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Updated: Trouble in the Debt Markets: Housing Industry Woes Ooze into Commercial Real Estate

Plunging Housing Market Intersecting with Peaking Commercial Market Puts Economy at a Crossroad
July 25, 2007
The big question everyone seems to be asking (but no one really knows the answer) is will the spillover from rising housing loan defaults and foreclosures and plunging housing demand eventually drag down the overall economy?

There's no question that lenders and credit ratings agencies have tightened their underwriting as a result, which is having at least a moderate cooling effect on the commercial real estate sector.

But, at least for now, national economic indications don't point to the problems cascading across other sectors of the economy. Although there appears to exist widespread anxiety among real estate professionals that signs of trouble could show up soon.

The market is shrinking from the bottom up, Cary McCord, president of Murphy Commercial Realty Inc. in Clearwater, FL told CoStar last week

"We have seen a substantial drop off in buyer/tenant calls as well as broker calls relative to our listings. Our business division (the largest in Florida) is experiencing a slow down as well in business transactions," McCord said. "We have the distinction here in Florida of being the state with the second highest foreclosure rate in the country. Since the vast majority of properties being constructed have been housing units and small commercial projects, we now have a substantial amount of people looking for work. All of the peripheral support services that surround construction are suffering, i.e. developers, general contractors, lenders, title companies, sub-contractors, environmental, architects, engineers etc. All of these folks lease and purchase commercial real estate. Not any more!"

"My thoughts are that," McCord said, "we are in for a long hard pull and purchase prices and lease rates may take one step back before going forward. Possibly two!"

On the other side of the country, Christopher N. Bosley, director office brokerage for Cushman & Wakefield of California Inc. in Irvine, sees much of the same.

"I think the softening residential market has caused a lot of space to be put on the market for sublease," Bosley told CoStar. "Unfortunately, mortgage companies have poor credit and no one is willing to take the risk to sublease from them. The real impact will be when the sublease space is recaptured by the landlord upon default or end of the lease."

"Another factor is the credit markets," Bosley added. "The lack in confidence in the mortgage market and its impact on CDOs and CLOs is reverberating into CMBS market and causing increased loan rates for commercial buildings and pressuring cap rates. This impact is just occurring."

(Editor's Note: In this article we hear from a lot of CoStar Group news readers and the story is being updated regularly throughout the day. We'd like to post your comments on the economy or the story too. Tell us what you think. How are housing problems affecting your business? Or are they? How big an impact could it have? E-mail me at Read excerpts from pertinent follow up comments at the end of the story as they are added.)

The first couple of weeks of the third quarter have been dominated by more bad news coming from homebuilders and lenders. The usually strong spring housing market didn't spring, and in fact, continued to sink. And troubles in lending sector that came to light in the subprime collapse late in the first quarter started showing up on the bottom line in the second quarter reports.

"Following a disappointing spring, the housing contraction at present continues to be as intense, if not more severe, than in the pre-spring period," said Robert Curran, managing director and lead homebuilding analyst for Fitch Ratings.

Public homebuilders reported a decline in revenues and deliveries as well as much lower margins and sharply weaker profitability, excluding non-cash real estate charges.

In the latest indication that the housing market remains in a correction phase, building permits, which generally are a harbinger of future building activity, were down sharply last month for both single-family and multifamily construction.

"In view of current market challenges, we expect to see further erosion in housing starts during the second half of this year," said David Seiders, chief economist for the National Association of Home Builders.

Jeffrey Mezger, CEO of KB Home, the fifth-largest U.S. homebuilder, said last week he does not expect the overall U.S. home market to bottom out until the end of next year and that prices will not increase until well into 2009. It was one of the grimmest predictions by an executive in the housing industry.

The oversupply of existing homes on the market was thwarting his and other homebuilders' efforts to spur demand by cutting prices, Mezger said.

"If today new homes are priced below resale and still not selling, and you have this huge glut of resale inventory, until those prices get back down and they could go low enough for new homes to go down again, we're going to have an oversupplied market," he said.

Orlando, Florida is a prime example.

"The real housing problem is in the newer massive outlying subdivisions created in the last few years by the big national homebuilders in the popular price ranges," Mark Squires, a Realtor with Coldwell Banker Commercial NRT in Maitland, FL, told CoStar. "Huge overbuilding, with funny money negative am mortgages and hyped appraisals. Our board of Realtors MLS has gone from 5,000 listings to 25,000 in less than two years."

A Huge Battleship Heading in the Wrong Direction

Angelo Mozilo, CEO of Countrywide Financial Corp., agreed that the inventory in the house supply has to reverse itself.

"I think once that turns around, the psychology of the country changes," he said. "Because now the borrowers, potential buyers simply say, look, I will just wait, because I will be able to buy the house cheaper tomorrow than I can today. That psychology has to change; and the only thing that is going to change it is supply."

Mozilo told analysts this week that he hasn't seen anything like this market in his 54 years in the business.

"As I do reflect on it, and I do a lot," he said, "nobody saw this coming. S&P and Moody's didn't see it coming … they simply just downgrade bonds, they don't take hits. Bear Stearns certainly didn't see it coming. Merrill Lynch didn't see it coming. Nobody saw this coming."

"This is a huge battleship and it is headed in the wrong direction," Mozilo said. "First, we have to get it to slow down, then stop, and then turn. I think -- this is just a gut feeling -- based upon what I have seen in the past and the size of this market -- is that it's going to take 2007, the balance of this year, to get this thing to look like it is slowing down; 2008 to get it to slow down and stop; and 2009 to head in the other direction."

"My feeling is that by that time, you will have reduced competition, very substantial pent-up demand because of all of the people who have been closed out of housing, [and] probably lower interest rates," Mozilo added. "I do think that this ultimately has to have an effect on the economy."

Heading into the Reset Storm

Despite the absence of an economic recession, home mortgage delinquencies are surging, foreclosure rates are rising to multi-year highs and home values are falling. All told, an estimated 2.4 million owners could lose their homes, while investors may lose up to as much as an estimated $110 billion.

Bond rating agencies have downgraded hundreds of housing debt issues - some twice within the past three months. Most of the bond issues were backed by subprime loans made to borrowers with poor credit histories at relatively high interest rates and with interest rate escalation clauses built in.

Subprime loans have been a small but rapidly growing slice of the overall U.S. mortgage market in recent years and higher interest on those loans are now starting to kick in, in higher numbers too. Lenders who took out those loans are no longer able to keep up with their monthly payments.

J.P. Morgan Chase & Co. forecasted this month that by the end of 2008, subprime borrowers with home loans totaling $230 billion will not be able to refinance as they face higher rates, nearly quadruple the expected $60 billion this year.

"We are really heading into the reset storm," said Chris Flanagan, J.P. Morgan analyst. "We are on the cusp of that."

Two of Bear Stearns Cos. Inc.'s hedge funds that bet heavily on these risky subprime loans now have "very little value," the company said in a letter sent to investors last week.

Bear Stearns said in June it would provide up to $3.2 billion in financing to bolster up the funds. This week, it said it would probably seek "an orderly wind-down of the funds over time."

The fallout from the hedge funds' collapse is spreading worries about losses from the subprime investments throughout the capital markets.

Poor underwriting and investment decisions in subprime mortgage markets have led to the losses that are now even-handedly punishing lenders and investors, William Poole St. Louis Federal Reserve Bank president, said in prepared remarks last week delivered to a real estate group.

"I believe we should conclude that this year's markets punished mostly bad actors and/or poor lending practices," Poole said. "As is often the case, the market's punishment of unsound financial arrangements has been swift, harsh and without prejudice."

Nearly two-thirds of participants polled at Deloitte Consulting LLP's commercial real estate capital flows forum this week's said that commercial real estate will get "slimed" by problems in subprime mortgage arena. Participants said they were concerned about slow growth and said they believed there will be less liquidity in the market because of the problems.

FIRE is Going Out

Money has been the primary driver in the recent run up of commercial real estate values, as well it should be.

Commercial real estate returns are still an enticing 17% this year, said Dennis Yeskey, principal real estate capital markets for Deloitte Consulting.

So any bump in the economy that could restrict capital flow is a worry for the industry, and housing problems could be just that type of bump. In fact, Yeskey said, the spillover started showing up in early March. Commercial debt got more expensive and rating agencies started tightening up on underwriting standards.

In addition, weak residential investment subtracted almost 1 percentage point from overall GDP growth in the first quarter, Yeskey said, adding that historically as GDP slows down so do real estate rents.

Commercial real estate financing is already getting tougher, said Peter Gillin and associate with CB Richard Ellis in Anaheim, CA.

"I specialize in selling Class C apartment buildings in Class C areas in Orange County, CA (not the OC you see in Laguna Beach on MTV)," Gillin told CoStar. "I am seeing that the lenders are going through deals with a fine-tooth comb before approving the loan. For example, the lender on a C- asset in a C- submarket sent a licensed contractor out TWICE to inspect the property [the emphasis is Gillin's]. Then, they required a holdback in escrow equity to 5% of the loan proceeds. This makes closing deals more difficult."

To Donald A. Shapiro, president and CEO of Foresite Realty Partners in Chicago, too much liquidity in the market has been part of the problem because it could exacerbate conditions going forward.

"The housing slump is a significant sign of the inherent problems throughout real estate: too much liquidity combined with the wrong incentives for the production people employed in the debt markets," Shapiro told CoStar this week. "And artificially low interest rates a few years ago have created pricing that is not consistently attainable. This combination has encompassed most commercially reasonable markets and property types throughout the United States and will result in a downward spiral."

Rapidly rising housing values also contributed to the inflow of capital into commercial real estate said Bert Harrell, principal of The Wiley Cos. Inc. in Gainesville, VA.

"The most identifiable impact has been on the commercial office and industrial condo market," Harrell said. "In the last 24 to 36 moths, the commercial condo market was partially driven by purchasers extracting cash values out of their homes. Many purchasers were investors seeking to benefit from rising condo values. That too has cooled."

"Many of the same investors are now landlords seeking to rent the space," Harrell added. "In most cases they (the investors) will be at a disadvantage when marketing the space for lease. With decreased levels of office absorption in the market, the unsophisticated owner does not know about building the space out or the costs involved. Future buyers are going to be users looking for good opportunities."

The residential run up also has made it harder to get a return on small industrial properties, too, due to the run up in the cost and availability of land, said Michael F Flynn of Beacon Commercial Real Estate in the Philadelphia area.

"What concerns me is the lack of affordable suburban industrial land … partially because of the housing boom that took a lot of previously zoned industrial land out of inventory and ran the price up on the remaining parcels," Flynn said.

Flynn explained that to get a 10% return on investment in $100,000 piece of land required $1/square foot in net rent. Now, he said, "typical asking prices for industrial land are now in the $12 to $20 FAR range. That increases the required rent component to $1.20 to $2 per square foot. And that is making it harder and harder to make a good return.

Other ways the housing market has impacted commercial real estate is that the recent boom in home building supported by a lot of consumer finance related jobs, such as realty, title insurance, and mortgage companies, said Joseph S. Conwell, managing director of GPX Realty in Philadelphia.

"And as the housing market loses momentum, the demand for these services lessens, and business becomes slower, forcing companies to shed people and ultimately cut back office space," Conwell said.

"Just a few years ago, when interest rates were low, consumers leveraged their homes' equity to finance renovations and buy new and additional homes. Now, consumers' purse strings are tightening," Conwell added. "This will impact service companies dependent on consumers spending on homes. As a result, they won't need as much office space, leaving property owners with product to fill."

"We have seen clear indication of the slowdown in our office properties with mortgage companies and title insurance companies closing satellite offices or cutting back on the amount of office space they lease as they shed the employees they hired during the housing and refinance boom created by historically low interest rates," Conwell said.

The Sacramento, California, region for nearly a decade was one of the fastest growing residential regions in California and the nation. Builders were constructing on average 20,000 to 25,000 new houses per year. For 2007 most estimates are 8,000 to 10,000 homes, said Jim Gray, managing partner of NAIBT Commercial in Sacramento.

"Clearly the FIRE industries, (finance, insurance, real estate, and engineering), are affected by the slow down in residential real estate," Gray said. "Residential construction was a catalyst and made up a major portion of the regional economy. There clearly is some fall-out. The failure of mortgage brokerage companies -- bankruptcies, closings, pull backs, lay-offs etc. -- are apparent."

Gray added that retailers and retail developers historically "followed the rooftops".

"Well now a lot of that growth has slowed or stopped, a large percentage of the retail is partially leased, and the existing retailers aren't supported by enough population and households to make enough revenue," Gray said. "When the leases start rolling over and when the spec developers need to get their permanent financing-- another shoe will drop."

9 of the Last 5 Recessions

That housing is already impacting commercial real estate seems clear, what is not is how big an impact will it be.

Economist and government banking officials are hopeful that it won't be much - or at least won't drive the economy into a recession.

"A popular joke tells us that economists have forecast nine out of the last five recessions," wrote Keitaro Matsuda, senior economist for Union Bank of California, this week in his monthly economic outlook. "Economists always seem to be warning the general public of one risk or another that is supposed to undermine the health of the economy. Over the past few years, the risk most commonly cited by those more pessimistic members of my profession has been the housing market."

Matsuda said the spillover into the general economy has not been severe because employment growth has remained steady.

"Recent employment and industrial production data show that the economy still has good momentum. Consumer spending remains robust and business investment has increased," he wrote. Because the ongoing housing correction has turned out to be gradual, it would likely take a bigger shock (perhaps combined with decreased residential investment and construction employment) to send the economy into a recession."

(Editor's Note: Let us know what you think. How are housing problems affecting your business? How big an impact is it having? How big an impact will it have? E-mail me at Read excerpts from pertinent follow up comments at the end of the story as they are added.)

Follow Up Comments from Readers

No Major Adjustments

Tampa continues to have little vacancy for industrial and office space. We are seeing a slight uptick in vacancies for flex and office as homebuilders and their complimentary businesses are subleasing or not renewing. We are seeing an increase in sublease space as well.

However, Florida has 18 million people and they need services, so new companies continue to move to Tampa, companies are continuing to expand so I believe we will see some adjustment, however, no major adjustments in the market place.

Mary Clare Codd
Senior Office/Industrial Specialist
Colliers Arnold
Tampa, FL

OK in NJ

In New Jersey commercial real estate, we are not seeing the same "spillover" as others industries. Yes, tenants are locking in current rental rates by renewing leases as opposed to relocating. Yes, contractors are charging more due to the higher costs of raw materials, which is affecting the level of work allowances offered by landlords. However, vacancy rates are declining across much of Central and Northern NJ and we are seeing new construction (or plans for new construction) of several buildings from Red Bank and Princeton to Woodbridge (MetroPark) and Parsippany.

Michael A. Gordon
Cushman & Wakefield of New Jersey Inc.
Edison, NJ


In Kentucky we have also seen a large reduction in home sales but the housing market seems to have caught its footing. We must remember we just came out of record sales for a record length of time. When you cut this back to what would be a good stable growth that is sustainable, I don't think that we are that far off.

When you look just outside of Louisville you will see that smaller counties like Spencer County, which is working hard to build a tourist area around the lake, have stabilized and are now moving forward at a steady rate.

Too many homes on the market? Yes but when people look to buy here they are looking to buy within a 30-minute drive of Louisville. They are looking to get away from the bustle.

Commercial that's another question here. The market is tight but with a fiscal court that is aggressive and while there are state incentives available, Spencer County is the perfect location for a company to locate from out of state. Just recently, a new company came to locate here and they will receive $300,000 in incentives for the relocation and as they grow and hire more people, they can receive more. For this reason and the fact that construction cost and land cost are much lower in Spencer County, I feel that we will continue to see more companies locate here -- especially mid-sized companies.

This is the way that I feel the market is heading: incentives for companies, aggressive small counties like Spencer County, KY, will continue to pick up small- to mid-sized companies and bring more jobs and also more home sales in the future.

Bill Drury
Metts Company Realtors

Steady Demand Continues

Charleston, South Carolina, continues to grow. Steady demand from medical, education, defense, tourism and Port related industries as well as continued rapid growth of the second-home market has kept residential more on track than in many areas. Homebuilders and attendant industries are not expanding as they once were, but we do not see much contraction either.

The office market continues to experience rapid absorption and low vacancy rates. Rents are increasing due to higher land, construction, finance and operating cost, but so far tenants have continued to prefer the newer buildings with their more efficient floor plates, and adequate build out allowances. The market has shown great resilience during the past five years, and we see no signs of a slowdown on the horizon.

Marcus R Durlach, IV
Durlach Associates
Charleston, SC

Here's the Beef

As the economy heads downward, people will change eating habits. Not only eat out less, but also choose less expensive venues. Also, their home consumption of beef will decrease. In both cases higher quality beef cuts, such as Sirloin, T-bone, Porterhouse, Prime Rib, etc. will be replaced with lower cuts such as Round steak, Chuck Roasts, etc. This will impact all beef producers but most especially those of us raising such quality beef as Registered Black Angus.

As the beef industry turns downward, more farmers will decide to exit the farming lifestyle. Their land thus becomes available for alternate uses. Does this not, in turn, lead to a glut of land?

Also, as that industry slows down so to does the demand for new farm implements such as tractors, trucks, hay bailers, forage wagons, etc. And of course that simply adds to the downward economic spiral. Just as we are in a global economy, so to are we in a totally integrated economy. That is, every section in some way interacts and affects every other section.

Bob Swanson
Elmark Farms
Monterey, TN

Risk Has Come Home To Roost

I am an 18-year Realtor and veteran of the commercial real estate business. I have noticed in the last six months that the velocity of money has slowed considerably. Many of my landlord customers, who pay me commissions annually for long-term leases, have been slow to pay those commissions. In several cases, they have refused to continue paying commissions on these long-term leases. These are the same landlords who at the inception of the lease refused to pay the full commission in advance. Instead, the landlords opted for a long-term commission schedule paid annually over time. The long-term schedule generally is more risky to me; so, the commission rate is slightly higher. It seems my risk has "come home to roost."

The reason our current problems are not yet showing in the national statistical analysis is the same old reason: Developers only know how to do one thing and that is build, build and build some more in spite of the oversupply of inventory ... all they know how to do is build. This flawed, blind strategy keeps employment numbers, starts and building permit statistics up long after the buyers have left the market. By the time these houses are completed, it is to late to have any options except to lower the prices of the houses. This pattern makes an orderly resolution of the excess supply more difficult. It appears, according to your article, that the market has reached that point in Florida and California.

Jim Hoch
Coldwell Banker Commercial Bennett Williams
Harrisburg, PA

Careless Headline

I do not agree with your latest article. Something about "woes ooze into commercial real estate." In Tampa and throughout the rest of the state (and probably the country) this has not been the case at all. Underlying market fundamentals remain very strong. Demand isn't at the unprecedented pace that it was when housing was on fire, but it is still healthy and everyone I have spoken with is confident in the market and the fundamentals.

Headlines like the above are careless, unsubstantiated and negatively impact our industry.

Rick Narkiewicz
First Vice President, Industrial Properties
CB Richard Ellis
Tampa, FL

Follow the Smart Money

It’s playing economist and market psychologist to suggest this, but thus far whether for this reason or otherwise I’ve been quite right on: interest rates have hit their highs for this year. In May I had clients literally panic-locking rates on deals, with one client closing seven deals in one week as rates were rising against them and another client signing a lock at an interest rate for a refinancing that was higher than I had seen on a deal in two years. My position was very strongly to wait and let rates come back down (thankfully they did very quickly).

The GOOD news for the commercial markets is that interest rates have enabled, if not driven the cap rate compression of recent years, and the rise in rates and the widening of spreads in the CMBS and CDO markets has helped cool things off before they got too dangerously out of hand. However, those that are panicked thinking that the good times are all done now aren’t seeing that if the Fed allows rates to go any higher the subprime and ARM reset situations will turn into a national disaster for the economy and there is no way they are going to let that happen, so rates can’t head higher for any time soon.

It is actually the problems with the housing market and the consumer debt levels that will hold the economy in check and at the same time will, by forcing the Fed to keep interest rates low, keep debt costs low and the commercial investment market, therefore vibrant.

Lastly I’ll note that one client of mine, one of the larger privately held real estate companies in the country, had completely stopped all domestic investment for the past six months. They have just now decided to start re-investing domestically, specifically in multifamily projects in middle markets that are conversion potential - with a deliberate target of three years out before they will condo convert them. In my experience, they were the first guys to see the trend moving against the housing market and to get out of it, and if they are now the first guys getting back in, I’d follow them as the smart money.

Gabriel Silverstein
Angelic Real Estate
Chicago IL

Cali Caliente.

The state of the housing market in Southern California is rather as ironic as it is in most the country: while sales are down to their lowest point in 14 years, the median price of the single family home has increased over 25% in most areas, with the exception of the Inland Empire. Unlike others in the housing industry, I saw the downturn as imminent, it simply doesn’t make any sense to continue to build $1M plus product when affordability ratios are at 14%, as they are in San Diego County.

However, the industrial market in Los Angeles is stronger than ever; vacancy rates are at all time lows of 2.4% and rents have increased on averaged 8.9%. Apartment occupancies are at 97% on average and are expected to grow at least 5% this year alone. Office vacancies are at a 15-year low at 10%.

What accounts for Los Angeles being such an obvious outlier to the data? Most likely it is the continued population growth and modest job growth numbers we are seeing. Supply is extremely constrained: there is simply no vacant land out there to build upon anymore, and whatever infill is available is getting to be too expensive to build upon. More and more opportunities are going to have to be found in cleaning up dirty dirt, exemplified in large funds like those being put together by Cherokee Group, which just raised over $1B to acquire contaminated properties, of which Southern Cal has plenty.

At any rate, the Southern California commercial real estate market is still hot. On the other hand, I would expect the next downturn to happen in the retail sector beginning in the Inland Empire, followed by office properties in Los Angeles and Orange Counties.

John J. Tilley
Manager of Real Estate
Jacmar Builders
Alhambra, CA

Ramping Up

Historically commercial values have always been a lagging indicator of the residential market. All rating agencies are predicting a spike in CMBS loan defaults this fall.

We have ramped up to purchase billions in distressed debt secured on commercial real estate nationwide through 2009.

Rick Russell
Newport Special Asset Fund
Newport Beach, CA

No Cap Rate Increases

We are seeing a slow down in retail sales volume in Southern Cal both based on the stats that you publish and in our day to day business. There have been fewer portfolio transactions as well. However, we have seen no cap rate increases on the retail side. Most of the increase in average price/sf is driven by higher NOI, not cap rate compression.

Richard West
Vice President
CB Richard Ellis
Newport Beach, CA

Need Workers for the Harvest

I am a real estate broker specializing in commercial, however, gloom and doom stories do not help! A year ago, i moved from South Florida to Daphne, Alabama, (Baldwin County area) and things are almost booming, so far. Banks are coming to this area. Bass Pro Shop, Penney's, Honda and Toyota new car dealerships are in construction phases as well as a new cancer hospital. New Lowes and Sam's Club recently opened in Daphne. Alabama has encouraged new manufacturing companies to come to Mobile. Auto manufacturing and a new German steel mill is coming to mobile (Thyssenkrupp) and bringing 3,000 jobs. Our problem in Alabama is we need workers! I hope with the federal government would realize the home buying and home building industry need fed help with very low interest rates to keep the economy going so everything does not slow down.

Robert Ciani
Broker Associate
Southerland Realty
Daphne, AL
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