Economic downturn pounds commercial real estate market
By Sue Kirchhoff, USA TODAY
Contractors, investors and developers are bracing for what could be the worst real estate crunch since the early 1990s, when the industry built a small city’s worth of speculative office buildings that later went begging for tenants. Commercial property sales plunged 73% last year, according to Real Capital Analytics. Vacancy rates are rising, and hundreds of large properties are in default.
The American Institute of Architects’ billing index, a leading indicator of construction six months ahead, is at a record low. Unemployment in the construction industry is 15.3%, well above the average 7.2% jobless rate.
The 1990s crisis was sparked by federal tax breaks that encouraged overinvestment and overbuilding. This time around, the real estate frenzy was fueled by cheap credit, which allowed investors and developers to bid up prices of existing properties. But the economic fallout could be similar: rising bankruptcies and unemployment and slower economic growth at a time when the economy is already reeling from a historic housing depression.
“This is a rolling problem that’s only going to get worse,” says Jeffrey DeBoer, president of the Real Estate Roundtable, estimating that about $400 billion worth of commercial real estate mortgages will come due by the end of 2009. Investors and developers might have trouble refinancing many loans, due to tight credit and falling rents and property values.
“Businesses need to be able to access the credit market when their debt comes due and their business needs require. Right now, they’re not able to,” DeBoer says.
The Roundtable is part of an industrywide coalition that’s pushing the Federal Reserve and Treasury Department to create a special lending program to resuscitate the commercial mortgage-backed securities market. The industry says such a move would provide liquidity and restore confidence to a sector of the credit market that has essentially frozen. The Treasury Department and Fed have not issued a formal decision, but Treasury noted in November that a similar program aimed at auto, credit card and student loan lenders could be extended to include commercial mortgage-backed securities.
In a recent analysis, Citigroup noted that the sharp drop in the commercial mortgage-backed securities market is putting more pressure on banks, forcing them to extend existing loans. But the Citigroup analysts said that problems are well below the levels of the 1990s, and that banks should be able to manage the commercial mortgage-backed securities that are coming due.
Though the problems in the non-residential sector of the real estate market aren’t likely to be nearly as calamitous as the housing market collapse, they could contribute to a deeper and longer recession. The non-residential real estate decline could shave about a third of a percentage point, or $30 billion, from U.S. economic growth in 2009, says Aaron Smith, senior economist at Moody’s Economy.com.
Banks held more than 50% of commercial real estate loans in the second quarter of 2008. Smaller, regional lenders have a relatively larger exposure to the commercial real estate market than large money-center banks, Smith notes. The charge-off rate for such loans is about 1.1% but is quickly rising.
Government regulators moved to tighten standards for commercial real estate lending several years ago as the market heated up. The Fed, for example, imposed more stringent guidelines for banks that had a large concentration of commercial real estate loans.
Some lenders that initially fought the move now say it was helpful. But they also say the current tough stance of bank regulators is making it hard for them to extend new credit and may be adding to market uncertainty.
“We’ve had situations where we’ve shown the (federal bank) examiners a particular appraisal on a property, but they’ve not accepted it and told us the property was worth less than the appraisal,” says James McPhee, CEO of the Kalamazoo County State Bank in Michigan.
“It’s been difficult for us to get a handle of what is expected … with the devaluation of real estate, I think people are somewhat confused as to what values we dare use,” says McPhee, currently vice chairman of the Independent Community Bankers of America.
How bad will it get?
Robert Murray, vice president for economic affairs at McGraw-Hill, says the downturn will get worse in the coming year but may not end up being as dramatic as the 1980s and 1990s real estate implosion. The outlook depends on what happens to the overall economy.
Office construction peaked at about 218 million square feet of new space in 2007, compared with a high of 350 million square feet during some years in the 1980s. With the exception of retail, “I don’t really think there was overbuilding to the extent of the late ’80s and early ’90s,” Murray says. “In the case of retail, it was partly due to (shopping malls) springing up where new housing developments grew; also a movement to open-air shopping centers.”
Murray expects commercial real estate construction, measured by square footage, to decline by 24% or more in 2009, after falling an estimated 24% in 2008. The retail segment, stores and shopping centers, which fell 33% in 2008, will decline another 29% in 2009.
Office space construction will plunge in 2009 by 26% — though Murray cautions that the office market is becoming increasingly vulnerable as unemployment rises. The hotel industry will move from a 3% dip in 2008, to a 30% drop in 2009.
Still, Goldman Sachs last week upgraded its outlook for hotel stocks. Noting a 70% increase in the number of hotel projects abandoned or deferred in the past 12 months, Goldman Sachs analyst Steven Kent said a more realistic supply outlook should help stabilize earnings for the industry.
Conditions differ regionally, though the pain is becoming widespread.
Charles Hendricks, a partner at architecture firm The Gaines Group, says he still has enough work to carry his office through the first quarter of 2009, and possibly the first half. The six-person firm, with offices in Charlottesville, Va., and Harrisburg, Va., specializes in environmentally sustainable architecture, doing light commercial projects and residential work.
“Our clientele is pretty well protected from the ebb and flow, and still moving forward,” Hendricks says. “As the economy slows down … we’re doing more renovation; people are staying in place.”
Not the same view
In Phoenix, it’s a different story. The office vacancy rate in metropolitan Phoenix has climbed near 18%, the highest in the nation. The pain isn’t ended yet, given that 3.9 million square feet of additional office space is under construction, says Elliott Pollack, who heads the Phoenix forecasting firm Elliott D. Pollack and Co.
Pollack expects the local office vacancy rate to climb to 20% next year. He expects Phoenix will post net job losses in 2009 after shedding jobs this year. That would be the first time employment has fallen in the area for two consecutive years since the 1950s.
“When things clear up, as they invariably will, you will see Phoenix grow out of it,” Pollack says. “There will be an extended period where there is little new office construction. There was virtually none for four years in the early 1990s; it could easily take three or four years this time, as well.”
Overall, the U.S. office vacancy rate increased to 11.7% in the second quarter of 2008, according to CoStar, a Bethesda, Md.-based firm. That’s the third quarterly increase in a row, and the highest vacancy rate since 2005.
Detroit had the second-worst performance behind Phoenix, with a 17.2% vacancy rate. Oklahoma City, by contrast, had some of the lowest numbers, with an 8.3% vacancy rate.
But the outlook depends on whether the economy starts to stabilize by midyear, as many economists forecast, or deteriorates more than expected.
Huge retailers, including Target, Best Buy, Home Depot and Lowe’s, have scaled back on new construction and closed existing stores, while others, such as Linens ‘n Things and Circuit City have filed for bankruptcy-court protection.
NAI Global, a major real estate leasing and financing firm, noted an increasing number of empty downtown storefronts, with vacancy rates for such properties rising by 14%, to 7.5% in 2008. Still, the national average rental rate for downtown retail space rose 7% last year. The national average rental rate for regional malls fell 21%, and the vacancy rate nationwide increased by 15% to 5.6% in 2008.
“We believe we will see further erosion in all sectors before vacancy rates and rental rates stabilize in late 2009 or early 2010,” said Jeffrey Finn, president and CEO of NAI Global.
Finn says he hopes President-elect Barack Obama’s emerging economic stimulus plan will revive the economy and consumer confidence. Some firms are hoping for even more immediate assistance.
As the housing and commercial real estate sectors have slowed, construction firms have relied on public works projects such as bridges and schools to stay busy. A number of those projects are being mothballed as states and cities struggle to balance their budgets in the face of declining tax revenue.
“Arizona has a (budget) shortfall, so they are starting to put state-funded or tax-funded projects on hold. We have a couple ready to start construction that are on indefinite hold, and we don’t know what indefinite means,” says J. Doug Pruitt, chairman and CEO of Sundt Construction in Tempe, Ariz.
Pruitt’s firm, which also does work in California and other states, says that if conditions don’t turn up soon, he’ll have to start thinking about layoffs at his company.
He and others in the construction industry are pushing Congress to quickly approve hundreds of billions of dollars in new public works spending, including bridges, roads and schools, to tide workers over until the economy recovers.
Source: USA Today