Commercial Real Estate Market Seen Staying Soft

Author: Robert Julavits, American Banker
Source:
Date: 12-17-2001

Commercial Real Estate Market Seen Staying Soft

Commercial Real Estate Market Seen Staying Soft

BY ROBERT JULAVITS


Tyson's Corner, an oasis of tony stores and corporate offices in northern Virginia, is feeling the pinch of the recession.

At Tyson's II, an upscale office park attached to the Tyson Galleria shopping mall and its Ritz-Carlton Hotel, developers have put plans for what would be one of the park's largest buildings on the shelf until the economy improves.

Lerner Enterprises, a commercial real estate developer in the Washington area, has pulled the plug on plans to construct a 600,000-square-foot, 26-story office building. Instead it has chosen to break ground next summer on one about half the size on a different parcel of land. "It was the hope a year and a half ago to start the (26-story) building on a speculative basis, but the economy has clearly slowed that down," said one source familiar with the project.

The decisions show the effects of the rapidly receding commercial real estate market. The economic downturn is expected to deter most commercial construction -- particularly hotels and offices -- next year.

The dot-com implosion, months of layoffs, and a general slowdown in corporate spending have caused office vacancy rates to skyrocket, and demand for new space has plummeted. And because business and pleasure travel was down even before Sept. 11, few lenders or developers are willing to go anywhere near a hotel project.

"It's been much more difficult to do new construction this year," said John B. Levy, a principal at John B. Levy & Co. Inc., a real estate investment banking firm in Richmond, Va. "I don't know what it would take to get a hotel construction loan today."

Jeanette Rice, a principal at Lend Lease Real Estate Investments in New York, said that few projects got off the ground this year, and that she expects "very little" new construction to start or finish next year.

"The slower economy means less demand for commercial property," Ms. Rice said. "Corporations don't need as much space, and they're more conservative on travel. In most markets there's less occupied space today than a year ago."

As a result, large amounts of office and retail space has been dumped on the market. Many companies have cut back drastically on their need for offices, and others -- from Montgomery Ward to technology companies -- have simply gone out of business.

The problem has thus far been confined to tenants who must find subtenants, but some market observers expressed concerns that a highly skewed supply-and-demand situation could eventually lower rents enough to hamper the ability of property owners to make loan payments.

Even though office vacancy rates are still below the 19% levels reached in the recession of the early 1990s, they have risen sharply this year. According to Torto Wheaton Research, the national rate in the third quarter was 12.3% -- a 52% increase from the same period a year earlier.

In some areas, particularly those affected by the slumping tech sector, vacancies have catapulted. In San Francisco the third-quarter rate more than quadrupled from a year earlier, to 14.8%, and in Boston it more than tripled, to 12.1%.

Raymond G. Torto, a principal and managing director of Torto Wheaton Research in Boston, the econometric forecasting arm of CB Richard Ellis, said about half of the rise this year in the national vacancy rate has been caused by the glut of available sublet space.

"This is the concern for the real estate market," Mr. Torto said. "When companies dump space they can create a situation where quoted rents come down" across the board.

He expects the national vacancy rate to reach 14.2% by the beginning of 2003 before leveling off.

Industry observers say the construction slowdown is actually a healthy sign. Speculative building in the years before the last recession resulted in massive losses for both lenders and developers, who learned from those mistakes, the observers say.

Commercial real estate went into the 1990 recession with lots of excess capacity, and that led to a high number of defaults and losses, Ms. Rice said. "This (recession) is much different, because developers as well as the capital sources were much more disciplined in terms of starting projects."

Specifically, most lenders now require a building to be close to 100% preleased before ground is broken, Ms. Rice said. And taking a page from residential mortgage lenders, many commercial ones are also requiring developers to take an equity stake in a project before they will underwrite a loan, she said.

Stacey Berger, an executive vice president at Midland Loan Services, a Little Rock technology provider for commercial real estate lenders, said underwriting standards have gone up, and "we expect them to stay relatively tight."

Well-capitalized borrowers with strong balance sheets and high-quality properties will still have access to credit, but banks will be selective about whom they lend to and scrutinize their decision-making, he said.

"Historically, real estate has been the source of credit problems, but today it is the star of the credit universe for banks," Mr. Berger said. "They have been much more conservative in how they underwrite."

Observers also point to commercial mortgage delinquency rates, which are below 1%. Most say that figure will go up in the next 12 months, but will not reach alarming levels unless the current recession -- expected to be short -- is prolonged.

Ms. Rice said she expects the recession to end by the first quarter, and the commercial real estate industry, which lags the broader economy, to recover in the third. If the recession lasts longer, "then defaults could rise more than 2%," she said. "That would be detrimental. There will be losses."
 
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