As the credit squeeze from escalating residential loan defaults takes a toll on real estate services companies, the owners of commercial buildings are also experiencing pain. While much of the subprime mortgage problem has focused attention on the residential market, Chicago-area office landlords are now feeling the pain as the problems spread into various channels of the commercial property industry.Big Chill in Orange County
Gone are the days of frenzied commercial property sales with investors buying buildings at high prices, raising rents and flipping them at even higher prices.
Now, rather than anticipate big sales, commercial landlords are worrying about how to pay the debt on buildings that are generating less income than just a few months ago. It's a national problem but one that is felt more acutely in Chicago, where rents were already low and where new office space threatens to push down prices even more.
This dynamic has caught squeezed office owners off guard.
With leasing sluggish, especially in the northwest suburbs, lowering rents to attract tenants will lower properties' financial performance and threaten property values. This makes it difficult to pay off loans that in recent years have covered as much as 95 percent or more of a building's cost. As rents diminish and credit rating agencies lower the extravagant asset value assessments of recent years, an owner could be holding a building that is worth less than the amount owed on it.
"For landlords, it's a vicious cycle," said Joseph Cosenza, vice chairman of the Inland Real Estate Group of Cos. in Oak Brook. The more landlords lower rents, the more property values sink.
Then, "if a landlord can't sell a building and can't afford to pay the 95 percent leverage on it plus operating expenses, they're likely to default," he added. " If they give buildings back to the lender that could cause credit problems throughout the country."
But leasing is not landlords' only problem. New York-based Tishman Speyer Properties LP this summer spent $1.7 billion to buy a downtown Chicago office portfolio. But in a slowing sales market it now finds itself having to hold and manage two buildings it had hoped to quickly sell for an easy profit and hefty cash infusion.
Tishman did not return calls seeking comment.
The problems are not confined to the Midwest. "All across the country there are huge spaces where tenants aren't paying rent," Cosenza said.
Landlords under serious financial strain now face a real estate landscape that may make it more difficult to work out problems, said William McCall, chairman of McCall & Almy, a Boston real estate adviser.
In past real estate recessions, banks that performed property lending held on to loans for decades and often knew borrowers personally. If a borrower had problems they could arrange with the loan officer to skip a few payments and make it up later. But now property loans originated by private equity and banks are routinely securitized, bundled into huge tranches and syndicated to investors worldwide. There may be one financial institution that services a loan but there is not one lender who holds it and can work through problems, McCall explained.
"Who do you sit down and talk to?" he asked. "There isn't a bank to work with."
The Wall Street Journal is reporting Troubled Lenders May Chill Once-Hot Market.
The subprime-mortgage industry crisis and Orange County's economic tailspin are likely to have a chilling effect on nearly all types of commercial real estate in this formerly go-go market, some analysts say.Shopping Center Ripple Effect
A number of shrinking mortgage companies are already dumping office space on the market. The area's weakening job and housing market will also pinch consumer spending while budget-constrained would-be renters may forgo their own homes and apartments in favor of doubling-up with parents or friends, says Kenneth T. Rosen, chairman of Rosen Consulting Group, a Berkeley, Calif., real-estate research firm.
The New York Times is reporting Shopping Centers Begin to Feel Ripples of Housing’s Ills.
Shopping centers have been caught in the credit squeeze that has transformed the capital markets. Private buyers, who were once able to finance 95 percent or more of the cost of a transaction, are being driven out of the market because such high leverage is no longer available.Manhattan Blockbuster Deals In Trouble
According to investors, brokers and analysts, deals are taking longer to complete, and prices — at least for the second- and third-tier properties — are declining by as much as 10 percent.
“What we have seen is a lull in the market, what you might call the calm before the storm,” said Fritz McPhail, the owner of Blue Ridge Capital, an Atlanta real estate company that specializes in acquiring troubled strip malls. “We are seeing prices change. We are seeing deals blow up. People are calling us back a second time to see if we want to consider another offer.”
While demand for space remains strong at the high-end regional malls, the average vacancy rate at strip malls, which are generally anchored by supermarkets, has been creeping up for more than two years, even though relatively little new space has been developed, according to Sam Chandan, the chief economist for Reis, a New York research company.
Mr. Chandan said the vacancy rate stood at 7.3 percent at the end of June and was expected to rise to 7.6 percent by the end of the year, its highest level since 1995.
In the second half of the year, he said, about 26.2 million square feet in strip malls will be completed, which would contribute to an oversupply. “That’s the highest level of completions we’ve seen in many years, and it coincides with the slowdown in the underlying drive for space,” he said.
The strip mall vacancy rate has accelerated sharply in some metropolitan areas, including Trenton, Dallas and Oakland, Calif., according to Abigail Marks, an economist at Torto Wheaton Research, a Boston company owned by CB Richard Ellis.
And retail chains are closing stores faster than they did in 2005 and 2006. During the first half of this year, Merrill Lynch counted 6,126 closings, an 11 percent increase over the period a year earlier.
Like residential mortgages, commercial mortgages are pooled, sorted into risk categories and sold as bonds.
In the past several weeks, demand for these bonds has weakened, with investors demanding to be paid more for the risk. As a result, said Pete Bethea, a principal at Burnham Real Estate, a brokerage firm in San Diego, lenders are changing the terms of deals. “Even if people thought they had their deal locked, there’s no such thing,” he said.
The New Your Sun is reporting Real Estate Record Hits Hurdle
When the private equity firm Somerset Partners announced last month it was acquiring 450 Park Ave. for $1,589 a square foot, a record for a Manhattan office building, it was hailed nationwide as a sign of the historic strength and high demand in the city's commercial real estate market. Now, just weeks later, the firm is struggling to close the $510 million deal, beset by the rising cost of debt.Bargaining Power On Leases Rise
The purchase of the 321,000-square-foot office building, at the corner of East 57th Street, is only the latest of several high-profile deals that are in turmoil. Metropolitan Real Estate Investors, an Israeli investment group, only just closed on its acquisition of the Lipstick Building at 885 Third Ave. and 292 Madison Ave. after struggling to secure permanent financing, and Harry Macklowe is reportedly in trouble with his $7 billion acquisition of several Manhattan skyscrapers from the Blackstone Group.
At the time these blockbuster deals were struck, they were touted as signs of an escalating real estate boom. Now that they are in trouble, real estate insiders say it portends a potentially severe downturn.
"There are tons of lenders reworking deals right now," a principal at real estate advisory firm Ackman Ziff, Patrick Hanlon, said. "A lot of deals are getting re-cut, and a lot of them just won't happenÂ--it will take months, not weeks till this sorts itself out."
Metropolitan Real Estate Investors struggled to find enough debt to finance its acquisition of the Lipstick Building on Third Ave. for $648.5 million and another property at 292 Madison Ave. for $164.5 million. After a struggle to get a loan, it managed to cut a deal with RBC Capital Markets, according to a real estate person familiar with the deal. Mr. Macklowe is said to be at risk of losing his stake in the GM Building if it cannot secure the debt he needs to close his $7 billion purchase of eight Manhattan office towers from the Blackstone Group.
The news is a drastic turnaround from just three weeks ago, when the market seemed to be on a constant upward trajectory. "We have a complete change in the way deals will be made going forward," a broker at Cushman & Wakefield, Yoron Cohen, said. "We will see much more institutional money now rather than hedge funds."
Already, the market is starting to feel the strain, and it isn't just the big deals running into trouble. Mr. Gross thought he had a buyer for a property he was marketing on East 10th Street. But the deal fell through because the buyer failed to get sufficient financing.
Financial Week is reporting Retailers flexing their muscles on shopping mall lease deals.
Retailers looking to rent in community shopping centers have more bargaining power than they’ve had in years, as sputtering consumer spending and increased competition from a flood of new centers have pushed vacancies to a four-year high.Credit Woes Hit Office Market
The vacancy rate at shopping centers with a big-box retailer or a supermarket as anchor tenant rose to 7.3% in the second quarter, up a tick from the first quarter and a rate not seen since the third quarter of 2003, according to data released last week by Reis Inc., a commercial real estate market research firm. The vacancy rate was 6.9% in the second quarter a year ago.
Low-double-digit vacancy rates are common in many Deep South and Midwestern cities. In Ohio, Columbus and Cincinnati both have vacancy rates of about 13%, for example. And that means landlords in those cities have to offer more concessions to lure tenants.
On the flip side, some urban areas of California are seeing virtually full occupancy, with vacancy rates below 3%.
Brian McDonald, a CB Richard Ellis vice president in Ontario, Calif., said rates on new construction in Southern California are at historic highs, up 50% to 75% in the past three to four years, but that’s not likely to hold, as there is a flood of new construction in the pipeline.
The LA Times is reporting Credit woes hit office market
The global credit crunch that has rattled financial markets the last few weeks is finally reaching the vast commercial real estate investment and development industry.I could not possibly disagree more with White about commercial real estate fundamentals. They could hardly be any worse. Commercial follows residential with a lag, and the above sequence of articles show the lag has been used up. Vacancies are soaring in many locations and rents are dropping.
Predictions by some analysts that prices are poised to drop for office buildings and other commercial properties are sending shivers through the business, driving down real estate company stock prices and delaying some deals.
Archstone-Smith Trust in August postponed its $13.5-billion sale to a group led by Tishman Speyer Properties until October. Mission West Properties Inc., owner of commercial buildings in Silicon Valley, said Aug. 13 that the company's $1.8-billion sale might fail after a bank withdrew funding.
"There has been a spike in the last 30 days of deals falling out of contract," White said. "People planning to close deals last month got hesitant."
The commercial real estate market is on firmer footing than the residential market, said Brett White, president of Los Angeles-based brokerage CB Richard Ellis, the largest in the world.
"The fundamentals behind the business remain very strong," he said.
Another difference from the residential market is that "the delinquencies in commercial mortgages are virtually zero," White said. "We're seeing virtually no delays or defaults."
Perhaps White is singing the "all real estate is local" tune but we all know how that played out in residential: Prices dropped nationally for the first time since the great depression, and are poised for still more drops, especially in bubble areas like California.
It's clear the economy is slowing, the jobs picture is horrendous (see Moonbats Active Again in Massive Jobs Disaster) there is absolutely no reason for businesses to expand in this environment, and financing for deals has virtually dried up. And in Southern California, one market that appears strong at the moment "there is a flood of new construction in the pipeline." Those are "strong fundamentals"?
Flashback August 22 2007
Foolish Concerns, Foolish Optimism, Foolish Logic
Far from being the savior that many think, commercial real estate is soon going to get crushed. It is overbuilt, overloved, and due for a collapse. If Bernanke thinks he has a problem now, watch what happens when commercial real estate blows up. Fannie Mae (FNM) and Freddie Mac (FRE) might be able to keep people in their houses in lieu of foreclosure by renegotiating terms down and down again (for a while anyway but certainly not forever), but bank funding of unneeded strip malls is another thing indeed.I'm sticking with that story. So here we are, right near the tip top in commercial real estate insanity where no price was too high to pay for a building on the silly belief that property values would continually rise and lease prices right along with them. Few bother to note that commercial real estate is now staring over the abyss. Given how rapidly investor psychology is changing in this sector, it won't take much now to send it over the edge.
Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/
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