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Tuesday, May 15, 2007

Commercial Real Estate: Slump Ahead?

by Calculated Risk on 5/15/2007 08:44:00 PM

With the release of the Fed Loan Survey, we can connect another dot in the possible Commercial Real Estate (CRE) slump later this year.

Fed Loan Survey Nonresidential InvestmentClick on graph for larger image

The first graph shows the YoY change in nonresidential structure investment vs. loan demand data from the Fed Loan survey: Net Percentage of Domestic Respondents Reporting Stronger Demand for Commercial Real Estate Loans

Unfortunately the demand survey data is only available since 1995, but the correlation is clear: falling demand leads lower investment by about a year. The causation is obvious, loans taken out today impact investment over the next couple of years.

This is more evidence that the normal pattern will hold: nonresidential structure investment will probably follow residential investment "over the cliff".

Here are some earlier dots:

1) Non-residential structure investment has been booming for the last few years. Commercial rents have been rising and office vacancy rates have been falling. But signs of a trend change are emerging, from the IHT on May 2nd: Alarm raised over U.S. commercial real estate lending

... signs are emerging that the office market is slowing down in the United States. Though rents continued to rise in the first quarter of this year, the average vacancy rate for 58 U.S. metropolitan markets rose to 12.6 percent from 12.5 percent, the first increase for any quarter since 2004, according to Torto Wheaton Research, a division of CB Richard Ellis.
Residential vs. Nonresidential Investment2) This graph shows the YoY change in Residential Investment (shifted 5 quarters into the future) and investment in Non-residential Structures. In the typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for four straight quarters (following two minor declines). So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

3) The WSJ noted earlier this month that demand was "sluggish" for office space. The current office space absorption rate is about 8 to 10 million square feet per quarter, but "... developers will open 76 million square feet of new office space by the end of this year." Since supply will grow significantly faster than the absorption rate, vacancy rates will rise.

4) Many banks are over-exposed to CRE lending. With rising vacancy rates, defaults will probably start to rise for CRE loans.

And remember, non-residential investment is the great hope of the soft landing view. That is why many economists are watching non-residential investment closely.