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Friday, August 24, 2007

Pearlstein on Commercial Real Estate

by Calculated Risk on 8/24/2007 11:41:00 AM

Steven Pearlstein writes in the WaPo: Commercial Real Estate, Come On Down

Here's the next shoe to drop as a result of the bursting of the credit bubble: commercial real estate.
In markets like Washington, New York, Boston and San Francisco, the last four years have been among the best the industry has ever seen -- falling vacancy rates, rising rents, soaring values and a ton of new development. Now, that's all about to come to a grinding halt as financing becomes more expensive and more restrictive, the economy slows and a big slug of new inventory hits the market.
As a reminder, in a typical business cycle, investment in non-residential structures follows investment in residential structures with a lag of about 5 quarters.

Residential vs. Nonresidential Structure InvestmentClick on graph for larger image.

This graph shows the YoY change in Residential Investment (shifted 5 quarters into the future) and investment in Non-residential Structures. In a typical cycle, non-residential investment follows residential investment, with a lag of about 5 quarters. Residential investment has fallen significantly for five straight quarters. So, if this cycle follows the typical pattern, non-residential investment will start declining later this year.

Right now it appears the lag between RI and non-RI will be longer than 5 quarters in this cycle. Although the typical lag is about 5 quarters, the lag can range from 3 to about 8 quarters.
... in markets like Washington, the pace at which buildings have been leasing has slowed even as a large number of new buildings are about to come on line.

According to the latest data from CoStar Group, for example, office vacancy rates along the I-270 corridor have risen to 11.6 percent from a low of 9.7 percent a year ago. Buildings under construction will add another 5 percent to supply over the next two years, with roughly a third of it pre-leased.

The market in the Dulles corridor is also beginning to weaken. There, the vacancy rate is up to 14.2 percent from 13 percent in the past year, with nearly 4 million square feet of space under construction, equal to about 8 percent of current supply. After four years of steady growth, rents are beginning to flatten out.
Pearlstein also discusses tighter lending impacting commercial real estate (CRE). This fits with the recent survey from the Fed: The July 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices

Commercial Real Estate Lending

Lending standards for commercial real estate loans were reportedly tightened further over the past three months: About one-fourth of domestic institutions—a slightly smaller net fraction than in the previous survey—and about 40 percent of foreign institutions indicated that they had tightened lending standards on commercial real estate loans in the July survey. Regarding demand, approximately one-fourth of domestic and foreign institutions reported that demand for commercial real estate loans had weakened over the past three months.
And that survey was pre-turmoil. I also suspect Pearlstein is correct and that CRE is the 'next shoe to drop'.