Is There a Bottom in Sight for Commercial Real Estate?

Editor's Note: This article was written by Keith Jurow who currently writes about overlooked aspects of the housing debacle. This piece was originally posted on Real Estate Channel.


In the last 18 months, the commercial real estate market has seriously deteriorated. Yet many analysts are hopeful that the worst is over and that pressure on property owners will begin to ease. Let's take an in-depth look at whether their optimism is justified.

Early 2007: The Perfect Calm

Charles Dickens began his classic, A Tale of Two Cities with the famous opening, "It was the best of times ..." That was the tone of the Mortgage Bankers Association's (MBA) January 2007 assessment of the commercial market which was entitled The Perfect Calm. Indeed, everything looked calm and promising to the MBA.

Record amounts of investor money were pouring into the market. Delinquency rates had dropped to only 1% of all commercial real estate loans, down from the heart-stopping rate of 12% in 1991 after the S&L collapse of the late 1980s. The author of this MBA review could find little on the horizon that warranted concern except for possible overbuilding by optimistic developers.

Although the residential subprime market collapsed only three months after this report appeared, this had little effect on the commercial real estate market. For the rest of 2007, investors continued to bid on just about anything that hit the market at prices that defied traditional standards. A record $522 billion in sales transactions were closed that year according to Real Capital Analytics. The chart below shows how purchases skyrocketed from 2001 to 2007.



The Blackstone Group (BX), perhaps the nation's leading real estate management and advisory firm, wisely sold off $60 billion of its holdings during the market peak of 2005-2007. Yet even it was subject to excessive exuberance, purchasing the Hilton Hotels empire in October 2007 for a whopping $26 billion. That was 40% more than the stock market valued the common shares at the time.

It Was Quite a Party While the Lending Flowed

The previous commercial real estate boom in the 1980s was characterized by massive overbuilding fed by easy money from the S&Ls and commercial banks. Total office market space actually doubled in the 1980s by the time the boom collapsed. The market was saved from total ruin only by Congress' creation of the Resolution Trust Corporation (RTC) which took over the assets of failed S&Ls and sold them off in bulk, often for pennies on the dollar. It cost the taxpayers $157 billion according to the Congressional Oversight Committee's February 2010 report on the state of the commercial real estate market.

The lesson was clear: When threatened with a potential systemic failure, the federal government would bail out surviving financial institutions and all their insured depositors. No need for depositors to exercise any prudence as to where they put their money.

Like its residential counterpart, the commercial real estate bubble of 2004-2007 was a buying binge fed by a seemingly inexhaustible supply of mortgage funds. Most of the lending was provided by two sources -- the commercial banks and institutional investors who purchased commercial mortgage-backed securities (CMBS).

Since the late 1990s, small and mid-sized banks have drifted away from their traditional role as short-term lender to commercial developers. Over the last dozen years, these banks gorged themselves on commercial real estate mortgages and became the primary lenders in this market. According to the Federal Deposit Insurance Corporation (FDIC), banks with assets between $100 million and $10 billion held 36% of their total assets in commercial real estate loans at the end of the first quarter 2010. Half of their total loan portfolio was in commercial mortgages.

Between 2000 and 2004, CMBS lending averaged $70 billion annually according to the real estate law firm Robins, Kaplan, Miller & Ciresi. Then it took off in 2005 and peaked at $248 billion in 2007.

Underwriting standards went out the window. According to the Congressional Oversight Committee report cited earlier, during the peak bubble years of 2006-2007, nearly 90% of CMBS loans were either interest-only or partial interest (negative amortization). Many of the deals required little down payment. As prices soared, lenders justified their actions by assuming that rising rents would continue indefinitely.

The Office Market in 2009

In the largest commercial sector -- the office market -- the statistics didn't seem right to the CoStar Group in April 2009. Millions of jobs had been shed since the recession began, but the vacancy rate had not gone above 12.5%. Then Mark Heschmeyer, their chief analyst, published an article entitled "Has the Office Vacancy Rate Become Irrelevant?" In it, he quoted the firm's CEO, Andrew Florance, who put it bluntly: "Never has a vacancy rate chart been more useless in commercial real estate than right now."

Florance went on to elaborate: "Based upon the job losses we've seen to date, we should be seeing something on the order of 450 million square feet of negative absorption compared to the negative 20 [million] we've actually experienced."

The firm's conclusion was that there was an enormous "hidden supply" of available space which hadn't been listed on the market. Some of the key reasons for this were:
 

• Established tenants were still hopeful about being able to rehire laid-off staff.
  
  
• Major tenants such as those in the financial services industry were fighting bigger fires and weren't focusing on a few million dollars in underutilized space.
  
  
• Smaller and mid-sized tenants were worried that putting their unused space up for sublease might send an impression that they weren't financially stable.
  
  
• Lenders weren't forcing the issue of recognizing unoccupied space as long as owners were still collecting rents and making loan payments.

Their conclusion was that a 1,100 basis point spread existed between the official vacancy rate and the actual percentage of available space. In other words, the percentage of total available space was not 12.5% but 23.5% of all office space. An incredible and frightening number!

CoStar found that in the 15 largest office markets, leasing activity had plunged by an average of 46% from a year earlier. With fewer deals being done, the average time between a space being listed on the market and a signed lease had soared from 270 days at the start of 2006 to 415 days in the first quarter of 2009.

Furthermore, office building prices had collapsed in early 2009. Class A space was down 21% from the previous quarter and by an average of 51% from the peak in early 2008. Class B space had fared even worse -- down 40% in the first quarter and 55% from the third-quarter 2008 peak.

A good example of the unreality that CoStar had found so frustrating was an announcement by Morgan Stanley (MS) in December 2009. Bloomberg reported that Morgan Stanley's real estate division, which had spent $8 billion to purchase properties at the peak in 2007, planned to "relinquish" five San Francisco office buildings to its two lenders after having purchased them two years earlier from the Blackstone Group. One analyst estimated that the properties had lost half their value since having been bought as a result of a 37% plunge in prime office rents in the third quarter from a year earlier.

The Bloomberg author explained that Morgan Stanley had been negotiating an "orderly transfer" since early 2009. A Morgan Stanley spokeswoman took pains to explain that "This isn't a default or foreclosure situation." Really? What was it, then? A deed-in-lieu of foreclosure?