Office Vacancies Soaring, Rents Falling in Major Cities

Some months ago we speculated that the sector of the economy to fall out of the sky would be retail real estate as the proliferation of shopping malls and small strip centers ran headlong into what at that time appeared to be a looming wave of retail store closings.  That wave is now building to a tsunami and half finished retail construction and newly vacant storefronts can be seen everywhere.  But another sector of commercial real estate that is also suffering is office space.

Monday The New York Times reported that there is chaos in all parts of commercial real estate and everywhere in the country.  The article cited problems with vacancies, rents, and lending, particularly focusing on office space where it vacancy rates now exceed ten percent in virtually every major city in the country and are rising rapidly.

The Times article pointed to a number of cities where problems are already worse than expected even a few months ago.  Chicago vacancies have risen from ten percent and may be at 17 percent by the end of this year.  Dallas is expected to hit 19 percent from the current 16.3 percent vacancy rate.  Orange County California is particularly hard hit as the many subprime mortgage companies that called the area home have shrunk or disappeared completely and vacancies that were at seven percent two years ago now top 18 percent.

In mid-December the National Association of Realtors® (NAR) reported that investment in commercial real estate had ground to a virtual halt because of the lack of commercial lending and that job losses are curtailing the demand for space.

Lawrence Yun, NAR chief economist said in a press release at the time there were serious structural problems in commercial lending but stressed that default rates of commercial loans were still low by historical standards.  He warned, however, that this could deteriorate significantly if something was not done about liquidity in that market.

The NAR report covered all aspects of the commercial real estate market - industrial, retail, multi-family residential, and office sectors - but said specifically of the prospects of the office space market:

"Office rent is likely to contract next year as erosion in the job market curtains demand for space.  Vacancy rates are projected to increase to 16.4 percent in the third quarter of 2009 from 13.4 percent in the third quarter of this year."

The release said that New York, Honolulu and Seattle were still seeing office vacancies under 10 percent while Detroit, Phoenix, and Dallas were recording rates over 20 percent.

"Annual rent in the office sector is expected to slip 0.4 percent this year and decline another 3.6 percent in 2009.  In 57 markets tracked, net absorption of office space, which includes the leasing of new space coming on the market as well as space in existing properties, is seen at 12.3 million square feet this year before contracting by 63.0 million in 2009."

While there have been relatively few defaults on commercial mortgages so far, many of these loans are due to be refinanced and there is virtually no liquidity in the market.

The Times called the rising rates and the falling rents "a ticking time bomb for banks" but pointed out that pension funds, insurance companies, and hedge funds are also big holders of mortgages on commercial buildings or mortgage based securities which have proliferated along with their residential counterparts in a growing secondary market.  Like residential loans, commercial loans have also been "sliced and diced" and sold to many investors which compounds the difficulty building owners will have renegotiating or rolling over current loans.

Regional banks are particularly vulnerable to any widespread defaults in the market, The Times said.  "In the last decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players."  Commercial lending by regional banks has doubled in the last six years.

The New York paper quoted a report by Real Capital Analytics that stated that already $107 billion worth of office towers, shopping centers, and hotels are in some type of financial distress.  New York leads the list with 268 troubled properties but 19 other cities each have more than $1 billion in troubled properties including Atlanta, Denver, and Seattle.