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The Domino Effect

Pain has rippled through the commercial real estate sector. Are industry players positioned to pick up the pieces?

The credit crunch and recession set in motion a chain reaction across all disciplines of commercial real estate, with repercussions that are still playing out in 2010. Some service sectors are well into recovery mode while others are bracing for further declines.

Nonfarm payrolls have fallen by 8.4 million since December 2007, reducing demand for commercial real estate and forcing brokerages, contractors and other professionals to scrounge for new revenue sources. “I never imagined the downturn would be this severe,” says Ken Simonson, chief economist for the Associated General Contractors of America.

Whether it's an investment broker helping lenders to reposition properties after foreclosure or a builder retrofitting existing buildings for energy efficiency, service providers are earning their keep by helping clients deal with adversity.

How we got here

To appreciate where each sector stands on the road to recovery, it is helpful to understand the winding path of distress that moved through the commercial real estate industry. Indeed, some sectors hardly noticed a tremor as the first dominoes began to fall in the summer of 2007.

In hindsight, it's clear that trouble was brewing years earlier. In the middle of the decade a surge of investor capital flowed into commercial real estate and set the stage for the ensuing crisis.

By the summer of 2006, prices driven up by bidding wars began to exceed the levels that traditional investors were willing to pay for a risk-adjusted return. In other words, prices decoupled from underlying cash flows.

Investors motivated to buy properties for their income streams began to drop out of the bidding and were replaced more and more by buyers intent on profits from speedy resales. As a result, price escalation accelerated, according to Sam Chandan, chief economist at New York-based researcher Real Capital Analytics.

That rapid appreciation helped to convince many buyers that assets were merely priced to perfection rather than overpriced, given the soaring trajectory of asset values. “And the bubble feeds itself,” Chandan says.

The inevitable correction began in 2007, when investors realized that risk had been squeezed out of price calculations and many owners were vulnerable to massive value losses.

The market reaction played out in waves on the commercial real estate ocean, first showing up as an investor pullback from commercial mortgage-backed securities and quickly spreading as a credit lockdown for new projects.

Brokerages diversify

With few new transactions, full-service commercial real estate companies have largely retooled their offerings to meet the demands of distressed investors and lenders dealing with financially troubled properties.

Voit Real Estate Services, for example, has done away with silos that once separated its brokerage services from asset management and other business groups within the Newport Beach, Calif.-based company. Today, Voit puts all of its resources at a client's disposal, from business planning to market research and development services.

Coordinating across the service platform isn't always easy, but it helps clients succeed in a difficult market, according to John Strockis, Voit's executive managing director of asset services. “Everybody is working harder for less money,” he says.

An integrated approach to investor services has been a key to Jones Lang LaSalle's strategy for years, according to Bill Krouch, the Chicago-based company's CEO of markets. The trick is coordination, he says. Clients want access to a range of services, but they want the delivery of those services managed to avoid redundant efforts.

Jones Lang LaSalle is growing its business with what it calls middle-market companies — those that occupy between 10,000 and 50,000 sq. ft. in several markets. Specifically, the company is tailoring its service offerings to suit the outsourcing needs of individual clients.

Too big to be effectively serviced by small real estate shops and yet under the radar of service providers who cater to Fortune 500 firms, these medium-sized companies are proving to be a fertile field for Jones Lang LaSalle's outsourcing real estate services.

In 2009, the company landed contracts in this market segment to provide management, leasing, investment sales or other real estate services for 42 million sq. ft. of commercial properties across 19 portfolios.

“This whole middle segment of the market is untapped,” Krouch says. “We are connecting the dots and customizing around that particular client set, and we are winning business.”

Some professional disciplines, including valuation services, have boomed during the bust. While appraisers are fielding fewer requests to value commercial real estate for acquisitions these days, many clients want to determine the value of their properties on today's market, according to Jeffrey Rogers, president and CEO at New York-based Integra Realty Resources.

Appraisals performed for lenders as part of foreclosures and other litigation work have also mushroomed in proportion to rising levels of distress in the market.

“Overall our work has increased and not decreased,” Rogers says. “Our business is really good in times of boom and bust. Through the entire downturn, we haven't lost one employee.”

Delayed reaction

Companies that depend on new development to drive revenues, however, have few alternative sources of business when construction activity wanes.

Commercial construction spending didn't peak until 2008 and is continuing to decline at a steep rate of roughly 1% per month, according to Simonson.

“Many general contractors went into 2009 with at least a small backlog of work that had been started before the collapse of late 2008, but their backlogs have continued to shrink,” Simonson says.

“Many are now laying off experienced personnel, which will make it hard for them to come back when the market picks up.”

Construction spending on non-residential projects shrank 13% between October 2008 and the end of 2009. Simonson expects the decline to continue in 2010 but at a more moderate pace, as federal stimulus funds cushion some of the ongoing drop in construction.

Design in dire straights

Architecture firms, which produce the drawings from which general contractors build new projects, have suffered two years of monthly revenue declines, according to Kermit Baker, chief economist for the American Institute of Architects (AIA).

Demand for commercial design services remained strong for several months after the credit crunch began in August 2007, but fell off suddenly the following February. That's when the Architecture Billings Index, which tracks projects in progress at U.S. architecture firms, dropped below 50. An index value below 50 indicates a decrease in billings.

The worst was yet to come, however, and the design sector saw billings sink further as the banking crisis began to unfold during the summer of 2008. The index dropped to 41 in September from 47 in August, eventually bottoming in January 2009 with an index value just less than 34.

Of the more than 500 architecture firms that the AIA surveys to produce its index, 90% of respondents rate the current downturn as more severe than the slump of the early 1990s. In fact, 60% of respondents rate the current crisis as “much more severe.”

The near universal reach of this recession has precluded many of the survival strategies that kept designers in business through past cycles, says Baker, the AIA economist.

Unlike previous downturns, there are few international or regional markets within the United States offering substantial development activity, for example. The small numbers of firms that are outperforming their peers have a focus on energy infrastructure or federal government work, which have enjoyed moderate demand. “But that's about it,” Baker says. “Pretty much everyone has been exposed to this downturn.”

Most design firms have cut back on staff, and many have closed their doors. “There have been dramatic layoffs,” Baker says. “Close to 25% of staff at architecture firms have been laid off over the last year and a half.”

Unfortunately, signs of economic recovery haven't reached the design sector, which saw billings decline again in January of this year. With most property values falling below replacement costs, there is little need for design and construction, Baker says. “Why would you build a new building if you could buy one for dimes on the dollar?”

Projects also are being delayed or cancelled due to what Baker describes as unusually stringent equity requirements that lenders are placing on developments.

“This serious situation is being compounded by a skittish bond market, decreased tax revenues for publicly financed projects and declining property values — all of which serve as deterrents for construction activity.”

Builder blues

January's slowdown is bad news for architects but a death sentence for many builders who typically have had to wait nearly a year after design work picks up before demand improves for construction. It takes nine to 12 months on average for a commercial project to move through the design phase.

“There's a very high correlation between design activity and construction activity with this lag effect,” Baker says. “That tells us what's going on in the construction markets nine to 12 months before it actually happens.”

Architecture firms should start to see increasing demand in the second half of 2011, Baker predicts. If that's the case, then contractors won't see any significant improvement until well into 2011, due to the lag between design and construction.

Many construction firms won't survive to see better days, experts say. Every month of inactivity makes it more difficult for contractors to retain employees and bid for new jobs.

What's more, construction companies typically don't get paid upfront. Instead they bill for their work incrementally throughout the construction period, according to Jeffrey Raday, president of Rosemont, Ill.-based McShane Construction Co.

For example, a contractor who lands a $12 million job that is expected to take one year to complete must first wait until the client is ready to start construction, which may take a few months. Then the contractor will be able to bill the client for approximately $1 million after the first month of construction.

Months of waiting for that first check will be too long for some companies to endure, and some will fold before they reach the end of the first billing cycle. “2010 is going to be very tough,” Raday says. “We are beginning to see some glimmers of a potential upturn toward the end of 2010 and the beginning of 2011, but the challenge for many contractors is simply to weather the storm in 2010.”

The most promising construction opportunities in 2010 will be infrastructure projects benefiting from stimulus dollars, including water and wastewater plants, energy projects, building retrofits for energy conservation and transportation such as highways and rail facilities.

Investors and developers launching projects in 2010 can take advantage of a relatively low cost of materials and bargain-basement contractor pricing. Before hiring a builder, however, it will be critical to vet a contractor's resources and likelihood of remaining in business long enough to complete the work.

“We use the same philosophy in hiring subcontractors,” Raday says. “What other projects do they have out there that may be in trouble and may take them down?”

Government contracts aplenty

McShane Construction has suffered along with the rest of the building industry. The company's headcount is down about 30% from where it was in 2008, with reductions spread across skilled and unskilled labor and management personnel. The firm is currently lining up projects set to break ground later this year, however, and by 2011 Raday expects his crews to be back under full steam.

McShane Construction is benefitting from a decision it made in late 2008 to pursue federal government contracts. Raday says the skills required to develop multifamily projects also apply to military housing.

McShane crews that once specialized in building medical office buildings, too, have proven adept at constructing similar structures for the Veterans Administration.

Federal projects, as well as multifamily projects by private developers using government-backed loans, have provided a lifeline of work for builders, says Raday.

The only other significant source of demand has been from corporations with enough cash to develop projects without leverage. “What we've seen over the last couple of years is almost a complete disappearance of bank financing for commercial construction,” he says.

Of the commercial real estate disciplines, general contractors may be hardest hit in 2010 because they have the longest time to wait before demand recovers for their services.

For the moment, the only areas of healthy demand for contractors are energy infrastructure and government- funded projects, according to Simonson, the economist for the Associated General Contractors of America.

“Federal stimulus funds are starting to show up in federal and state construction,” Simonson says, “but it's not enough to offset the downturn in state and locally funded projects.”

Matt Hudgins is an Austin-based writer.

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