Already suffering ill effects from a persistent credit crunch, the commercial real estate industry in 2009 faces the likelihood of weakening fundamentals and more distress. With refinancing sources scarce, struggling property owners who are unable to make their mortgage payments will be forced to work out new terms with lenders or return the keys to the bank.
Across property types, what is shaping up to be a prolonged recession is already dragging down occupancy rates and cash flows as tenants grow averse to new lease commitments. Three consecutive quarters of negative absorption drove up the national office vacancy rate to 13.7% in the third quarter from 12.6% a year earlier, according to Reis, a New York-based real estate research firm. Meanwhile, the national retail vacancy rate climbed to 8.4% from 7.3% during the same period.
Even the typically dependable apartment sector hasn't been immune to the economic and financial strife, with the vacancy rate climbing 40 basis points over the past year to reach 6.1% in the third quarter.
“Demand for space has weakened for all property types,” says Sam Chandan, chief economist at Reis. “While localized pockets of strength remain, national vacancy rates are increasing in every property sector.”
Symptoms of failing fundamentals are emerging. Just last month, two large conduit loans sliding toward default sent ripples through the market for commercial mortgage-backed securities (CMBS). One was a $209 million mortgage backed by two Westin hotels in Tucson, Ariz., and Hilton Head, S.C. The other loan was a $125 million financing of Promenade Shops at Dos Lagos, a retail center in Corona, Calif.
Lender J.P. Morgan underwrote both loans in 2007 using cash flow projections that the properties have been unable to meet, prompting analysts to flag the deals as likely to default.
At press time, Chicago-based mall giant General Growth Properties was negotiating with multiple lenders for more time to restructure its $27 billion debt, including some $900 million in mortgages that were set to mature at the end of November.
If the credit crunch persists, investors can expect to see similar default scenarios unfold in 2009 and 2010. More than $81 billion in CMBS loans will mature during that period, challenging property owners to extend their mortgages or obtain replacement financing.
While the delinquency rate for CMBS loans 60 days or more past due was just 0.51% in October, that rate is expected to reach 75 basis points by the end of this year, according to Fitch Ratings. Some analysts expect the delinquency rate for CMBS loans to exceed 1% in early 2009 and then climb to 2% or even 3% in 2010.
Further deterioration in real estate fundamentals will force many investors who are still clinging to lofty asking prices to swallow a bitter dose of value correction. At the same time, buyers will have to settle for annual returns based on existing and potentially weakened income streams rather than on the skyrocketing price appreciation that made commercial real estate golden earlier in the decade.
Perhaps the most striking aspect of the outlook for commercial real estate is how quickly the consensus view in the industry changed from optimism to pessimism, observes Robert Bach, chief economist at Grubb & Ellis.
Jolted by September's avalanche of bad news that included bank busts, buyouts, and the federal government's takeover of Fannie Mae and Freddie Mac, real estate pundits who pointed to the resiliency of property fundamentals changed their message almost overnight to warnings of sinking demand and rent rolls in jeopardy.
“It was like a capitulation of the bulls,” Bach says. “Suddenly there is an expectation within our industry that there is medicine to be taken.”
Let's make a deal
There is no fast cure for market cycles, but there are treatments to ease the pain. Diligent property management and leasing can help maintain occupancy and stave off declining rental income. Bringing in equity partners to pay down the principal owed can lighten the debt-service load. If default seems imminent, workout specialists may be able to help the borrower avoid foreclosure while minimizing losses for the lender.
No one feels the credit crunch more acutely than borrowers who face a loan maturity at a time when replacement financing has all but dried up. Yet even those owners have a few options from which to choose: Consider the example of Sheffield57, a 900,000 sq. ft. luxury condominium and office project overlooking New York's Central Park.
Last month, owners of the incomplete project announced an 18-month extension of their construction loan to April 2010. Jon Estreich of Estreich & Co. negotiated the loan extension for the joint-venture owners, YL Real Estate Developers, SH Equities and Swig Equities.
“In a world where many things are broken, it is heartening and uplifting to experience a truly collaborative effort on the part of all our lenders and my partners to insure the continued success of Sheffield57 through this loan extension,” says Kent Swig, president of Swig Equities and the operating partner for Sheffield57.
How deep will recession cut?
Specific start and end dates for each recession are determined by the National Bureau of Economic Research, based on gross domestic product (GDP), employment, industrial production, retail sales and other factors. Those determinations are often made more than a year after the fact, however. A commonly used alternative definition of a recession is two consecutive quarters of shrinking GDP.
If the falling GDP that began with the third quarter's 0.5% decline continues in the current quarter and into next year, as many economists predict, that will meet the working definition of a recession (see economists grid below).
That would be an unusually protracted decline in GDP, according to James Smith, chief economist at Parsec Financial Management in Asheville, N.C. Since the government began keeping quarterly records in 1947, only two recessions (1953-1954 and 1974-1975) have lasted as long as three quarters. Even so, Goldman Sachs is predicting not three — but four — quarters of shrinking GDP, the longest recession on record.
By a more practical definition for commercial real estate, the recession began with the onset of net job losses in December 2007, according to Dr. Mark Dotzour, chief economist at the Real Estate Center at Texas A&M University. The reduction in non-farm payrolls began to accelerate this fall and totalled 1.2 million through the first 10 months of 2008.
In each of the nation's past four recessions, job losses spanned an average of 17 months from peak to trough, Dotzour says. By that measure, job losses in the current downturn should continue through May 2009. “We've been in a recession almost this whole year,” he says, “so in my opinion we're almost half through.”
Smith is even more optimistic, positing that the recession is nearly over and that GDP growth will return, albeit slowly, by the end of this year. He expects GDP to expand at an average rate of 2.2% in 2009. Other forecasters don't see GDP climbing above negative territory until the first or even second quarter of 2009.
Lament for landlords
The recent acceleration in job losses is an ominous indicator of weakening demand for commercial space of all kinds, particularly for the office market. At 6.5%, the national unemployment rate in October already exceeds the 6.3% jobless rate that followed the 2001 recession. Bach expects the rate to peak between 7% and 8%, while Boston-based Property & Portfolio Research predicts the unemployment rate will crest just above 8% in 2009.
Investors can take some solace in the likelihood that this recession won't be followed by a jobless recovery like the one that followed the tech bust, economists say. That recession ended in November 2001, but job cuts continued for nearly two years as employers maintained a laser-like focus on efficiency.
Economists emphasize that the nation's employers remained lean through most of the last upswing, so the jobs that are currently being eliminated will need to be replaced when the recovery begins to take shape.
Forecasters expect a more typical three-quarter lag between a return to GDP growth and a corresponding uptick in real estate fundamentals, so landlords can expect demand to improve six to nine months after the economy begins to grow again. That will bring renewed demand for space in 2010.
In the meantime, landlords will wrestle with softening demand as tenants lay off workers and downsize their space needs. Reis predicts that the national office vacancy rate will reach 15.8% over the next two years before it eases again in 2011.
Investors take action
What can owners and investors do to minimize losses until the next growth cycle? Every property owner should focus on liquidity and cash flow, says Clay Wilson, executive vice president of commercial real estate lending at Coral Gables, Fla.-based BankUnited FSB, the largest Florida-based bank.
Steady income from a fully leased building enables the owner to maintain debt payments, and to obtain maximum loan proceeds if it becomes necessary to refinance or request a loan extension, Wilson says. It's also a good preventive measure to avoid an unwanted sale. “On commercial property that's cash flowing, there's no reason to sell if prices are down,” he says.
Some investors will need to sell assets, perhaps to liquidate capital to shore up the rest of a portfolio. Targeting the most able or motivated buyers will help to garner a reasonable sales price, according to Dan Vittone, senior vice president of Voit Commercial Brokerage in Irvine, Calif.
For Vittone's clients, that means marketing to all-cash buyers because they have the capital to complete a transaction, and to 1031 tax-deferred exchange buyers who are motivated to do what is necessary to close a deal.
“The former group is targeting distressed properties and is less motivated to pull the trigger, while the latter group has the proverbial gun to their head and must face the question of paying their taxes, or perhaps slightly overpaying for a property in a declining market,” says Vittone.
If conventional marketing doesn't bring the desired result, consider selling at auction, says Ross Ford, president and CEO of Plano, Texas-based TCN Worldwide. A consortium of independent real estate firms, TCN Worldwide's auction division recently sold Westside Market Shopping Center in Lubbock, Texas, to a buyer from the United Kingdom for $3.39 million, or 71% more than the seller's minimum price of $1.96 million.“In some cases, to get an asset off the books by a certain date is more important than an incremental gain in sale prices,” according to Ford.
Few lenders are interested in increasing their exposure to real estate, so borrowers with loans maturing in 2009 or 2010 have a better chance of getting a replacement loan from their existing lender than from a new provider.
Contact the lender as early as possible before the loan expires, urges Steve Bram, senior director of George Smith Partners, a Los Angeles-based real estate investment and mortgage banking firm. The lender will probably cap leverage on a new loan at 50% to 70% and will want repayment guarantees or other credit enhancements, which take time to arrange.
Leverage of more than 70% is available from a few sources but is scarce and costly, says Steven Kohn, president and principal of Cushman & Wakefield Sonnenblick Goldman in New York, an investment banking arm of Cushman & Wakefield. By the same token, very few lenders will hold loans of more than $50 million on their balance sheet.
Like Bram, Kohn advises borrowers to work with a financial advisor as early as possible to begin lining up the additional equity, such as mezzanine capital, required for today's loans.
“It's important that ownership and their advisors remain flexible in a market like this, because many transactions need to be heavily structured,” says Kohn. “Our job is to structure these transactions to appeal to each group's risk-reward tolerance.”
Commercial real estate brokerages, mortgage bankers and other service providers are forming workout groups to help troubled borrowers avoid default by striking a compromise with their lender.
Even if a default is unavoidable, borrowers should work with an adviser to contain their losses, according to attorney Tom Gryboski, a partner at Atlanta law firm Morris Manning & Martin LLP.
Even non-recourse loans may carry provisions that trigger recourse obligations, making the borrower responsible for the unpaid balance on a mortgage even after the asset has been turned over to the lender. Triggers can include a declaration of bankruptcy by the borrower, or a variety of actions that vary by loan.
KeyBank Real Estate Capital, a direct lender that provided $21.9 billion in financing for commercial real estate projects in 2007, is helping borrowers to avoid foreclosure on maturing short-term construction and bridge loans, working out terms both parties can live with until the loans can be repaid in full.
“We understand our clients are in a difficult spot, and we do everything we can to help them,” says Elliott Quigley, senior vice president at the bank. “And our clients understand that we're in a difficult spot. Hopefully we meet somewhere in the middle.”
During a turbulent period when many owners could find themselves in rough financial waters, relationships and trust are critical. Lenders and service providers can help borrowers stay in business so they can ride the next upswing.
“It's important for us all to remember that this too shall pass,” says Quigley. “We are going to do business with each other on the other side of this, and we need to temper our actions and our reactions.”
Matt Hudgins is an Austin-based writer.
PREDICTIONS FOR MID-YEAR 2009 FROM NOTABLE ECONOMISTS
NREI asked four forecasters to predict the direction of key economic indicators. Here are their responses:
Chief Economist, Grubb & Ellis
“In early 2010, I expect the office vacancy rate to test the previous two peaks recorded in the first quarter of 2004 (17.9%) and the third quarter of 1991 (18%).”
Chief Economist, Reis
“Many of the nation's bellwether office markets will be among the worst performing markets in 2009.”
Director, Strategic Research, Property & Portfolio Research
“2009 will be the year of the asset manager.”
James F. Smith
Chief Economist, Parsec Financial Management
“Don't be surprised if the 2010 and 2012 elections look like 1930 and 1932 in reverse, shifting power from the Democrats to the Republicans.”
GDP growth: negative 0.5%
Core CPI inflation rate: 2%
Monthly job gains/losses: -200,000
10-year Treasury yield: 4%
Crude oil ($ per barrel): $85
GDP growth: negative 1.9%
Core CPI inflation rate: 1.1%
Monthly job gains/losses: -120,000
10-year Treasury yield: 3.8%
Crude oil ($ per barrel): $68
GDP growth: -1%
Core CPI inflation rate: 1.3%
Monthly job gains/losses: -93,000
10-year Treasury yield: 4.4%
Crude oil ($ per barrel): $68
GDP growth: 2.2%
Core CPI inflation rate: Less than 1%
Monthly job gains/losses: 125,000
10-year Treasury yield: 4.0%
Crude oil ($ per barrel): $60See also: Buyer-seller standoff: Who will blink first?