Commercial Real Estate Chartbook

Commercial Real Estate Chartbook: Quarter 3

Wed, Nov 11 2009, 16:32 GMT

by Anika Khan, Mark Vitner

Wells Fargo Investments, LLC

The Commercial Real Estate Centipede Loses Another Shoe

Hardly a day goes by without some mention that another shoe is about to drop on the economy as the rising tide of defaults and foreclosures of commercial properties overwhelms the financial system. Such talk is understandable given the circumstances and the nearness of the collapse of the residential market. There is still plenty of bad news stoking fears, both real and imagined. Property values are declining. Credit is hard to obtain. And there are numerous high-profile commercial real estate bankruptcies such as General Growth Properties, Extended Stay Hotels and Capmark reminding folks of just how perilous the real estate industry is today.

While many of the challenges facing commercial real estate are well known, there are also important differences with previous real estate crunches. One of the most notable differences is that real estate is not nearly as overbuilt as it was in the late 1980s and early 1990s. Commercial development did not really get going until the last two years of the economic expansion and significant office development was largely confined to a handful of markets. Retail development and industrial construction were more widespread, with the housing boom fueling explosive gains in consumer spending and an import boom. The result was a massive wave of retail development and a boom in industrial development around many major seaports.

The flip side of that import boom was that a huge pool of capital accumulated overseas. Eventually this surplus was recycled into various investments, including commercial real estate, which helped pushed prices much higher than the fundamentals ever justified or anything seen in previous cycles. Once housing values started falling, consumer spending quickly wound down and the capital markets stumbled. With the capital markets frozen, investors no longer had access to a cheap source of capital and prices for commercial properties quickly turned south.

Various measures of commercial property values show prices topped out in late 2007, right about the time the capital markets froze. Prices are currently down a cumulative 34 percent from that peak across all property types. We expect further price declines over the next 18 months, as sales of distressed properties increase. The largest drops will continue to be in areas where housing weakened the most, including Florida, southern California, Arizona, Nevada and Georgia. Office buildings and shopping centers remain exceptionally vulnerable as employment is still falling and discretionary consumer spending remains on the back burner.