Posted on Friday, December 17, 2010
Commercial real estate in the U.S. encompasses a wide diversity of building types and sizes. Recent problems with declining commercial space sales and prices, stagnant and declining rents, troubled assets, and financing illiquidity began with the onset of the Great Recession. The market performance of the sector tends to lag the economy in general, with sector stabilization and initial recovery projected for 2011.
Market Size, Drivers and Demand
The overall amount of commercial space available in the U.S. is estimated at 78.8 billion square feet located in 5.3 million buildings. This is the latest data from the Energy Information Administration. In addition, there are an estimated 15.3 million apartment units in buildings with 10 or more apartments.
Building sizes vary widely. There are an estimated 9,000 buildings that are larger than 500,000 square feet, and 3.8 million buildings with less than 10,000 square feet—of which 2.8 million are less than 5,000 square feet in size.
The major economic drivers for space demand are changes in employment and economic growth (GDP). Both drivers were negatively affected by the Great Recession, and recovery has been slow.
• The dollar sales volume for core commercial space (office, retail, apartments, and industrial) declined to $52 billion in 2009 after reaching a high of $428 billion in 2007. The good news is that in 2010 there has been a slight uptick in commercial demand, with an estimate approaching $70 billion in 2010.
• Commercial leasing demand has declined for most property types over the past two years. Multifamily has been the only resilient property type to weather the economic recession, with that segment of the commercial market registering positive net absorption. However, rents have declined across the board.
• Commercial real estate prices have also declined from their peak. Currently both rental and sales prices for Class A office building space are recovering, but the recovery of the rest of the market has been somewhat slower.
From 2005 through 2008 international investors purchased in excess of $100 billion of commercial real estate, approximately 7.0 percent of the market. In 2009 foreign purchases were $3.9 billion, and may ultimately be in the neighborhood of $6 billion in 2010. Foreign investors generally have focused on prominent office properties in gateway markets such as San Francisco, Chicago, New York, and Washington, DC. One reason foreign investors are drawn to U.S. commercial properties is that the spread between cap rates and 10-year treasuries in the U.S. is much higher than in other national economies. This makes U.S. property an attractive proposition.
Key Issues Affecting the Commercial Real Estate Markets
A number of issues affect commercial real estate markets. Two of the major ones are troubled properties and credit availability/financing.
Troubled Properties: Decreased commercial real estate market demand has generally resulted in increased vacancies and lower rents for commercial space, resulting in an increase in financially troubled properties and foreclosures. Overall, financial recoveries from the liquidation of distressed properties have been reported at the 60 percent level, exclusive of costs and fees. Recovery rates vary widely, depending on geographic location, type of property, initial Loan to Value (LTV), and loan purpose (land development, construction, conversion, and redevelopment). In many instances a workout rather than liquidation rolls over troubled loans through a “pretend and extend” effort. Estimates of troubled commercial real estate are in the neighborhood of $157 billion. The overall level of distress seems to be leveling off and the number of resolutions has been rising, reaching close to $50 billion in cumulative value during October 2010.
Credit Availability and Financing: Funding in the past year has been a challenge. Although there have traditionally been a number of sources for commercial loans, adverse economic conditions have combined to limit credit:
• Commercial banks have typically been the major funders, with one estimate suggesting holdings of $1.5 trillion in early 2010—44.9 percent of total commercial debt.
• Commercial mortgage backed securities have been estimated at $740 billion, 22.3 percent of total commercial debt.
• GSEs finance multifamily housing, an estimated $248 billion, 7.5% of the total commercial debt.
• Other sources are estimated at $837 billion, 25.3 percent of total commercial debt.
The major problem in the past several years has been the collapse of the CMBS (commercial mortgage backed securities) market accompanied by significantly tighter credit conditions by banks. In the past decade, regional commercial banks significantly increased their exposure to commercial real estate, with a number of loans subsequently entering default. This has resulted in a reduced level of credit availability, both as a result of the need to protect the bank’s capital base as well as in response to regulatory requirements.
NAR Forecasts: Outlook and Market Recovery
In general, it is possible to summarize the state of the commercial real estate market in terms of three major areas:
• The market for Class A Space is generally in reasonably good condition. Known as trophy buildings, these office buildings have recently been able to command good prices and rents. Although a number of highly leveraged buildings entered bankruptcy, overall the Class A Space market has been on an upswing. Although prices of distressed properties have continued to fall, in major markets such as Washington, New York, and Los Angeles the demand for trophy properties has caused Class A prices to rise. Investors are risk averse, and major markets and core properties are considered desirable.
• The overall commercial real estate market—Class B space, warehouses, retail, etc. – in general is not expected to reach significant recovery until 2012.
• Small buildings, typically selling for under $2.5 million, have had a downward trend of expectations of falling prices, volume, and rents, starting to level out.
NAR projects vacancy rates to peak out in 2011, while other sectors will start to improve slowly.
The Great Recession had a major negative impact on the demand for building space. When employees are laid off and retail sales are down, there is significantly less need for commercial space. Although there has been a substantial increase in liquidity available to the financial markets, lending standards appear to have substantially tightened. Financial institutions appear to have over reacted to the need for tighter credit standards. Accordingly, the commercial sector has been lagging the economic recovery.
The overall value of the commercial real estate sector has been estimated at $6.5 trillion. This contrasts to the total value of residential properties of $17.1 trillion. Both commercial and residential real estate sectors have experienced declining prices and sales as a result of the Great Recession.
Approximately 80,000 members of the National Association of REALTORS® identify themselves as being primarily focused on commercial real estate. NAR members typically report that they sell buildings in the under 10,000 square feet range—the bulk of the commercial market in terms of number of buildings. A recent survey of the NAR membership has projected a slow recovery starting in 2011.
by Jed Smith, Managing Director, Quantitative Research NAR