New York’s Stuyvesant Town in default, massive General Growth Properties succumbing to bankruptcy, Las Vegas’ mega-project CityCenter barely back from the brink. High-profile commercial real-estate blowups just kept coming.
Even playing host to a high-profile PGA Tour event and to Tiger Woods’ televised mea culpa in February couldn’t keep the owner of the Sawgrass Marriott Resort in Ponte Vedra Beach, Fla., from filing for bankruptcy protection a month later.
And for each multibillion-dollar failure, there have been hundreds of smaller commercial defaults on hotels, offices, shops and apartment complexes that didn’t make the national news.
The distress reached crisis proportions late last year. In the last quarter of 2009, the commercial-mortgage default rate in the United States more than doubled, sending off alarm bells in the nation’s capital and throughout corner offices.
Even now, more than 10,000 commercial properties across the country collectively worth over $205 billion are in trouble, according to Real Capital Analytics, a real-estate research and consulting firm in New York.
Unlike home loans, which generally are long-term, commercial properties typically are funded with short-term loans that must be refinanced every several years. That was just fine during the boom, when developers and investors loaded up on debt to purchase office towers and other commercial properties, figuring they’d be able to hike rents or flip the properties for a fast profit before the loans came due.
Finding a Bottom
Is there any end in sight to the bad-news trend?
It appears there is. Already this summer, glimmers of a recovery have been spotted. However, the rebound is weak and appears to be confined so far to major markets on the Atlantic and Pacific coasts, MSNBC reported in July after speaking with industry insiders in New York, Boston, Los Angeles and Seattle. But because these small waves of looser credit and more business have not yet reached the heartland, a debate is raging among industry experts as to the authenticity of any rebound.
“Most commercial real estate recoveries begin in core markets—usually the two coasts and with activity in core [investment-grade] properties. This is how this recovery is behaving,” David Rifkind, managing director of George Smith Partners, an L.A.-based real-estate investment banking firm, told NBC’s cable-news network. “After some time, the recovery spreads from there.
“It is precisely because we are in the beginnings of a market recovery that there is so much debate,” Rifkind adds. “Our colleagues in Kansas City, Atlanta and Dallas are not experiencing much in their local markets just yet.”
As commercial rents have come down, more leases are being signed, and some companies are taking back subleased space, says Maria Sicola, executive managing director of research for Cushman & Wakefield in San Francisco. She predicts “slow and steady improvement over the next several quarters,” assuming there is some minimal job growth. “If more jobs are lost, that will slow the recovery,” she says.
Others point to the vast pool of capital amassed on the sidelines waiting for the right opportunity. By some measures, there is more capital today looking for commercial-property investments than at the height of the market, says Dan Fasulo, managing director at RCA.
Investors are looking for properties with bond-like qualities, meaning they provide a steady, predictable income stream. And there is pent-up demand: For 2009, sales of office buildings totaled just $15.5 billion, the lowest on record, according to Cushman & Wakefield.
After a long hiatus, buyers, sellers and lenders are venturing back into the market in places such as midtown Manhattan, the nation’s premiere commercial market. In early March, two newly offered properties—The Helmsley Carlton House residential hotel and an office tower at 340 Madison Ave.—were drawing strong interest. Leasing activity in Manhattan hit the highest levels in nearly four years in May, jumping a robust 221 percent from a year earlier, according to Cushman.
That, says Fasulo, could push up commercial real-estate values this year. For “core” properties with stable income streams, “I see a feeding frenzy coming,” says Fasulo.
Prices already are inching up. According to Moody’s Investors Service, prices for U.S. commercial properties rose in December by more than 4 percent—the largest month-to-month increase in the 10 years the company has been compiling its REAL Commercial Property Price Index. Office properties saw the largest gain—7.9 percent, while prices for apartment buildings rose 7 percent and industrial properties 5.6 percent. Only retail properties declined in value, by 1.5 percent for the quarter. But then, after three consecutive months of growth, prices dropped by 2.6 percent in February and another 0.5 percent in March—showing that recovery will likely be uneven and on the slow side.
Although Moody’s is holding off on proclaiming a bottom until further data supports the trend, it does conclude in a report that “the period of large price declines is over.”
And if investors finally pile into the market and drive up prices further? “All of a sudden, some of these doomsday predictions disappear very quickly,” says Fasulo.
Indeed as bad as it has seemed, the commercial real-estate market is still better positioned than it was during the last major crisis in the early 1990s. Vacancy rates and defaults were even higher then, and the extent of overbuilding was far greater, industry professionals say. And, even if a number of small banks go under, that wouldn’t reverberate throughout the economy the way the failure of, say, a Lehman Brothers did.
Commercial Rebound Likely to Lag Housing Market
Just as the commercial market lagged the residential market on the way down, it likely will trail the residential market on the way back up. Real Capital Analytics projects that commercial default rates will peak at 5.4 percent toward the end of 2011, before starting to decline.
Both Fasulo and Sicola say the commercial real-estate recovery will be uneven with major metro areas emerging first. Fasulo’s bets are on what he calls “global gateway cities” such as Boston, New York, Washington D.C., San Francisco, Seattle and LA.
Areas such as Florida and Las Vegas that had extreme overbuilding and price inflation will have to wait a little longer for a turnaround.
Fasulo acknowledges that the potential for a double-dip recession exists, although the probability is low for now, he says. Barring that, he says, “I’m the most bullish I’ve been in several years.”
Amy Cortese is a freelance writer based in New York. Her work has appeared in The New York Times where she was a Sunday business columnist, the NYTimes Magazine, Business Week, Portfolio.com, Chief Executive and other publications. She previously was news editor for HousingWatch.com, an AOL real-estate website.
Looking to Invest in Underpriced Commercial Property?
Learn More About REITs
Despite the precarious state of commercial real estate (or perhaps precisely because of it), there are opportunities to invest in the commercial real-estate market, especially with today’s low interest rates.
If you’re not in a position to buy distressed properties, you can invest in a fund that does. Real-estate investment trusts (REITs) are one way to do that. These companies manage portfolios of investment properties and distribute some of their earnings from rent and other fees to investors in the form of dividends.
Boston Properties Inc. (NYSE: BXP) owns and operates Class A office properties in major metropolitan markets. Host Hotels & Resorts Inc (NYSE: HST), as its name suggests, owns and acquires hotel and resort properties—think Ritz Carlton, Four Seasons and Marriott, among other brands.
Or for a play on the real estate downsizing trend, you might want to consider Public Storage Inc. (NYSE: PSA). This REIT owns and operates self-storage facilities across the United States.
Many REITs have had fairly good run-ups lately, so be sure to check the P/E ratios before committing funds.
Another option for investors is an exchange-traded fund that tracks REITs. The Vanguard REIT Index ETF (NYSE: VNQ) is one of the biggest, and it has one of the category’s lowest expense ratios to boot.