Have We Hit Bottom?

If, indeed, the U.S. is in the early stages of a long anticipated rebound, there were no signs of it in the commercial real estate industry in the first half. The most obvious trends were rising vacancies, falling rents and mounting loan delinquencies. Aside from retail, every sector showed signs of stress.

And, say industry watchers, the worst is yet to come. The office vacancy rate hit 17.6% in the first quarter of 2003, up 2 percentage points from a year earlier and the highest national rate since the early 1990s, reports Grubb & Ellis. But, with no sign of a significant rebound in hiring, few companies are adding space. “Look for vacancy to drift above 18% by year-end 2003 with rents softening through mid-2004,” says Bob Bach, national research director at Grubb & Ellis.

Adding to the gloom are some menacing job projections. A recent study by employment agency Manpower Inc. found that out of 16,000 U.S. employers interviewed, only 20% intend to hire more people in the third quarter — and nearly 10% said they plan to reduce staff. News like that combined with a third straight year of falling rents and rising vacancies is putting more properties closer to the edge, despite historically low interest rates.

One thing is emphatically clear: The longer Corporate America avoids hiring and investing in new capacity, the further away a recovery in commercial real estate will be. “We have not seen a real pickup in the level of office demand, and we don't expect to for the balance of 2003,” says John Germano, executive vice president with Insignia/ESG in Washington, D.C. “We hope 2004 is the year that we start to turn around.”

How acute is the problem of excess office space? It varies across markets. Vacancies exceed 20% in Atlanta and Chicago — where even more space is under construction. And Insignia/ESG reports there is approximately 23 million sq. ft. of vacant space — including 45 empty buildings — in Northern Virginia alone. Corporate consolidation isn't helping matters either. General Dynamics Corp. recently announced its plans to acquire defense contractor Veridian Corp. “I have to think that the merging of two companies of that size will cause additional vacancy,” says Germano.

Sector-By-Sector Declines

The multifamily sector also is being hammered. A supply glut is kicking up vacancy rates and driving down rents. Vacancies hit 6.8% in the first quarter of 2003, up from 5.7% in the first quarter of 2002, according to Reis Inc. Net effective rents were essentially flat between the first quarter of 2002 and 2003, dropping from $855 to $854. Low interest rates continue to help renters become homeowners, pushing the national home ownership rate to 68%, up from 64% two years ago. And the prognosis for a quick rebound is poor: Apartment builders have not put the brakes on development. Lend Lease Rosen, a consulting arm of Australia-based Lend Lease Corp., reports that apartment builders started 349,000 units in 2002 vs. 331,000 in 2001. Lend Lease Rosen projects that the apartment market will face downward pressure on revenues for the rest of 2003.

On the industrial side, many industry executives were saying that the sector had stabilized earlier this year. But at midyear, it looks like the slow pace of economic activity has driven industrial real estate back into a “double dip,” according to Lend Lease. In most markets, vacancies have been rising since the end of the first quarter. Only a few areas, such as Chicago and Phoenix, have begun to stabilize.

Retail remains the strongest property sector. But growth in consumer spending has become anemic and, if Americans continue to fret about possible job losses, retail sales could go negative — taking out marginal tenants and pushing poorer performing shopping centers into distress. That is one reason Trepp LLC and JP Morgan predict that retail CMBS loan delinquencies will rise from 1.5% to 2% by December. Neither office, apartment nor industrial CMBS loan delinquency rates are projected to get that high.

While the likelihood of an interest rate increase anytime soon is slim, such an increase could hurt retail landlords who have been refinancing aggressively lately. The combination of rising rates and declining consumer spending could have a lethal effect on such owners.

But no sector has been battered more than hotels, which have never gotten traction since the Sept. 11 attacks caused consumers to reduce travel. The slow economy and job losses have kept demand soft for both leisure and business travel and the numbers tell the tale: RevPAR (revenue per available room) has been plunging for three years, as have average room rates and occupancy rates.

Lend Lease predicts a hotel recovery starting in the first half of 2004, when rising demand and little new supply start to bolster revenue per available room (RevPAR). The firm also predicts a 50% decrease in hotel construction this year vs. 2002. New construction already had dropped 30% last year.

The recovery won't come soon enough for some properties. Defaults are already on the rise in the hotel sector. A recent high-profile casualty is Ian Schrager, who is facing foreclosure at Miramar, his Santa Barbara, Calif., hotel. In June, Schrager's lender, Santa Barbara Bank & Trust, filed a notice of default against Schrager for failure to repay the $16 million loan.

And there will be failures across all property sectors, investors predict. Late this year or early next year, “there is going to be a round of foreclosures, particularly on the office side,” says Bill Maher, director of North American research and strategy for Chicago-based Jones Lang LaSalle. As loans expire, he says, owners of troubled office properties may not be able to find willing underwriters. Maher points to that shaky Northern Virginia market as a potential trouble spot.

Industry experts predict the default rate on multifamily loans also will rise. “We now tell investors to underweight apartments because the economy has been much worse [than anticipated]. There is far too much supply, and prices have gone up in spite of all that,” says Maher.

Distressed Debt

Across all property classes, loan delinquencies have been rising. Fitch Ratings reports that the number of delinquent loans behind U.S. commercial mortgage-backed securities (CMBS) jumped by 14% to 1.39% between Jan. 1 and Mar. 30 — the largest quarterly increase recorded since the index was created in 2001. Fitch considers a loan delinquent when the borrower is more than 60 days late on a payment.

Mary MacNeill, senior director at Fitch, cites a dramatic rise in hotel and office delinquencies as the biggest reason for the increase. Hotel loans accounted for roughly 35% of the $2.8 billion in delinquent CMBS loans; office accounted for only 9%. That 9% may seem small, but Fitch projects a steady increase in office loan delinquencies through mid-2004.

Delinquency rates so far this year have hovered around 1% across all the property types. As of May, only 1.5% of all retail CMBS loans were delinquent while industrial CMBS posted a slightly higher delinquency rate of 1.61%. And apartment CMBS closed out May with only 1.08% overall loan delinquencies — far fewer than the troubled hotel sector's 5.88%.

Trepp LLC and JP Morgan are forecasting that overall delinquencies will continue to rise. In the relatively healthy retail sector, for example, their research concludes that the rate of CMBS delinquencies will nearly triple from .58% last December to 1.46% by the end of 2003. Their forecast for hotels is particularly gloomy, calling for hotel CMBS delinquency rates to hit 7.15%, up from 5.17% last December.

“We see retail and office delinquencies rising, and yes, people are concerned. I think things may get a little worse before they get better,” says Dale Grossman, chief credit officer at LaSalle Bank's Real Estate Capital Markets Group.

If interest rates weren't at such historic lows, the delinquency problem would be a lot worse. The 10-year Treasury yield, the benchmark for permanent, fixed-rate loans in U.S. commercial real estate, registered about 3.4% in late June compared with 4.4% a year ago. Meanwhile, the London Interbank Offered Rate (LIBOR), the basis for floating-rate loans, was a paltry 1.3% in mid-June.

Given the state of the recovery, many real estate executives are confident that rates will not rise in the next six months. But developers and investors should not get complacent about rates, cautions Earl Webb, CEO of the capital markets group at Jones Lang LaSalle. “People now are starting to think that this interest rate phenomenon is more permanent than not, and we all know that's not true.”

Indeed, once investors perceive that rates are about to pop, there will be a stampede to lock in fixed-rate debt, says Jones Lang LaSalle's Maher. Some borrowers who now rely on extremely attractive floating-rate deals may find they can't get through the door. “Every time interest rates go up, a lot of borrowers get left holding the bag,” says Maher. The big danger is a sudden jump in rates, he adds. “No one can tell whether rates will go up 100 basis points and stay there for a while, or go up 300 basis points.”

Where Are the Deals?

Even with interest rates at nearly a 50-year low, diminishing returns are catching up with valuations.

Last year office buildings were still fetching record prices, despite deteriorating fundamentals in most markets. By the first quarter of this year, however, Reis reports that office values nationwide declined 1.7%.

Sales volume has also slowed. Tim Welch, executive managing director at Cushman & Wakefield's New York City office, says that hungry investors acquired the most highly prized real estate in 2002 — a year in which domestic buyers alone spent nearly $100 billion on U.S. office buildings, according to Real Capital Analytics. That leaves a scant inventory of desirable buildings on the market. “The buying side this year is like one hand clapping — you need a seller,” says Welch. What he does see coming to market, he says, is not in the same league as the properties that moved in 2002.

“There's money out there to buy, but I'm hearing that investors aren't seeing enough product,” Welch says. One problem is that many sellers believe the bid-ask gap has widened over the past few months, he explains. With interest rates still very low, many would-be sellers are refinancing, rather than selling. Real Capital Analytics reports that office acquisitions in April were around $1.7 billion, the lowest monthly volume since February 2002.

A possible factor depressing the office sales business is the absence of hot foreign money. A year ago, German funds were pouring money into U.S. commercial real estate. “Momentum was driving a lot of Germans into this market in the second half of 2002, and we thought it was going to continue,” Webb says.

This year, the Germans are all but invisible. One theory: strained U.S.-German relations. After the U.S. failed to persuade Germany to reverse its stand against an invasion of Iraq, German fund managers pulled back, fearing that their high-net-worth investors would no longer support big bets on the U.S., says Webb. He believes the resentment still lingers. German investors are still active, he says, “But they're not there with the same kind of zeal.”

Meanwhile, Robert White, president of Real Capital Analytics, says Middle Eastern investors have been the most aggressive offshore buyers so far this year. Through the end of May, Real Capital Analytics data shows that Middle Eastern investors have spent $712 million on U.S. office properties. That's on track to exceed their purchases last year, which amounted to $1.2 billion.

Potential Red Flags

Investors and developers polled by NREI insist that the recovery is coming and that demand for office space will pick up by next year. But the game has changed in ways that may leave tenants with more leverage, even after the supply/demand situation improves. Corporate space users, most notably technology companies, are demanding shorter leases with renewal options.

Burned by their decisions in the late 1990s to lease excess space to accommodate expansion that never materialized, these companies are now looking for flexibility. They will even pay a premium for shorter leases that reduce their risks, Maher says. “Companies are saying, ‘We can't forecast our business in advance for more than a year or two.’” The problem for lenders and owners is that building valuations are based on long-term leases and the steady cash flows they generate.

Meanwhile, the key ingredient of a recovery simply isn't present: job growth. More than 320,000 jobs were lost in the U.S. during the first four months of the year, according to the Labor Department. In May, the national unemployment rate hit 6.1%, its highest level in almost a decade.

According to some industry experts, the worst is yet to come in some sectors. That's one reason the sublease glut is not going away: Bach of Grubb & Ellis estimates that there were 135 million sq. ft. of sublease space on the national market at the end of the first quarter, up from 124 million sq. ft. at the end of the year.

Encouraging Signs

But there are some glimmers of hope for the real estate market this year. Grubb & Ellis, for example, cites the drop in new speculative office space as a plus. Deloitte & Touche reports that after-tax profits in the business sector increased throughout 2002, rising 4.1% between the end of the third and fourth quarters of 2002. That's the largest quarterly gain in three years, and it could have set the stage for a flurry of business investment this year.

As Bach points out, the commercial real estate market has taken a number of hits and is still standing. “Given what's happened in the market over the past few years, you have to believe that things could be a whole lot worse than they are,” he says. He cites a strong decline in the amount of new sublease space flooding the office market this year as another positive sign.

And, says Bach, Class-A office absorption was a positive 3.7 million sq. ft. during the first quarter of this year. That is the highest positive absorption that the national office market has posted since the fourth quarter of 2000.

Still, any real estate recovery is contingent upon jobs. “It's all really a function of when the national economy does recover,” says Thomas Jaekel, managing director at Chicago-based Cohn Financial. “We believe that the first few quarters of 2004 will continue to be very difficult for real estate.”

Please send comments on this story to [email protected].


Vacancies increased across all property sectors, with the exception of retail, between the first quarter of 2002 and the first quarter of this year. The sharpest declines were sustained by hotels, followed closely by the office sector. ]

Office Vacancy Rental Rates* Net Absorption
1Q 2002 15.7% $29.95 -16.5 million sq. ft.
1Q 2003 17.7% $28.50 -654,000 sq. ft.
*Class-A weighted average
Source: Grubb & Ellis
Industrial Vacancy Rental Rates Net Absorption
1Q 2002 8.7% $5.98* -14.3 million sq. ft.
1Q 2003 9.9% $5.68* -19.4 million sq. ft.
*Manufacturing only
Source: Cushman & Wakefield
Multifamily Vacancy Effective Rates* Net Absorption
1Q 2002 5.7% $855 -68,452 units
1Q 2003 6.8% $854 7,814 units
Source: Reis Inc.
Retail* Vacancy Rental Rates New Construction
1Q 2002 7.1% $16.39 4.8 million sq. ft.
1Q 2003 6.8% $16.79 2.7 million sq. ft.
*Stats are for neighborhood and community centers in the top 48 U.S. markets.
Source: Reis Inc.
Hotel Vacancy ADR* RevPAR
April 2002 61.5% $84.88 $52.22
April 2003 59% $83.22 $49.07
*Average Daily Rate
Source: Smith Travel Research

Mezzanine Financier Loves Hotels

Delinquencies and defaults abound and primary lenders are skittish. So, there's money to be made.

One industry's crisis is another's opportunity. That's how Richard Mandel views the battered hotel sector. “We think that the whole hotel sector is distressed, as we've seen values fall dramatically,” says Mandel, president of Ramsfield Hospitality Finance. And those falling values put hotel owners in a tough spot: Lenders are tightening requirements and, in many cases, refusing to fund hotels at all — creating a perfect opportunity for mezzanine lenders.

Mandel liked the opportunity so much that, earlier this year, he left real estate firm Kennedy-Wilson, where he was president of the commercial investment sales group, to found Ramsfield, which was a way to offer mezzanine financing for hotel owners and investors. His joint-venture partner is an affiliate of Minnetonka, Minn.-based Cargill Value Investment. Ramsfield will offer subordinated loans ranging from $3 million to $12 million on properties valued as high as $60 million. Mandel predicts that a flurry of hotel sales over the next year will supply the market with capital-hungry buyers. Refinancing efforts also are planned, he says.

Mandel expects to pour $75 million into mezzanine loans by the end of 2003. And so far, he says, business is strong, although he won't identify specific deals he's working on, or prospects for future business.

Fitch Ratings predicts an increase in mezzanine lending across all property types as banks tighten lending standards. For borrowers, mezz debt is anything but cheap: the interest rate ranges between 14% and 16%.

Of course lenders can demand the premium because of the exceptional risks involved. But Mandel figures that values are about as low as they will go for the cycle. Meanwhile, there will be plenty of opportunities: HVS International, for example, says New York City hotel values will not hit 2000 levels for another four years. Says Mandel: “It will be a long slog to get properties back to year 2000 levels in value.”
— Parke Chapman

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