By Woodwell, Jamie
Mortgage Banking , Vol. 71, No. 4
In May 2008, The Wall Street Journal quoted Rob Feckner, president of the Sacramento, California-based California Public Employees' Retirement System (CalPERS) board of administration, saying, "Real estate is a very cyclical business, especially right now." This truism is remarkably telling about today's commercial real estate markets and about what we can expect in coming quarters. * Commercial real estate markets are cyclical. When property fundamentals are improving, developers see opportunities and deliver new space to the market. With multiple developers each trying to meet market demand, the space that comes online typically overshoots demand, creating competition to lease the excess space and putting downward pressure on occupancies and rents. The resulting hit to property incomes and values slows new development activity until rents and occupancies once again begin to firm and developers once more see opportunities. * That is the typical cycle. * The current down cycle in commercial real estate follows a slightly different path. Today's high vacancy rates and rent declines were caused by a withered economy rather than excess new development. * Even so, the depth of the recession of 2007/2008/2009 hit property fundamentals hard, and the resulting pullback in new-construction activity is setting up the next phase of a classic real estate cycle.
Property performance is typically the driver of the real estate cycle. It was one of the first aspects of commercial real estate markets to decline during the recession, and it is now showing itself among the first to stabilize and recover.
The "Great Recession" had a profound effect on demand for commercial real estate. According to the U.S. Census Bureau, from peak to trough, more than 8 million jobs were lost, including more than 4.5 million services jobs; between July 2008 and July 2009, retail sales fell by 9.84 percent, the largest percentage decline on record; and in 2008 the number of households in the United States declined on a year-over-year basis for the first time since 1961.
The effects of these economic declines on commercial real estate were just as pronounced as overbuilding would be. According to Property & Portfolio Research Inc. (PPR), Boston, in 2008, 672 million square feet of more space came onto the market--through negative net absorption and completions--than was absorbed. In 2009, that number climbed to 815 million square feet. By comparison, in 2005, 305 million square feet more space was absorbed than came online.
The results of the excess space were spiking vacancies and plunging rents throughout 2008 and 2009.
As the economy and demand for commercial space fell, vacancy rates rose for all property types--most hitting record highs (see Figure 1).
[FIGURE 1 OMITTED]
Apartment vacancy rates rose from 5.7 percent in September 2006 to 8.4 percent in December 2009; industrial vacancies rose from 8.6 percent in March 2007 to 13.3 percent in March 2010; office vacancies rose from 14.5 percent in September 2007 to 19.6 percent in March 2010; and retail vacancies rose from 9.6 percent in June 2006 to 19.4 percent in March 2010.
Similarly, asking rents fell hard. Peak-to-trough (or current), asking rents fell 7 percent for apartment properties, 12 percent for office space, 14 percent for retail and 15 percent for industrial.
Economic growth--albeit slow--is starting to eat into vacancy rates and stabilize asking rents. During the third quarter of 2010, every major property type saw a decline in vacancy rates--the first time that has happened since the second quarter of 2006.
In addition, apartments saw their second straight quarter of growth in asking rents, and asking rents for office, retail and industrial properties each declined by the smallest percentages since mid-2008.
Lease terms are affecting how these conditions filter through to properties' bottom lines. …