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Commercial Real Estate on Borrowed Time?

Back in 2009 it seemed obvious that the next shoe to fall -- or bomb to go off -- was commercial real estate. The thinking went something like this: homes go into foreclosure fast, when the mortgage holder loses a job, or the monthly payment adjusts to some ungodly number that dwarfs the hapless homeowner's disposable income, or they simply realize that they can rent a similar house for half the money. Commercial properties take longer to fail because an office building or strip mall has multiple tenants with leases that renew at different times. So even in a deep recession a project might limp along for months or even years before the total number of tenant defections turns its cash flow negative.

2010 was supposed to be the year that thousands of overleveraged commercial properties finally slid into default and took their regional and local bankers down with them.

But like so many "obvious" events, the commercial real estate bust didn't happen. Massive federal hiring supported consumer spending and demand for office space, while extremely low interest rates made it possible for marginal properties to refinance on favorable terms. Lately it has begun to look like commercial real estate might return to "boom" without passing through "bust".

Nope. The government spending part of the equation is about to go negative. See Government Cuts Clip Office Market

Smaller government means less demand for office space, and that is acting as a drag on the recovery of the commercial-real-estate market.

In Washington and elsewhere, government leasing has helped prop up demand in tough times. But now cash-strapped governments are moving to cut back on office space, even as commercial real estate struggles to recover.

In Washington, which has benefited from a surge in space rented by government agencies, the Securities and Exchange Commission renegotiated a 900,000-square-foot lease for new office space down to about 300,000 square feet because the agency didn't get the congressional funding it had counted on to hire new employees.

"We're starting to see the impact of a very, very difficult fiscal situation in the government trickling down to decisions being made for leasing," said Don Miller, chief executive of national landlord Piedmont Office Realty Trust, which will lose the Office of the Comptroller of the Currency as a tenant in at least one building in the wake of the agency's decision to move into some of the space no longer being leased by the SEC.

The biggest impact is likely to come on state and local levels. The states of Illinois, Missouri and Kansas recently hired brokerage firm Jones Lang LaSalle Inc. to reduce real-estate costs, and other states, from California to Florida to South Carolina, are examining ways to pare back their use of space, brokers said.

Investors have taken notice. J.P. Morgan Chase & Co. analysts said in a note to clients recently that real-estate investment trusts, or REITs, with a lot of government exposure "should be watched more closely in a budget-tightening environment as renewals may not be the lay-ups they once were." And REITs with lots of government leases have lagged behind peers in recent months.

Brokers and investors expect government demand to slow down. Research firm Reis Inc. predicts occupied office space in Washington will increase by one million square feet this year and about 800,000 square feet next year, compared with a jump of 2.8 million square feet in 2010.

The New York City government has vacated 380,000 square feet since last year when Mayor Michael Bloomberg launched a push to move out of 1.2 million square feet of city-leased space by 2014, for a projected annual savings of $36 million. The program involves consolidation as well as moving toward more open work spaces.

Florida's portfolio of leased office space, at 8.3 million square feet in 2008, has shrunk about 5% since then, said Ann Duncan, president of Vertical Integration, a Tampa, Fla., firm that advises governments, including the state of Florida, on real-estate use. She predicts another decline of roughly 500,000 square feet this year.

Rents have been rising in some prime markets since the depths of the downturn. In Washington's Georgetown market, effective rents were up 2.2% in 2010, according to Reis. In Midtown Manhattan, rents rose 0.2% during the year.

But in many markets rents actually fell last year, with net effective rents down 1.5% nationally, according to Reis. If government agencies contract without the private sector expanding more, downward pressure will continue, some predict.

And In California, Dreams May Turn to Nightmares

Just as the California commercial real-estate market begins to stir from its post-crisis lows, many property developers fear they are about to lose a financing tool needed for hundreds of projects across the state.

Builders are lashing out against a provision in Gov. Jerry Brown's proposed budget that would eliminate the state's 425 redevelopment agencies, local authorities that pay for low-income housing as well as roads, sidewalks and other infrastructure.

The developments cover everything from a proposed $2.2 billion project with houses, shops and transit access across the river from downtown Sacramento to a planned affordable and senior housing development and child-care center near downtown San Diego.

The bond debt that finances infrastructure projects is paid off using part of the increases in local property-tax revenue that result from the development. Under the current model, any extra revenue goes back to the agencies to pay for low-income housing and other improvements. Gov. Brown, whose budget proposal could be voted on as early as this week, said any increased property-tax revenue would be better used to pay for schools and other services.

The plan comes at a dismal time for the construction industry in California, whose boom and bust were more striking than nearly any other state. Construction jobs in California have dwindled to 559,800 from 933,700 at the peak of the housing boom in 2006. Redevelopment has been a rare source of funding for new projects.

California isn't alone in its budget woes: 44 states face projected budget gaps for fiscal 2012, according to the Center on Budget and Policy Priorities, and other states have eliminated tax programs that benefit developers. California's budget hole, projected to be $26.6 billion in 2012, is the largest in the country.

Some thoughts:

  • Governments at every level in the US are just waking up to the fact that they're broke, so public sector employment -- and demand for office space -- will decline for years. This is secular, not cyclical; today's cuts will be followed by bigger ones in 2012 and beyond.

  • Commercial real estate busts usually take the marginal, lower-quality properties first. But a lot of the office space now leased to government agencies is relatively high-end, which means some of the better buildings will be under pressure soon.

  • Low interest rates will continue to help, but as bankers notice the above trend they'll be less likely to lend to commercial properties, regardless of the yield on Treasury notes. So the prime rate might stay low but it won't be available to most developers.

  • This validates the observation that the next bubble asset is never the previous one. The liquidity created as the US monetizes its own debt is bypassing real estate and flowing into gold, silver, food and oil.

 

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