdened with excess space. And the value of REITs, on the whole, already incorporates anticipated market improvements.