Cracks Showing in Commercial Real Estate: Report

Following up on last week’s post which pondered risk-taking in commercial real estate, the Wall Street Journal reported Monday that the national vacancy rate for office buildings rose during the fourth quarter — the first such rise in four years.

From the story:

Nationally, the office vacancy rate — as measured by 79 metropolitan markets — rose to 12.6% at the end of the fourth quarter from 12.5% at the end of the third quarter, according to Reis Inc., a New York real-estate research firm …

Continued nervousness about the possibility of recession and the prospects for business in 2008 is likely to push vacancy rates higher. In 2003, at the height of the last major downturn in the office market, vacancies topped out at 16.9%. “I think we’re going to see the market continue to slow in 2008,” said Sam Chandan, chief economist at Reis.

Net absorption — the change in the amount of occupied space — dropped slightly below 4.4 million square feet in the fourth quarter. By contrast, 16.2 million square feet were absorbed in the previous quarter. In 2000, when the office market was roaring at the end of the technology boom, the figure topped 36 million square feet in a single quarter.

Dramatically slowing absorption isn’t the only worrisome trend; the Journal also reports that developers are likely overbuilding as well, with more than 19 million square feet of new office space completed in the fourth quarter. That’s the most since the fourth quarter of 2000. The Journal also notes that 75 million square feet of new space is scheduled to be available in 2008, up from 53 million in 2007.

I want to take a minute to return to the post I wrote last week on CRE, which discussed risk-taking in commercial mezzanine financing.

Most mezzanine financing has a short-term maturity at a rate comparable to consumer credit, which means it must either be refinanced or rolled into the mortgage if value is increased sufficiently to do so. During boom times, mezzanine financing is a way to leverage returns; but, just like we’ve seen in the residential mortgage market, it becomes an absolute albatross during market downturns.

If the CRE market is entering such a period, deals like the one I highlighted last week will be problematic — one, because it’s a office-space conversion project at a time when demand for office space is declining; two, the use of mezzanine financing means the investor is likely expecting some additional value to be generated within a short period of time.

The WSJ story above suggests that those expectations may be misguided in many major markets.