Money & Real Estate: Commercial property markets have peaked

As experts argue about whether the U.S. economy will enter a recession in 2001, most commercial real estate markets are still quite prosperous. Office vacancy rates are low, shopping centers are doing good business, rents of all types are at high levels and demands for space are still expanding somewhat. Nevertheless, I believe that most U.S. commercial property markets have peaked for this general business cycle and this real estate cycle. Property prices in private markets have passed their high points and will be either flat or declining somewhat in the remainder of 2001. Except in a few red-hot markets, commercial rents also have surpassed their high points and will either stabilize or fall during the remainder of the year.

The U.S. economy in general has entered a definite slowdown after nine years of continuous expansion. The first few years were at slow rates of growth, and then several years exhibited rapid rates of growth. Therefore, demands for space of all types, which steadily accelerated from about 1994 to 2000, have also slowed down - though they are still expanding somewhat in most areas. Meanwhile, new construction of space of all types has grown enough so that it will outpace added demand in most markets in 2001. That will put downward pressures on both property prices and rents. The only exception is residential apartments, which are not being built at a fast enough pace to meet existing needs in many areas, especially California.

From the viewpoint of existing property owners, there is both bad news and good news. The bad news is that property values have stopped rising and will begin to decline somewhat - and so will rents. The good news is that this turnaround will not result in steep value or rent declines as occurred in the early 1990s. There has been no massive overbuilding of commercial space like that which occurred in the late 1980s. As a result, there will be no collapse in property values and rents similar to that which took place from 1990-1993.

One factor that caused the stunning collapse in values and rents at that time was a sudden disappearance of almost all private financial liquidity in real estate markets in late 1989. Government regulators were pressuring banks, insurance companies and savings and loans to stop making any real estate loans to anyone in view of the high levels of defaults on existing loans. Developers and owners could not find any money with which to complete or refinance their properties, no matter how desperately the funds were needed.

At the present time, there also has been a decrease in private-sector liquidity for real estate transactions, but it is not nearly as complete a shortage of funds as took place in the early 1990s. Moreover, defaults from excessive vacancy and over-leveraging of new properties are much less prevalent today than they were in the late 1980s and early 1990s. True, a lot of new construction of office, industrial and retail space has taken place in the past two years, but demand for space kept rising during that period; so absorption continued at significant positive levels.

These conditions mean that the real estate economy is moving from the development boom phase of its three-phase cycle into its overbuilt phase. That phase change is occurring because during 2001 new construction already launched will come onto markets in greater quantity than rising demand for space. But the coming overbuilt phase will, at least initially, be a relatively mild one. With nationwide office vacancy rates in the middle of 2000 hovering around 8%, the degree of overbuilding in the near future will be vastly lower than what occurred when those vacancy rates exceeded 20% in the late 1980s.

How far down from their recent peaks will property values and rents fall in the coming overbuilt phase? That depends upon how big a slowdown occurs in the general economy, and how long it lasts.

Also, there will be much less economic distress among commercial property owners in this overbuilt phase than there was in the similar phase from 1990-1993. That is because so much commercial property today is owned by REITs, and they are not nearly as heavily leveraged with debt as were most developers in the late 1980s. Hence fewer defaults and foreclosures will occur, even if demand for space drops off quite significantly.

This situation has three important implications for owners of existing commercial properties. First, if you have reason to consider selling, and market prices for your properties have not yet declined much from their mid-2000 levels, this would be a good time to sell. In the near future, prices and rents will be lower in most markets than they are today. Second, be prepared for an economic slowdown by adopting a conservative posture toward taking on unusual expenses or assuming more debt. This is a time to do something a bit less severe than battening down all the hatches, but in the same general direction. Third, only undertake new development projects if they have unusually strong performance characteristics with high pre-leasing and you can carry them out without excessive leverage.

If you follow that advice, you should be prepared to survive the remainder of this real estate cycle in a reasonably prosperous fashion.

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