Commercial-real-estate bust is coming, report warns

But downturn will present buying opportunities over the next 18 months, industry expert says

Oct 26, 2008 @ 12:01 am

By Janet Morrissey

Economists and market experts say a doom-and-gloom report on commercial real estate released last week confirms the industry's worst fears about an imminent major correction.

The widely respected annual report, "Emerging Trends in Real Estate," by the Urban Land Institute of Washington and PricewaterhouseCoopers LLP of New York, predicts that in 2009, commercial real estate will suffer its worst year since the industry's crash of 1991-92, with a noticeable rebound unlikely until 2011 at the earliest. It also forecasts a decline of 15% to 20% in property values, on average, from their 2007 peaks, with even sharper declines coming in weaker markets.

Amid the gloom, however, there will be pockets of opportunity for cash-heavy investors in discounted loans, distressed debt, raw land, apartment buildings and other niches, the report said.

Over the next 18 months, there will be investment conditions similar to those that prevailed in the early 1990s, according to Robert Bach, chief economist with Grubb & Ellis Co., a commercial-real-estate-services and investment company in Santa Ana, Calif.

"If you look back, there were tremendous opportunities available to anyone who would take the leap and buy properties at a discount from the [government-owned] Resolution Trust Corp. and that set the stage for strong growth among REITs," he said.

At the time, though, there were dire predictions "that there would be no need for another square foot of commercial real estate until about 2010 or 2015," which spooked investors, Mr. Bach said. "But people who bought properties back then did very, very well."

Nevertheless, the report throws cold water on any hope for a speedy turnaround.

"The industry was sort of whistling past the graveyard for a while, thinking that things would be OK, but this is probably an indication that times will be tough in the next year and a half. I agree with the report," Mr. Bach said.

"This is going to be the worst year since the 1991-92 industry depression," Stephen Blank, senior resident fellow for real estate finance at the Urban Land Institute, said in a webcast. "We expect to see drops in value, negative returns, sharp increases in delinquencies and foreclosures it's a bleak picture."

The report, which surveyed about 700 industry developers, lenders, investors, property owners and consultants, predicted that commercial real estate will take a beating similar to the one that has decimated the housing market in recent years.

"The private commercial markets need to correct; they're lagging everything else," said Jonathan Miller, a partner in Miller Ryan LLC, a real estate marketing advisory firm in New York, and author of the ULI/PWC report. "That [correction] is going to happen over the next 12 to 18 months."

Commercial real estate can no longer hide from a "minefield" of troubles, including the country's deepening credit crisis, broken financial system, rising unemployment, high energy prices, housing crash, stock market volatility, global uncertainty and a mounting national debt that tops $11 trillion, according to Mr. Blank. Still, commercial-real-estate delinquencies are unlikely to reach the 7.5% level of 1992, he said.

Of the 50 metropolitan markets tracked, the study found only two Dallas and Houston where prospects for investment and development in 2009 were better than in 2008, thanks to their exposure to the energy industry. All other markets face deteriorating conditions next year, the study said.

In general, the report urges investors to sit tight and be patient "because the markets have yet to correct as much as they're going to," Mr. Miller said.

However, the report cited investment opportunities for those with cash and low leverage, noting bottom-fishing opportunities among distressed sellers and lenders, whose highly leveraged loans are upside down.

"As the major lenders offload their balance sheets, opportunities will arise to buy discounted loans," Mr. Miller said. Also, there will be opportunities to rescue distressed borrowers who face refinancing dilemmas, he said.

On the bricks-and-mortar side, rental apartment properties should continue to show strength due to the reeling housing market. Infrastructure and transportation projects are also good bets, the report said.

Mr. Miller added that residential lots and raw land should offer good investment opportunities over the next 12 months, but investors should avoid hotel and retail properties. "It's going to be ugly in retail," he said.

The report predicts that real estate investment trusts will likely fall further but could offer a buying opportunity before the end of 2009.

REIT returns, which include dividends, were off 37.3% year-to-date through the close of business last Wednesday, with most of the decline coming in recent weeks, according to the National Association of Real Estate Investment Trusts in Washington. The decline was similar to that of the Standard & Poor's 500 stock index, which meanwhile had fallen 37.9%.

In a recent report of its own, The Goldman Sachs Group Inc. predicted that commercial real estate values will tumble 19%, and vacancy rates will approach 1990s levels. The New York firm recommends that investors avoid REITs with high leverage, near-term refinancing risk and a reliance on development and merchant building for growth.

Debt capital and the commercial-mortgage-backed-securities market must return for real estate to rebound, though the days of cheap, easy financing are likely over at least for now, Mr. Miller said. "It's not going to be a quick fix, and so we can't expect a quick rebound," he said.

The report predicted that the debilitated housing market will bottom in 2009, but not before pricing levels tumble to 2003-04 levels. Distressed Florida condos with ocean views could offer good long-term investments when they bottom sometime in 2009, Mr. Miller said.

Fitch Ratings Ltd. in New York thinks that 75% of the housing correction is already behind us and that prices may tumble only another 10% before hitting bottom in the next few quarters.

"2009 will be downer, and 2010 may not be much better, but maybe by 2011, a slow recovery will be under way," Mr. Miller said. "It all depends on the economy we need a jolt."

E-mail Janet Morrissey at


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