Commercial Sector Suffers Continued Strain

January 14, 2010

Despite data suggesting an end to the recession, commercial real estate lagged during the third quarter, the Mortgage Bankers Association reported this week. MBA’s Third Quarter Commercial Real Estate/Multifamily Finance Data Book said effects of the recession continue to hang over the economy and commercial and multifamily real estate markets, with rising vacancy rates among all property types and declines in sales and construction activity. Despite improvements in overall economy in the third quarter — growth in gross domestic product, stabilizing retail sales and signs of new life in the stagnant housing market — commercial real estate markets showed the strains of the downturn.

The Data Book noted vacancy rates rose in the third quarter for all major property types. For apartment properties, vacancy rates rose to 8.4 percent from 6.5 percent in the third quarter of 2008. Industrial properties saw vacancy rates rise from 9.8 percent to 13.0 percent; office properties saw a rise from 16.0 percent to 19.4 percent and retail vacancies rose from 12.9 percent to 18.6 percent.

"Given this environment, it is not surprising that property sales and construction activity have seen significant declines," the Data Book noted. Year-to-date Q3 property sales in 2009 were 72 percent lower than they had been in 2008, which were 66 percent lower than they had been in 2007. Every major property type was affected.

With such low volumes of transactions, gauges of commercial property prices are spotty at best, the Data Book reported. The Moody’s/REAL Index showed an 11.5 percent drop over the quarter, while the NCREIF TBI showed a 4.4 percent increase in values.

"The small number of transactions, and the fact that many of them are likely distressed sales, mean that current transactions — and the gauges that track them — may not represent true ‘values’ of non-distressed properties," the Data Book said. "Likewise, new construction activity has slowed to a crawl. Nationwide, construction was started on only 5,000 units in multifamily housing in October — the lowest level ever recorded (since January 1959). Given market fundamentals and pricing, it is unlikely we will see a significant rebound any time soon."

Multifamily mortgage origination activity also fell. The Data Book said third quarter volumes were 54 percent below Q3 2008 levels, which were down 53 percent from 2007. Fannie Mae and Freddie Mac continued to provide significant support to the multifamily market, while banks and life companies each saw a slight pick-up in volume.

"Some recent (Q4) activity in CMBS issuance may signal a partial unfreezing of that part of the market as well," the Data Book said. "With few new loans being sought or made, and existing loans paying off and paying down, the level of mortgage debt outstanding is holding relatively flat."

The top line numbers from the Federal Reserve show a 0.8 percent decline in commercial and multifamily mortgage debt outstanding during the third quarter, led by a $20 billion drop in the holdings of banks and thrifts. Excluding construction loans, however, banks and thrifts saw a $6 billion increase in their holdings of loans backed by commercial and multifamily properties. Coupled with increases in the holdings of multifamily mortgages by Fannie Mae and Freddie Mac, and decreases in the balances backing commercial mortgage-backed securities, the Data Book said overall amount of commercial/multifamily mortgage debt outstanding remained relatively unchanged.

"The stress of the economy continues to filter through to the performance of loans backed by commercial and multifamily properties, but key distinctions exist," the Data Book said. "First, different investor groups are experiencing different trends. While loans held by banks and thrifts and in CMBS are experiencing stress roughly on par with what was seen following the stress of the late 1980s/early 1990s, loans held by life insurance companies, Fannie Mae and Freddie Mac are performing far better than the experience of that time. In addition, and despite the stress, commercial and multifamily mortgages are performing through this recession better than many other types of loans, particularly construction loans and single-family mortgages, and are seeing delinquency rates roughly on par with other commercial and industrial loans."

Looking ahead, the Data Book said while economic recovery is underway, it remains fragile, with full recovery dependent on the ability of consumer and small businesses to obtain credit and the unemployment situation. Financial markets have been in a healing process since late last year; stock prices have risen dramatically, yields spreads have narrowed and larger businesses have been able to tap the money and capital markets for funds," the Data Book said. "But smaller businesses and consumers are heavily dependent on banks for obtaining credit, and there is little evidence that, as yet, banks have loosened the purse strings."

On unemployment, the Data Book said declining employment and moderation in wage rates has robbed the consumer of the income needed to support spending, although recent employment data suggest that the job market may be beginning to recover, albeit at a slow pace.

"’Real estate lags the economy’ is a common refrain, although few specify whether the expression refers to property prices, vacancies, rents, net operating income, mortgage delinquencies or some other aspect of the market, or is more applicable to multifamily, office, retail or hotel," the Data Book said. "Regardless of the specifics, the fact that the economy -- at least as measured by GDP -- began to grow during the third quarter may begin the countdown on the ‘lag’ and on when the economy will have grown sufficiently to rekindle demand for commercial real estate. Given the depth of the recent downturn, the commercial property market has a significant amount of ground to recover."

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