Some painful days still ahead

ORLANDO — Disney is the land of make believe where all your dreams can come true, right? I'm sure members of the Mortgage Bankers Association of America (MBA) who gathered here at the Walt Disney World Dolphin hotel Feb. 3-6 would love to wave a wand and, “poof,” make the recession disappear. Instead, what these lenders heard was a real-life tale of hardship without any prospects for a truly magical ending anytime soon.

Tony Pierson, the popular gloom-and-doom economist, warned that until layoffs stop and job growth returns with vigor, the commercial real estate industry will experience increased vacancies across all property types, with the office sector being the most vulnerable.

Pierson, the managing director of TimesSquare Real Estate Investors in Hartford, Conn., believes the U.S. economy likely will experience three to four more months of rising unemployment rates and job losses. “The job losses were in manufacturing, now they're spreading into more industries and are more white collar than blue collar,” he says.

The U.S. Department of Labor reported that the national unemployment rate in January registered 5.6%. Pierson believes that figure will continue to creep up over the next six months. That's a significant point because the fortunes of commercial real estate are so closely tied to job creation. “It's inevitable that as our slowdown continues, all real estate starts to feel the pain,” he says.

Pierson's research shows that an average of 2 million jobs are lost nationally during an economic downturn, and that in this recession we've lost about 1.3 million jobs to date. At a minimum, he expects the loss of another 800,000 jobs. “By the end of the year, we'll start to gain jobs. I believe GDP (Gross Domestic Product) will recover mid-year and accelerate, but the employment market will lag,” he predicts. Stated another way, Pierson says it takes two years on average for the labor markets to go from peak to trough and back again. And bear in mind that corporations shed jobs a lot faster than they restore jobs.

Office market poses greatest problem

There is a debate whether the sharp jump in national vacancy rates in the office sector is due to dwindling demand or oversupply. Pierson favors the oversupply argument, which says that a wave of new construction led to the delivery of millions of square feet in 2001. “If I'm right, and the labor market continues to deteriorate, it will start to impact office more and more severely as we go through this downturn.”

Torto Wheaton Research reports that 50 million sq. ft. were added to the national office supply during the first half of 2001, and another 77 millionsq. ft. came on line in the second half, which underscores Pierson's point. So it's no wonder the national vacancy rate for office is well into the double digits.

“Vacancies have to rise in this environment,” Pierson insists. “Values are at risk either from capital market assumptions changing to reflect risk or from the inevitable NOI (net operating income) erosion that occurs over time as leasing activity is less robust than it was.”

The good news is that there was a big downturn in the number of new construction starts in 2001 vs. 2000 among all property types. Pierson reports that in 2001 office construction starts fell by 27%, followed by industrial distribution space (23%), hotels (21%), retail (11%) and apartments (7%).

The other positive news is that the discipline of the capital markets today is limiting the magnitude of the overbuilding compared with a decade ago. That discipline will enable the industry to tread water this year rather than sink.

While it's hardly a fairy-tale ending, it sure beats the horror show of a decade ago when vacancies soared and real estate valuations plummeted for six years.

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