So where is the commercial real estate market really headed?

Latest Economic News Headlines

June 22: Fed officials see the U.S. economy settling into a disappointingly weak recovery, and say they have done all they are prepared to do…

July 27: U.S. Durable Goods Orders Unexpectedly Sink in June

July 29: GDP 2nd Q shows an expansion of only 1.3%; 1st Q downgraded to .4% from 1.9%

August 1: Euro-zone Manufacturing at near Standstill In July

August 1: U.K. Manufacturing Shrinks In July, PMI Shows

August 1: U.S. Manufacturing Activity Falls to Lowest Level in Two Years

August 2: Personal Spending Falls for First Time in Almost 2 Years

August 2: “Tens of thousands of layoffs are being reported daily. I stopped my search after the first twelve listed companies. They average close to 7,000 layoffs each…80,500 in total.”

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It is a known economic fact that Commercial Real Estate is a lagging economic indicator.

It has always been and always will be.

If you truly believe the commercial real estate market operates in a vacuum and is not affected by overall economic conditions then stop reading here.

I have waited over 100 days to write another Blog after my last article titled “Commercial Real Estate Predictions that Defy logic”. I waited as I received so much push back that I was wrong and just being negative. I waited to see if I had been correct in my analysis.

Well the verdict is in…With the above headlines pouring in it is not with happiness that I write this article, rather it is about caution and realism.

It appears the recent commercial real estate headlines are full of optimism.

Reports of record sales and high sale prices, low cap rates, and increasing leasing activity can be read in every trade magazine and business section including those published by the commercial real estate data/information providers. The data providers don’t just report the “facts” anymore they now have begun to put a spin on their “news” releases. I guess they want to prop up the hand that continues to feed them.

Well I hate to be the one to burst the proverbial bubble. Do not believe any of this publicity because that is what it is all hype. Have there been some high profile purchases by high end investors scrambling to find yield in the Top U.S. markets, yes. Has there been some leasing activity going on, yes, but not enough to move the vacancy needle to any extent worth noticing.  As one Federal Reserve Governor was quoted recently, “Flat is the New Up”. That speaks volumes as to what is going on in the commercial real estate sector. Now that the economy is contracting, and low GDP will beget even lower GDP due to the less than robust so called “recovery”, there is only one way commercial real estate can go…and that is down. I would look at the commercial real estate market as having reached its “Post 2007-2008 recession” highs at the end of the 2nd Quarter.

Commercial real estate people have never operated in this type of an economic environment and really have no clue as to what is going on or where the market is really headed never mind how to navigate in these deeping troubled waters.

You hear reports that banks are lending again. That is just not true. Is there some lending of course, not the lending these “news” releases would have you believe. The Securitized (CMBS) Mortgage market is reported to be all giddy about the awesome volume this lending sector is achieving. I guess if going from Zero to 1 is an accomplishment, then yeah get excited. CMBS lending reached a peak in 2007 at $260+ billion. Now the news releases are trumpeting a high water mark of $40-$60 billion.

There are also reports which indicate the CMBS “underwriting” standards have loosened up a great deal since the collapse. That is a matter of perception and not knowing specifics it is hard to comment. I highly doubt they have gotten that much less rigid.

Industry folks are saying “Oh there is plenty of money for commercial real estate financing”…false again, and what financing there is does not come without a steep price and you need to know who is doing the borrowing. What you are not reading are the terms of these finance deals such as the equity to debt ratios, the terms of the mortgage, the debt service ratios, and all the little details which would tell the average reader following this aspect of the market where reality lies.

There was a report just the other day which said the Banks are sitting on so much cash. I am sure that is true, that being said, they are sitting on that as a direct result of the Federal Reserves’ QE2 intervention, which was to keep the banking system appear solvent and interest rates low.

Small business lending is down, due to the lack of demand by small businesses not needing to borrow because small businesses are stagnating and not expanding. Small business was the economic engine that fueled the last upward economic cycle and was responsible for the majority of the job creation within the United States. Not anymore.

There are reports the private sector is ready to unleash their money to hire again. I would suggest that report will need to be re-visited in light of the above headlines.

On top of all the above you have a contracting Federal Government whose physical footprint is shrinking. As evidence one rather large lease (1 million sq. ft.) for the DHS was just canceled. Why…because Congress would not fund it. There is going to be more of the same. Here is a quote from Real Estate Digital publication Biznow for the DC market, rated the best commercial market in the good Ole US of A from Grubb & Ellis suburban MD research head Jessica Mistrik told us most leasing activity in the area the next few quarters could be renewals, and some of those could be downsizing, like IBM, which shrunk from roughly 180k SF to 60k in North Bethesda. What this means is layoffs plain and simple. No other way of putting it.

Retail vacancy rates in shopping centers and strip centers is going up not down. The WSJ reported on July 8th “Vacancy rates at U.S. malls and strip-mall centers continued to rise in the second quarter as small-store owners struggled…” Add the lowered consumer spending numbers and what do you get…Yep a challenged retail real estate sector.  This contradicts the Retail Real Estate’s Industry Standard bearer ICSC. But then again what would you expect from an Industry Trade organization just as the NAR has lost all credibility.

June’s unemployment rate jumped to 9.2%. “The U.S. added 18,000 jobs in June and unemployment ticked up to 9.2%, dashing hopes that the economy was getting back on track”...according to the WSJ of July 9th. Just today August 2nd ”Job Creation Stays Flat As Employers Still Playing it Safe: Gallup Poll shows.”

The “new” reality of The United States is it will not be able to have an unlimited ability to print money. This factor is going to add to the misery index especially as it relates to business expansion. Less business expansion means less companies hiring which means stagnant or decreased occupancy levels for all commercial real estate sectors. Already in the DC suburbs namely in Maryland, job creation has stalled. The reason is the area’s high dependency on the Federal Government and its private sector contractors for jobs. The contractors both big and small that are starting to feel the pain of decreased Federal Spending. This begins with the Defense contractors all the way down to the home based business which have Federal contracts or are sub-contractors to the major Fed contractors.

The other negative is the continuing housing crisis. Reports indicate that foreclosure activity has slowed but in general this sector is still a very long way off to regaining any semblance health. And as I have been preaching nothing will get better with the economy until the housing market regains its health, whatever the new normal will be for it to be considered healthy.

Pending home sales figures dramatically dropped due to potential buyers canceling their contracts due to the inability to obtain financing. The reports stated the biggest reason is the appraisal values have been coming in lower than the sale contract prices and the buyers not having or not wanting to make up the difference needed in cash for the short fall in financing. Home ownership is at a 13 year low according to the NAR.

So the question that begs an answer is…How does the commercial real estate market have any chance of demonstrating it is growing healthier by each passing fiscal quarter faced with these hurricane force economic headwinds? And what justification is there to invest in commercial real estate faced with these formidable obstacles? These optimistic articles and predictions are based on smoke and mirrors and pure fantasy.

Some say the opportunities are there to buy at much reduced values. OK, how do you finance them and more importantly how do you sustain your ownership if the property is experiencing moderate to high vacancy?

The short answer would be for investors to stay away unless you have unlimited financial staying power. Tenants on the other hand should actually look to take advantage of this commercial real estate cycle if for no other reason to move up in the “Class” of their building and space. But be careful in this regard as well. Tenants want to make sure they are dealing with a landlord who is solvent and can perform the TI (Tenant Improvements) on the tenant’s behalf.

So the bottom line question is “where is the demand” for commercial real estate space going to come from with the current state of the economy the way it is and will continue to be, and what sector of the commercial real estate market will be the beneficiary?

I would be interested in your feedback.