We're not out of the woods | The recession's impact on commercial real estate will be prolonged
Capitalization rates have traditionally been the bellwether indicator of commercial real estate values. Prices for investment properties are generally quoted based on cap rates, and buyers use cap rates as an initial test of interest. Cap rates have an inverse effect on value, in other words, the lower the cap rate the higher the value, and conversely the higher the cap rate the lower the value. So it is no surprise that cap rates have historically gone up during recessionary periods.
A look at the last two recessions indicates a lag in the commercial real estate industry’s reaction to changes in the economy. Here in Maine, that lag is even more pronounced as Maine’s largest markets, Portland, Bangor and Lewiston-Auburn, typically see cap rates between 50 and 100 basis points off from the national rates, even in the best of times.
We expect to see cap rates in Maine’s major markets between 10% and 12% in the near term. But given the variables, it is going to be hard to predict the long-term effect on commercial real estate values. If history is any indicator, we certainly aren’t out of the woods yet.
A rising trend
Consider, according to the Korpacz Real Estate Investor Survey, that during the recession between July 1990 and March 1991 cap rates for the national office market increased 70 basis points from 7.45% to 8.15%. However, even after the recession was officially declared over, cap rates continued to increase over the next 11 quarters to top out at 9.77%. After the end of the dot.com recession in the winter of 2001, the overall cap rate for national central business district (CBD) office markets saw an increase of 70 basis points. Cap rates remained elevated for several quarters before starting a continuous 20-quarter decline brought on by unprecedented job creation.
As for the current recession, Korpacz reports overall cap rates for the national CBD office market have increased 130 basis points, moving from 6.64% in the fourth quarter of 2007 to 7.94% in the second quarter of 2009. The fundamentals in the office market have continued to deteriorate, with job losses aggravating higher vacancy rates resulting in the decline of rental rates. The survey indicates that cap rates will increase another 150 basis points over the next six months, pushing cap rates on CBD office assets to 9.5%.
Predicting the lag time for this recession is very difficult. There are a number of current market factors that were not as prevalent in the last two recessions, including the level of unemployment and the fall of the collateralized mortgage-backed securities market (CMBS).
According to the Bureau of Labor Statistics, the unemployment rate during the 1990-1991 recession topped out at approximately 7.6% and the rate for the 2001 recession topped out at 6.3%. Given that the current national unemployment rate is 9.5% and the Maine unemployment rate is not that far behind at 8.5%, it is almost certain this will have a lingering negative effect on all real estate sectors. We are already seeing a trend in the Portland office market of corporate downsizing. The net effect will be more vacant space, particularly in the office markets.
The shutdown of the CMBS market, which accounted for 33% of commercial real estate financing in 2007, has severely limited the availability of credit. The larger commercial banks are increasing charge-offs of core real estate loans in their portfolios and the resulting reserves have limited available credit. This translates into a decrease in value and further decreases the number of capable buyers.
Another factor is the threat of inflation due to the federal government’s prodigious spending spree. Investors translate this into higher interest rates and yield requirements on their investment due to decreasing value of the dollar. In addition, and perhaps more ominous, is the potential refinancing crisis as CMBS loans begin to mature. Deutsche Bank estimates that 65% of these maturing loans will fail to qualify for refinancing under the more stringent underwriting criteria currently being employed.
Evidence of these trends can be seen in all of Maine’s major metropolitan markets. The sale of commercial investment properties has softened dramatically. Per-square-foot sale pricing on downtown office properties has gone from a high of $200 per square foot in some instances to as low as $45 per square. For instance, 110 Free St. in downtown Portland sold (as a short sale) for just $45 per square foot down from $90 per square foot two years ago. Auctions for multi-family properties are becoming more frequent and are selling for as low as $35,000 per unit, down from $80,000 or even $90,000 per unit two years ago.
Until commercial real estate markets recover, tenants and capable buyers should take advantage of the opportunities this market presents, such as falling sale prices and reduced rental rates.
Frank O’Connor is a broker with NAI The Dunham Group in Portland. He can be reached at editorial@mainebiz.biz.
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