The burning question in real estate today is whether or not commercial real estate will follow in the footsteps of the residential property market. Residential property values have fallen as much as 40 percent and more in some markets, most notably Florida, Arizona, Nevada, and California. While some markets have seen a bounce off the bottom, primarily those hardest hit since 2007, many others have yet to reach their nadir. Commercial property values so far have not declined so precipitously. According to the Wall Street Journal,[1] commercial property values are only about a third less than their peak in the fourth quarter of 2007.
Arguing against further decline in the commercial sector, analysts point to the loosening in the public credit markets, which has allowed real-estate investment trusts (REITs) to raise debt and equity. “REITs raised $35 billion in 2009 to recapitalize themselves,” according to Ignatius Chithelen, managing partner of U.S.-based Banyan Tree Capital Management, speaking at the Knowledge@Wharton global real estate forum in December 2009. With these trusts sitting on billions of dollars of cash, some analysts argue this could help stem the tide as REITs start acquiring attractively priced, high-quality assets. Also, investors who have been sitting on the sidelines are starting to get back into the game, most notably foreign investors, like HABC Alternative Investments Ltd., which bought 1625 I St. in Washington, D.C. in January 2010 in a deal that valued the office building at a respectable $203.4 million.[2]
On the flip side, those who have a more pessimistic view argue that, with continued high unemployment and falling rent and occupancy levels, the price investors are willing to pay for lower cash flows is likewise falling and, thus, values will most likely continue to fall. Currently the unemployment rate is at 9.7 percent nationally, [3] but some argue it is as high as 15 to17 percent if you count all those formerly in the labor force who have simply given up on the job search or those who are under-employed. This, coupled with lower expectations of current cash flows from operations and less optimistic expectations of appreciation in the near term, indicates that commercial property values will, at best, continue to stagnate in the short term.
Further clouding the screen is the fact that commercial lenders are tightening credit standards, leading to a deleveraging of America’s real estate assets. Lower loan-to-value ratios, higher equity requirements, more stringent underwriting standards, and more escrow and reserves are all becoming the norm. If interest rates rise, as many predict will as the Federal government abandons its policy of keeping interest rates low, then commercial real estate assets will almost certainly take a big hit.
There is another important difference, however, between what is going on in the residential property markets and what is happening with respect to commercial property. While lenders holding mortgages on residential property have aggressively pursued foreclosure for borrowers in default, commercial lenders have, as of yet, not pursued this option to as great an extent. Thus we are not seeing many distress sales of commercial real estate assets even as the number of problem loans continues to grow. Rather, lenders are attempting to work out these problem loans by extending the maturity of the loan or otherwise modifying its terms in hopes of preventing it from going into default. According to Bob Steers, the co-chief executive of REIT investor Cohen & Steers, Inc., “The volume of the properties that are truly distressed and will be sold in a distressed fashion will be significantly less than had initially been thought.”[3]
So where does all this leave us? Precisely as the title of this editorial suggests, the commercial property market is on the brink of the abyss. Should unemployment numbers jump unexpectedly or interest rates spike, then the decline in the commercial sector could easily match that of the residential sector. Global factors must be considered as well. If the financial crisis in Europe worsens or there is another unexpected shock to the American, European, or Asian economies, the commercial property market will undoubtedly suffer further.
On the other hand, should the economy do better than expected in the coming year or the stock market resume its torrid rally that began in March 2009, this could be a boon to the commercial property market and bring it back from the brink onto more solid footing. And, as always, there is the 500-pound gorilla in the room: the Federal government. Should Uncle Sam decide he needs to become a player in the commercial property market like he did with the residential market to avoid a catastrophic meltdown, (although some would argue rather aggressively that the Federal government did more harm than good by interfering with the market’s ability to clear on its own accord), then we could see commercial property values start to rise, albeit at a very slow pace for the foreseeable future. But this alone will not be sufficient to spark a significant upturn. Only when investors believe the cash flows from commercial property investments have stabilized and rents can be raised when existing leases expire, will commercial property values once again start to rise.
So, where is the commercial property market headed? At this point, it would appear that the market will continue along its current path for the next several quarters. After that, the odds favor a slow but steady rebound from current levels. Certainly not all commercial property will see a rebound in value. Properties in established markets with good tenants and high occupancy rates will be the properties that lead the way. Less desirable properties will likely not see a rebound in values for a considerably longer period.
[1] Anton Troianovski, “Flush REITs Have Loads of Cash, Little to Spend It On,” The Wall Street Journal, Feb. 3, 2010, at C8.
[2] Christina S.N. Lewis, “Matter of Debate: Bottom in Commercial-Property Values,” The Wall Street Journal, Jan. 20, 2010, at C12.
[3] Christopher S. Rugaber, “January Unemployment Rate drops to 9.7 Percent,” The Associated Press, Feb. 5, 2010.
