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Christian S. Busken
Vice President
“Commercial real estate transactions slowed dramatically during the first three quarters of 2008, dropping by 90% on a year-over-year basis.”
PRIVATE REAL ESTATE
Commercial real estate transactions slowed dramatically during the first three quarters of 2008, dropping by 90% on a year-over-year basis. Financing became difficult due to tight credit markets and ongoing distress in the financial services sector related to liquidity issues and subprime mortgage losses. Technical pressure in the residential mortgage backed securities market (RMBS) pushed yield spreads on investment grade commercial mortgage backed securities (CMBS) to record highs despite low delinquency rates.
The National Council of Real Estate Investment Fiduciaries (NCREIF) National Property Index posted only a fractional decline of 0.2% in the third quarter, with income offsetting declines in value.1 Due to the lack of transaction activity, however, accurately assessing valuations in private real estate at this point is difficult, and we would anticipate write-downs as visibility increases. The key differentiating factor of the current commercial real estate downturn versus previous cycles is a lack of overdevelopment, which should provide some degree of stability going forward. While net operating income at the property level is likely to decline, this will be mitigated by the limited new supply in most markets.
From a sector perspective, rents on office properties were flat in the third quarter, and vacancies in major metropolitan areas such as San Francisco and Boston saw modest increases of 0.5-0.8% points. Vacancies in these markets now stand at approximately 10%.2 Additionally, the New York City office market saw vacancies increase by 40 basis points during the quarter to 6.1%, which while still the lowest in the nation, could see further increases due to fallout from the financial crisis.3 The worst-performing office markets continue to be in areas hit by weakness in the housing market and include Southern California and Florida, where vacancy rates are in the 15-18% range and where rents continue to decline.4
In the retail sector, vacancy rates at malls increased by 0.3% points, to 6.6% during the third quarter, their highest levels since 2001, as falling retail sales led to store closings.5 Closures in the retail sector outpaced new leases during the quarter (a phenomenon known as negative absorption) for the first time since 1980.6 For strip malls and outdoor shopping centers, vacancy rates were higher, at 8.4%, the highest level since 1994.7 Generally, strip malls suffer higher vacancies during economic downturns because their tenant base consists of smaller, local businesses, which are more vulnerable than large national retailers that make up the tenant base in malls. Weakness in the retail sector will likely continue through the fourth quarter, driven by a slowdown in consumer spending and cutbacks in expansion plans by national retailers.
Alternatively, the apartment sector remained strong, and continued to benefit from weakness in the residential housing market, which drove increased demand for rental properties. Vacancies were essentially flat and rents increased by 0.5% during the quarter.8 The key concern in the apartment sector going forward is job growth, as higher unemployment negatively impacts demand for apartments.
The factors influencing the real estate markets through fourth quarter of 2008 and into 2009 will be higher loan-to-value requirements from lenders (i.e., conservative underwriting), higher borrowing costs, and sales by distressed sellers who are unable to refinance debt taken on in the past several years. New construction should be limited and fundamentals should remain stable for most markets due to limited supply overhang. In this environment, there will be attractive buying opportunities for investors in the debt markets as well as for those who can buy properties from distressed sellers.
1 Information available from http://www.ncreif.com. NCREIF. Accessed on 6 November 2008.
2-4 Frangos, Alex. “Office Space is Emptying Out.” The Wall Street Journal. 3 October 2008.
5-8 Hudson, Kris. “Mall Vacancies Grow as Retailers Pack Up Shop.” The Wall Street Journal. 6 October 2008.
