The current downturn in America’s commercial office markets is different from those of the past and requires new strategies for recovery.
In the current climate of economic distress, a common refrain among anxious observers is that the next shoe to drop will be commercial real estate, whose complex financing over the past decade has yet to be unraveled and, in the end, could send already fragile financial giants into a five-spiral crash. But as the U.S. economy begins to show signs of recovery, cooler heads and a closer analysis suggest that the commercial real estate market, while troubled, is unlikely to drag down the global economy. Office properties in U.S. markets have not experienced massive foreclosures because commercial property lenders and investors, however dispersed and tranched, are willing to work with owners during this time of high vacancies and reduced revenue streams.
The key is the reduced revenue streams, which distinguish the current slump in office markets from the last severe office market downturn in the late 1980s and early 1990s, when revenue streams went completely dry. Back then, office vacancy rates averaged 19 percent nationally, and many analysts now predict the current downturn will produce equally high vacancy levels. The two key differences between then and now, these analysts report, is the way vacancies are distributed in office properties, and the underlying reason these vacancies have occurred. High vacancies today, they contend, are the result of the loss of jobs in the general economy rather than massive overbuilding, as was the case two decades ago.
“One factor that distinguishes this downturn from that one [early 1990s] is today there are few empty buildings in the market,” says Ray Torto, director of the CB Richard Ellis (CBRE) global research division. “Last time, investors could buy an empty building at discounted prices and lease it up gradually as the economy improved. Now, owners have enough tenants to cover debts or work something out with lenders. [Lenders] are mum, knowing the loan is underwater, but it’s better to let it go than to foreclose.”
Jim Costello, a principal with Torto-Wheaton Research and CBRE Econometric Advisors, comparing the 1990s slump with today’s downturn in office markets, found a key difference—one that, among other things, suggests that recovery from today’s problems will not take the same path as the past rebound. According to Costello’s research, in 1990, 40 percent of office vacancies were concentrated in buildings that were less than six years old. While the vacancy rate is projected to again reach the 1990 level, this time vacancies will not be concentrated in new properties. Costello found that 40 percent of the vacancies are spread among buildings that have come on line in the past 22 years. “Vacant space, then, is not a problem of young buildings,” Costello explains. “It’s a problem of all buildings.”
The difference between a market characterized by properties that are partially occupied and one dominated by virtually empty properties is significant. Owners of buildings with a diminished but stillflowing revenue stream generally are not compelled to sell, and they are not eager to unload assets at deeply discounted prices. “Owners can sit and wait and hope things will rebound,” says Torto. “There’s money out there to buy, but there’s nothing to buy, because there’s no incentive to sell.”
The primary goal for today’s owners of office properties is to keep existing tenants happy while devising strategies to attract new tenants. New strategies need to be built around trends in both the regional and national economy. “We are taking job levels back to 2002, which means we have excess space and thus high vacancy rates,” notes Costello. His advice to investors: “With vacancy distributed piecemeal into every asset in the market, it will take more work on the part of value-add and opportunity funds to boost income trends. It will take more legwork in the current market to find these diamonds in the rough.”
The link between employment and office vacancy is direct. “Every office job lost knocks off demand for 180 square feet [17 sq m],” Karl Case, professor of economics at Wellesley College, told the New York Times in the article “Inland Real Estate Dives into Troubled Commercial Market” (August 26). “With 6.7 million jobs gone—many in the service sector— a lot of demand has evaporated.”
If rising office vacancies are the result of the slumping economy and high unemployment rates—as opposed to overbuilding—the challenge for property owners is to analyze economic trends and identify areas of job growth. The challenge is substantial, but, in many regions, owners have an ally in municipal governments whose tax revenues suffer when vacancy rates rise and property values decline. A few examples illustrate how the office market varies from region to region around the country, and the different strategies being employed by cities saddled with vacancies.
In the Washington, D.C., metropolitan area, where government-related work has kept unemployment rates below the national average, vacancy rates are low and property is selling at a premium. A 12-story office building located on K Street in the center of Washington’s business district sold recently for $207.8 million, or about $830 per square foot ($8,900 per sq m). Among its attractions is the fact that it is fully leased for the next 15 years.
By contrast, in Seattle, where the office vacancy rate is currently 14.4 percent and prospects for job growth are dim, office buildings are selling at a deep discount. The Washington Mutual Center, a three-yearold, 42-story downtown office tower, sold recently for $115 million, or $132 per square foot ($1,420 per sq m). Adding to the woes of Seattle’s office market is the reality that 3.6 million square feet (334,000 sq m) of new space is under construction.
The New York City metropolitan area suffered major job losses in the financial services sector, reducing occupancy rates in prime office buildings in every borough. As unemployment has increased, especially among white-collar workers, area colleges and universities are experiencing a rise in enrollment of out-of-work students seeking retraining and enhanced skills. As a result, colleges need more space, and many are finding it in vacant office buildings. According to the city’s Economic Development Corporation, in 2007, close to a half million students were enrolled in the city’s public and private colleges and universities—before the economic crash. The growing number of applicants has sent school administrators looking for additional space. The School of Visual Arts, for example, recently subleased for 15 years a five-story, 54,000-square-foot (5,000-sq-m) building on 16th Street in Manhattan.
New York City real estate agents report that the combination of higher enrollment and the availability of offices at rental rates that have dropped by as much as 30 percent have made educational institutions a significant player in the office market. In addition, the city’s economic development office has worked out an arrangement with owners of buildings with vacant space in lower Manhattan to use the facilities as incubator space for entrepreneurs with good ideas and innovative business plans. In Detroit, where automobile-related jobs are slipping away at an accelerated pace, state and local governments are being creative in their search for replacement businesses. In April 2008, Michigan Governor Jennifer Granholm signed an incentive package that included a 40 percent tax credit and cash rebate for film studios that set up shop in Michigan. Louisiana and New Mexico have approved similar incentives.
Raleigh Studios, a large, independent film studio based in Los Angeles, recently purchased a 369,000-square-foot (34,300-sq-m) office building in an abandoned General Motors complex in Pontiac, Michigan, for $55 million. The building, which once housed 3,000 GM truck and bus engineers, will be used by the production staff. Raleigh also plans to convert another GM office building in the same complex for use in film production.
Kenosha, Wisconsin, the state’s fourth-largest city, which had been losing jobs even before the current crisis, for the past 20 years has been re-creating itself, searching for alternative economic engines to the oncedominant auto industry that accounted for 40 percent of the city’s jobs. Located halfway between Chicago and Milwaukee, Kenosha for most of the past century was a gritty, industrial town with multiacre factories blocking access to the city’s Lake Michigan waterfront. With the demise of the American Motor Company and the slow decline of its successor, the Chrysler Corp., the city was losing jobs, population, and a way of life. The revival strategy for Kenosha began with a master plan that called for demolishing old factories, remediating contaminated sites, insuring potential developers against environmental damage liability, and attracting a diverse range of new industries. According to Kenosha city administrator Frank Pacetti, the current downturn has slowed progress but has not halted it.
“Our industrial parks are basically full,” says Pacetti. “We have a lot more diversity in our economy, and about 20,000 of our 96,000 residents commute to jobs in northern Illinois.” Kenosha, he notes, with its long experience coping with economic disruption, can serve as a model for other cities. The formula, Pacetti says, is this: let go of old jobs and industries that are not likely to return; identify your assets; and attract businesses and investors who recognize that what you have to offer provides a competitive economic advantage. “It starts with a vision. If you’re satisfied with what you had, you will stay where you were,” he says.
