Whistling Thru the Graveyard: Could CRE Follow Housing into Another Trough?

Housing and commercial real estate are seemingly going in opposite directions nationally with housing prices and sales totals continuing to fall and CRE markets taking steps toward recovery. However, the fear of a double-dip housing recession is tangible - if not real - and continues to tug naggingly on the CRE industry.

When the recession began in 2007, the commercial real estate markets declines lagged but eventually paralleled the declines of the hardest-hit residential markets. If housing goes into a double-dip recession, the question many are wondering if commercial real estate is likely to follow? That was the question we put to a variety of CRE professionals and analysts.

"We are firm believers that the growing (residential) shadow inventory is causing normal buyers and sellers to pull back. This is reinforcing downward pressure in the residential market," said Gerald A. Klassen, research analyst for the Real Estate Center at Texas A&M University in College Station, TX. "With an estimated 2 million more homes headed for default in the next two years, I think the expectation of falling prices may become self-fulfilling. The only way out is to clear the market - and fast."

"If the banks are permitted to sit on inventory, then it could take years to clear just like after the Depression. This will leave real estate in a zombie state that will continue to be a drag on the economy," Klassen said.

"I am questioning the recovery in commercial real estate. The recovery has been very bifurcated," Klassen said. "Trophy properties in prime markets are fetching bubblicious prices because large institutional investors have cash burning a hole in their pockets. But from the folks we speak to, the secondary markets are still very dead."

"The risks we face in 2011 are greater than 2010," Klassen added. "The most significant risk is the end of fiscal and monetary stimulus in the first half of this year. It will take a lot of steam out of the economy. To me, prudence would dictate waiting until the end of summer to see how things pan out. By then, we will also know the extent of state and local government job losses, which may be significant according to what we are hearing in Texas. I wouldn’t want to be signing pricey contracts before then."

How real the recovery feels also seems tied to where respondents were located. Not every market across the country is experiencing diverging conditions. Tom Watson, managing broker of RE/MAX of Spokane-Commercial in Spokane, WA, said he doesn't see Eastern Washington's commercial market improving significantly over the near term.

"Closed sales from both sectors are lagging behind either of the last two year's numbers," Watson said. "It looks like our double dip has begun. Until the residential market smoothes out, little money will be available via traditional commercial sources."

And Paula Greer, an appraiser with Black & Associates in Portland, OR, said the concept of a double dip real estate market implies that values went back up.

"As far as I can tell from statistics here in the Portland market, there may have been a slight hiccup in residential home prices about a year ago. But it was more like a leveling out before they started trending downward again," she said.

"After hunkering down for the last couple of years, the investor segment is cautiously reappearing. From an appraiser perspective, it appears that they are being more selective about properties that they will invest in," Greer said. "This is a function of two factors: banks just aren't as aggressive with their underwriting as they were in the pre-2008 days; and there is a more limited inventory of good quality investment properties available for sale."

"From my work perspective, the biggest impact on the acceleration of the commercial real estate market here in Portland is the re-emergence of banks that are willing to actually part with some of their stockpile of funds and actually start lending again," Greer said. "I think that investors are starting to believe that the tsunami is not going to hit here and that it is time to get back to business as usual."

But the consensus is certainly not unanimous. While some question whether CRE is in recovery, others are seeing a turnaround in the fortunes of housing.

One of those seeing a silver lining to the current housing market is Frank Nothaft, Freddie Mac's chief economist, who said he expects "to see a bit of spring in homes sales activity during the second quarter. Sales contract signings for existing homes were up in February, positioning the market for a bounce up going into the traditional homebuying season."

Nothaft is projecting a 5% increase in 2011 home sales over 2010, on a calendar year basis.

For now, however, the majority of CoStar News readers appear to be taking a less-sanguine view on the housing market. Kevin White, a real estate strategist with the CoStar Group, concurred with the general sentiment that there are significant differences that have "unhitched" housing and commercial real estate at this stage of the economic recovery that will allow them to continue in diverging directions.

"Although the ties between housing and CRE are compelling, there remain important differences," White said. "Households may suffer more psychological scars from the (housing) bust, have more limited access to fresh capital, and be less inclined to appreciate real estate's value relative to other investment alternatives (whose prices have rocketed), all factors that would hinder housing's recovery compared with that of CRE."

"Most important," White added, "although the CRE market has had its share of government intervention (TARP, TALF, PPIP, etc.), these measures were far-less distortive than the homebuyer tax credits, which stabilized the market by pulling demand forward. While the housing correction, having been temporarily suspended, has further to go, the less-inhibited CRE correction has largely run its course."

Gary Tasman, executive director of Commercial Property Southwest Florida LLC in Fort Myers, FL, also noted that housing and CRE went into the recession with far different fundamentals.

"Traditionally there exists a lag in the commercial real estate market as it relates to the housing market. Commercial real estate typically lags between six and 18 months behind residential," Tasman said. "So it is a natural assumption that if the housing market double-dips, so too will the commercial real estate market."

"However," Tasman added, "given the significant difference in overbuilding between housing and commercial (specifically in the Southwest Florida area) - it is significantly more likely that housing would be a slower market to recover than commercial."

That slower recovery will weigh down CRE's recovery but not drag it down.

"Most commercial brokers in our area, despite positive data from first quarter, are currently feeling a small lag in prospective lessees and buyers," Tasman said. But "because the overbuilding in commercial real estate was not as extensive as the overbuilding that occurred in residential, I am optimistic that population growth coupled with lack of construction volume will inevitably absorb excess space and drive rental growth."

What follows are excerpts from additional comments that CoStar received from readers addressing this question.

There's Money for Businesses, While People Wait for Money for Housing

Commercial is doing better as people are out there starting businesses or expanding businesses; the stronger survived and now grow to provide services to the market with less competition - people are going back to work - even though unemployment stays high. This will lead to additional consumer confidence I would hope as people have money to spend...seems like this will lead us out of this

Housing won't come back until people stay in their homes - instead of moving out and into apartments and are able to get back on their feet with work. If the above commercial trend continues and people can stay in their homes with new jobs, new home sales (and permits for new construction) will increase again instead of people buying the multitude of cheap foreclosed, short sale and underwater homes.
Stuart Thomajan, a venture capitalist with The Chameleon Group in Austin, TX.

Decisions of the Head not the Heart

One quick simple answer is commercial investors could be motivated by inflation concerns and wanting to get cash into real estate before it takes off and residential decisions are driven by individuals, the avoidance of debt, and the fear prices will dip further.

Commercial is a business decision verses an emotional decision for homeowners. An apartment provides shelter just like a single-family home without the risk or capital requirement and personal debt. Quality, well located properties are still occupied with quality tenants paying rent. The poor quality properties are deeply discounted and not selling, as is always the case in a down market, quality sells and the rest wait/hope for a recovery.
Robert L. Muller II, CCIM, director of real estate services at MMA Real Estate Advisors LLC in Atlanta, GA

Waiting for Unemployment To Improve

In my practice, we do residential in Santa Clara County (CA) and we have a commercial project in San Benito County (CA). What we're seeing both in residential and commercial is that everything seems neighborhood and product specific.

In Santa Clara, nice homes in nice areas get multiple offers while average homes in average areas will sit unless priced aggressively.

In San Benito, commercial is at a standstill, and we've lowered prices numerous times without any increase in activity. We keep waiting for unemployment to improve hoping that's what's needed to stimulate this county.
Lee Schmidt, principal of County Property Exchange Inc. in Morgan Hill, CA

Pent Up Business Demand

I think commercial real estate is recovering in selected areas only. There are more investment sales, as the credit markets are opening up again. There are bank-owned properties that are being sold to get them off the balance sheets and plenty of opportunities for investors in distressed properties that are slowly working through the system.

Select office markets, such as New York City are seeing significant increases in leasing activity, but I would not consider it a balanced recovery. If anything is bolstering the commercial real estate markets on the leasing side, I believe it is a combination of pent-up demand from tenants who have been sitting on the sidelines during the recession, and a realization that the dearth of development is causing some availability shortages in spaces of certain sizes and quality, particularly for large tenants.

What worries me most is that this really seems to be a jobless recovery, with many positions gone, never to be replaced. If there is no growth in headcount, there will be no growth in office space needs.
Howard E. Greenbert, principal of Howard Properties Ltd. in White Plains, NY

Necessity is the Mother of Timing

Commercial real estate is driven by business; the needs of companies utilizing leased and purchased facilities to run their companies be it office, industrial, warehouse or retail space.

The housing market satisfies personal needs for individuals and families and those needs can be met with homes for sale or lease; and apartments. Families can upsize and downsize both their physical space and quality and by reducing the costs for owning/leasing and operating the household budget. Companies don't always have that flexibility.

A top shelf law firm cannot operate from a "C" quality office building; a hair salon running their business from 1,200 square feet cannot downsize to 500 square feet and still expect to exist.

So the differences between the two sectors are based mainly out of necessity for businesses to continue to operate; and homeowners and tenants ability to downsize in quality, location and size.
Daniel Wm. Hayes, principal of NAI DESCO in St, Louis, MO

CRE Hurts, Which Is Why It Is a Good Investment

Commercial real estate is not in recovery but simply showing signs of life because capital does not have positive alternatives and needs a place to park while riding-out the current anti-capitalist trends. [Note the price of gold is high and rising and other basic value-holding commodities]. As one forward-looking analyst noted a year ago - people should invest in things that would hurt if you dropped them on your foot [gold, industrial metals, steal, minerals, and real estate].

Large amounts of cash which have poor alternative options and are thus chasing the cream of location and quality to induce a cap rate decline (and corollary rise in prices) but only for the best markets and product.
Todd Zirkle, real estate consultant with The Metis Group LLC in Washington, DC

How Soon We Forget

What worries me is I specialize in land acquisitions in urban areas of Los Angeles (mainly A locations) to develop mixed-use projects (i.e. residential apartments over retail). What I am finding from not only owners of real estate but from lenders is how soon they forgot what got us in to trouble in the first place - lack of fundamentals. The asking price for land is pretty much back to where it was before the recession.
Marty Shelton, vice president of NAI Capital - Urban Development Group in Los Angeles

CRE Will Pull Housing Out

Businesses are re-tooling and the market is anticipating that. The expectation is that new jobs will be created as corporate profits rise and companies will need to hire more people in order to keep up with revenue growth. As employment grows it could prop up consumer confidence and demand for housing as employees move to take new jobs.
Kostas Stoilas, associate - industrial property sales and leasing, The Davis Team of Cushman & Wakefield Inc. in Tampa, FL

It Takes Longer for the Housing Buyer To Come Back into the Market

I agree that a double-dip housing recession is currently a tangible risk. Should this risk materializes, I feel the commercial real estate (CRE) will be saved from facing the same fate. Several factors worked (and still work) in favor of the CRE market; the threshold investment required to enter the CRE is much greater than the residential one.

This factor kept a lot of small investors at bay, and allowed entrance only to more sophisticated investors with greater funds or accessibility to funds, and greater accessibility to professional advices. So, higher sophistication level, better capitalization, and easier access to professional advices will save the CRE.

Smaller supply of new CRE also had serious positive impact on the situation, as well as reluctance on the part of banks and financial institutions to foreclose on defaulted properties, opting instead to work out other solutions with the defaulted owners, meant a smaller number of distressed sales.

As soon as the economy starts to improve and gains enough momentum, companies start to hire again, which of course results in a higher demand on CRE. While it will take the recently hired John Doe sometime to restore his savings to a point that would allow him to enter the residential real estate market.
Maurice Salama, principal real property agent of the County of Los Angeles Chief Executive Office in Los Angeles, CA

CRE Much More Disciplined

I was a residential broker in Texas in the late '80s when the market tanked there. The commercial market seems much more disciplined and less emotional. When the overall real estate market first started to teeter this time, the commercial sector didn't go into denial, it accepted the fact fairly early on that hard times were ahead. The commercial market did not get overbuilt this time around. There were enough folks around that remembered the '80's and didn't make that big mistake again.

The residential market kept whistling through the graveyard.
R. Dabney Tompkins, brokerage services at CB Richard Ellis | Office Properties in Portland, OR

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