A Dud of a Thriller? Commercial Real Estate Drama Lacks a Killer

Commercial Real Estate Industry Doesn't Know Where the 'Play' is Occurring, Whether On-Stage or Off, but That's Not To Say Someone Still Won't Get Hurt
Just as a good thriller can bring an audience to the edge of its seat in anticipation of that pinnacle of dread, the anxiety has mounted in intensity this summer within commercial real estate markets waiting for that long-predicted moment of economic distress when it will all come crashing down. The problem, if that's the right word, is that the market so far has not played out to a well-scripted ending. And while a jolt could still come, the end of this market drama could likely play out as more of a dud. It's no secret why people in the business feel anxious. Even the National Association of Realtors (NAR), which has been an energetic cheerleader for the economy - and just as incredulous in many ways - is now saying the softening of economic conditions in recent months should impact commercial real estate markets in the months ahead.
(Will Commercial Real Estate Topple or Stay On its Feet? What is your take on the outlook for commercial real estate? What could bring the industry to the same fate as residential real estate or what will help it muddle through the economic mire? You can reach me by clicking on the byline above or e-mailing me at Mark Heschmeyer. The story will be updated throughout the day with ertinent comments attached to the end of this story.
Lawrence Yun, NAR chief economist, said commercial real estate activity is projected to weaken over the next six to nine months, as measured by net absorption and the completion of new commercial buildings. "The pace of decline has intensified due to job cuts and very sluggish economic activity since the beginning of the year, particularly in those industries requiring commercial building spaces," he said. "We anticipate the weakest commercial brokerage activity in nearly three years as a result." "The U.S. commercial real estate market continues to have an uneasy 'Waiting for Godot' feeling about it," wrote Philip Conner, principal U.S. Office of Prudential Real Estate Investors (PREI) in Parsippany, NJ, in a new report this month titled "Waiting for Distress." "With the credit market troubles still hampering the orderly flow of capital and growing uncertainty about the near-term outlook for the economy, bid-ask spreads have widened as activity throughout the commercial real estate market, from lending to leasing to transactions, has slowed to a crawl," Conner wrote. "Though signs of distress remain largely confined to highly leveraged deals consummated at the peak of the investment cycle, in late 2006 and early 2007, there is an undeniable and growing sense of anticipation among investors that U.S. commercial property values are poised to fall and that widespread distress is just around the corner." From a personal perspective, it's hard to ignore the Down Under diggery doo sound from the media, economists and financial bloggers. At the same time, there has been no single triggering event that would appear to throw the commercial real estate industry into a tailspin. With the residential markets, the collapse of subprime market was the triggering event that wiped out a huge chunk of the buying market. The deterioration in value of those loans then prompted the credit market crunch. And those events have clearly spilled over into a slowdown in commercial transactions, but not with severity. In drama, the adage is that if a gun or other weapon is introduced in the first act, then someone will be killed in the third act. But as the commercial markets have played out this summer, if there is a weapon in the picture, it remains hidden. If there is a killer, it hasn't emerged. Commercial real estate fundamentals have continued to hold up this year. Conner of PREI only set up the overriding tone of the industry, but he also sees countering trends. "While today's low cap rates make it fairly easy to arrive at some sobering estimates for how far asset values can fall in the near term, it remains to be seen what kind of role distress will play over the next year or two," Conner wrote. "Property values already appear to have fallen 10% or more from the pricing at the peak of the market, and they may continue to decline over the near term." he continued. "But with property market fundamentals still relatively balanced, a modest supply pipeline, soaring construction costs, and a wall of capital waiting in the wings, prospective investors anticipating a repeat of the capital-starved distress in the early 1990s and the deeply discounted transaction market it produced may be disappointed." Then going back to his reference to the Samuel Beckett play, Conner noted that Godot never appears onstage. "His off-stage presence, whether real or imagined, and his expected arrival largely dictate what does and does not happen in the play," Conner wrote. "To be sure, more distress will surface in the transaction market before the credit market normalizes, and the combination of higher capital costs and lower rent growth will depress asset values in the near term. Though it's hard to generalize, it would not be surprising if property values decline 15% to 20%, on average, from peak-to-trough before values stabilize, which, if property values are already down by 10%, would mean that the correction is about halfway done, if not more. But most of the distress - and opportunities for investors - should remain "offstage" in the capital markets."
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