This Year, Pain To Replace Gain

Nary a Bright Spot in CoStar Group’s First-Ever State of the Market/Industry Outlook

The pain felt throughout the U.S. housing market over the past two years is going to catch up with commercial real estate in 2009 when the country will begin to see spikes in office vacancy rates climbing as much as 300 to 400 basis points with many markets expected to experience severe negative net absorption. That was the assessment of Andrew Florance, founder and CEO of CoStar Group Inc., as presented in the company’s first-ever 2009 State of the Office Market review and outlook delivered this afternoon from its Bethesda, MD, headquarters and webcast to CoStar clients across the country. Florance’s presentation laid out the economics and fundamentals detailing the impact of the financial meltdown on commercial real estate, finding little upside to report with all indicators projecting continued:
Constraint in the credit markets,
Dearth of investment and construction activity,
Corporate space contraction, and
Falling property values.The outlook is now for the current recession to take a higher toll, for a longer time, on commercial real estate than did the dot.com bubble burst of 2001-2002. Rather than try to reproduce the entire presentation or beat the dead horse that is the economy, here is recap of just some of the highlights.
ContractionUnlike in previous recessions in which the commercial real estate industry participated in its own demise through gross overbuilding, the current downturn was precipitated by an unparalleled run up in housing values and the subsequent burst of that bubble. Housing values continue to fall precipitously. Overlaying commercial office values with housing values, Florance showed that, while commercial values also experienced a rapid ascent, those values peaked at substantially lower levels than the housing peak. Also based on historical norms, it appears housing values still have a ways to fall, while commercial office space values have already returned to much closer what are their norms. That doesn’t mean that office values could hold at the level because clearly the market dynamics are working against them. The S&P 500 Index is down 40% from its highest levels and lower than what is has been in five years. The index is important to commercial real estate because without increasing stock prices, corporations will be less likely to expand. The lack of expansion is major drag on office space absorption, Florance said. In addition to stock price declines, initial public stock offerings that fuel the growth of newer firms have dried up completely this year. Corporate borrowing outside of federal government-assisted bailouts also has fallen to record lows - less than $25 billion/month in the most recent quarter compared to more than $400 billion just 18 months ago. The commercial mortgage backed securities (CMBS) markets also dried up completely in the fourth quarter and thus banks - were they even making loans - have nowhere to market or sell those loans to the secondary markets to make room to do more lending. The employment picture is also dismal. The U.S. economy already lost more jobs (1.9 million) in 2008 than during the dot.com bubble burst in 2001-2002. Economy.com is forecasting as many as 3.1 million job losses in 2009.
Inventory BuildupOne small bright spot to current commercial real estate conditions is that there was very little surge of new supply leading up the recessionary environment starting in December 2007. Commercial office space is entering the downcycle from a position of relative strength. Nor is CoStar forecasting much additional in the way of new supply coming onto the market through 2012. However, the office supply inventory is going to increase. In fact, the supply of available and vacant office space is beginning to increase as there is currently virtually no absorption of excess space occurring. Vacancy rates have begun to tick up as projects already under construction are being completed. Combining the forecasts for job losses in 2009 and a dwindling supply of newly delivered space, CoStar is predicting that U.S. office vacancy rates could climb from a base of 11.1% at the start of last year to 15.1% in 2010. Some U.S. markets will be hit harder than others but all are projected to grow to double-digit vacancy rates in 2009 and 2010. CoStar is projecting that the Phoenix and Detroit vacancy rates could exceed 20%. Job losses are also projected to be heavy in South Florida, the New York Tri-State area and San Francisco and those markets will likely see fairly steep increases in their vacancy rates over the next two years. There won’t be any clarity to when the markets can return to normal until the peaks in vacancies and the valleys in prices and rents hit top and bottom. In the two previous recessionary periods of early 1990s and 2001, office inventors did not return to the market until it was clear that the deterioration in conditions had stopped. And right now, the volume of investment activity is at or near its historical norms. So while the outlook for 2009 is grim, it is likely that the market for office building investments will remain flat through 2009. "The market needs to establish a new bottom before a recovery can take hold," Florance cautioned. "The sooner we reach it, the better off we'll be. If property values need to fall to X, it's better to get there in 18 months not five years." Faced with the grim outlook for 2009, a member of the audience asked Florance if he would advise the broker to give up his real estate practice and work on his golf game for the next 12 months. "Where do you golf?" Florance responded half jokingly before addressing the issue. "We adjust. As we've all seen the industry do in past down cycles, we focus on leasing rather than sales and on property management rather than on new development. And we become advisors. Your clients are going to need your expert advice."
More Distressed PropertiesFrequent readers of CoStar news are probably familiar with our coverage of distressed properties and delinquent loans. In preparation for its first market outlook, CoStar also undertook its first-ever complete analysis of delinquent and distressed properties in the CMBS market. CoStar identified nearly 1,200 commercial real estate loans that were either delinquent in loan repayments or had reached maturity without pay off of the loan. The principal and interest outstanding on those loans as of mid December totaled nearly $8.2 billion. CoStar also compiled a list of nearly 6,100 additional loans that servicers for the various securities have flagged as having potential credit concerns. The current scheduled ending balance of those loans totaled $57.8 billion. In addition, CoStar identified more than 160 properties that had been repossessed by various CMBS trusts. The properties had a loan value at the time they were taken over of more than $1 billion. Based on the properties most recent valuations, the bondholders were likely to take a loss of more than $300 million.
Go GreenNot wishing to end on a dour note, CoStar’s Florance concluded the U.S. portion of the forecast with a look at so-called green properties, which continue to enjoy a premium in the marketplace in terms of higher occupancy levels, rental rates and sale prices compared with "non-green" peer buildings. Currently in the U.S. only 1 in 15,000 properties are LEED or Energy Star certified. In fact, a new federal mandate that is set to go into effect in 2010 is that federal agencies will have to occupy green certified offices. According to Florance, the total federal requirement for green space outstrips the total available supply of green-certified buildings. In analysis of 9.8 billion square feet of office inventory in CoStar’s database, CoStar found that the national occupancy rate of green-certified buildings was 300 to 588 basis points higher than non-certified buildings and commanded rents that were anywhere from $3 to $18 more per square foot per year than the average rent. Green buildings also sold at prices that were up to 64% than the average. Written by Mark Heschmeyer COSTAR

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