Commercial market’s bottom could be longer even than residential’s

Manhattan’s residential real estate market might be feeling serious pain, but many real estate insiders believe the city’s commercial market will spend a much longer period in the doldrums.

While residential real estate is suffering from an oversupply of inventory and a bursting price bubble largely spurred by a drop in lending standards, commercial real estate is confronting obstacles on the debt side that appear to be more entrenched. What’s more, experts say the problems on the commercial side are in many ways just getting started and will require far longer to sort themselves out.

For one, Manhattan’s office vacancy rate last month was 13.1 percent, and the commercial brokerage Colliers ABR is predicting it may hit a high of 18 percent, significantly higher than the last downturn, said Richard Bernstein, a vice chairman at the firm.

Lawrence Longua, a clinical associate professor with New York University’s Real Estate Institute, said history has shown that the commercial market typically takes longer to recover than the residential sector in a recession.

“The national recession in the early 1990s was relatively short and mild, literally measured in months, and yet commercial real estate went into the tank and didn’t come out of it until about 1995 or 1996,” he said.

Bernstein pointed out that in past downturns — such as the stock market crash of the late 1980s — Manhattan had a fairly healthy financial services sector to assist in the recovery.

Not so this time.

“Even if the local and national economic indicators start to reverse themselves — and they will sooner or later — I think the commercial real estate side will have a much longer lag effect than the residential side,” he said.

That’s because in Manhattan, job losses directly affect the office sector, whereas the impact on residential real estate may not be as direct, said Barry Ritholtz, the New York-based CEO and director of equity research at Fusion IQ, an online quantitative research firm.

“On the commercial side, the job-loss implosion is one for one, square foot for square foot, job for job,” he said. “But only a percentage of the people who lost jobs lived in Manhattan — perhaps 30 or 40 percent.”

Sam Chandan, president and chief economist at Real Estate Economics LLC, said the stage was set for difficulties in the commercial real estate market when lending standards began declining between 2005 and 2007.

“We observed a significant deterioration in the quality of underwriting of mortgages that were being made. Some of that was [commercial mortgage-backed securities], and some of that was even deterioration in underwriting by balance-sheet lenders,” he said.

Commercial mortgage-backed securities, or CMBS, lenders bundle their commercial loans, split them up into tranches, and securitize the parts. Since they are dumping the loans, they tend to be less vigilant about lending standards. Balance-sheet lenders, on the contrary, do not sell their loans; hence, they have been less likely to loosen their lending standards. While some of these lenders have continued to make loans, albeit with more stringent terms, there are signs even these lenders are backing away from commercial property, Chandan said. That is making the refinancing of debt next to impossible, he said.

“What you see from the most recent Treasury Department data is, whether the deterioration is on the CMBS or the bank side, banks are looking at the commercial market and saying, ‘Delinquency default rates are going up, so we’re going to diversify out of commercial real estate,'” Chandan said. Ritholtz of Fusion IQ also said the willingness on behalf of investors to accept smaller returns, a phenomenon that started in the mid-2000s, paved the way for some of today’s problems.

“About 10 years ago, you used to want a reasonable ROI (return on investment) of 8 or 9 or 10 percent,” he said. “But as interest rates went down and down and down, the ROI seemed to follow, so especially with the weak dollar and a lot of overseas money coming in, investors bought buildings with ROIs of 4 or 5 or 6 percent, which is a convoluted way of saying they paid up for these buildings.”

Many investors purchased buildings with low returns on investment because
they hoped to flip them once they’d appreciated in value. To do so, many took out so-called “balloon mortgages,” where the loan didn’t fully amortize
over the term of the note — but left a balance due at maturity.

Now building owners are staring down huge debt repayments with minimal income from their office buildings. That pressure on the revenue side is only exacerbated by the lack of demand for office space prompted by the financial-sector job losses. The ramifications are just beginning to be felt, Chandan said.

Currently, default rates are higher on loans issued by balance-sheet lenders than CMBS lenders, but there was a greater deterioration in underwriting quality on the CMBS side, he said. He predicted that commercial mortgage defaults won’t hit their peak until 2011 and may remain elevated for some years after that.

“By 2011 and 2012, you’ve got this third wave of pressures on commercial mortgage performance, because you’ve got the five-year loans that were made in the CMBS market in 2007 finally coming to maturity,” he said. “It will be challenging to meet those refinancing needs because the leverage is so high.”

NYU’S Longua agreed that commercial real estate is going to suffer for years to come.

“You can see it in the CMBS numbers, where CMBS defaults have finally risen above 2 percent — which might not sound like a lot, but it’s 2 percent of $730 billion or thereabouts, and that number will grow,” he said.

He said the most significant problems are in the portfolios of commercial banks — the 7,000 banks nationwide that made loans on transitional properties, anticipating that they would be paid back by long-term investors.

“Banks aren’t lending now, and there’s no CMBS market, so you probably have close to $1.8 trillion of commercial real estate loans on the books of commercial banks that will be maturing over the next five years, and nobody to refinance it,” he said.

Longua also noted that employment will be a huge factor in the commercial market’s recovery going forward.

“You take an employee that accounts for 250 square feet of space, and you take the tens of thousands of employees that are laid off or will be counted as laid off, and you can start to see the impact.

“Rents are heading south; we have sublet space going back on the market. We have shadow space, which is space that is under rent but not being used, and that’s pushing down rents terribly,” he said.

The city’s Independent Budget Office projects a loss of 243,000 jobs from the city’s peak during the first quarter of 2008. Longua pointed out that many financial services workers who were laid off have yet to be counted in the most recent unemployment numbers because they received severance.

On the residential real estate side, job losses have contributed to the fairly dire conditions in Manhattan, where the median sales price of resale apartments in the second quarter was down 25.6 percent from the same period last year, and the rental apartment vacancy rate is predicted to hit 4.7 percent by 2009. Still, the island is much better off than the rest of the country, Chandan said.

Because of the preponderance of co-ops in Manhattan, which typically require 20 percent or more down, the inflated leverage that spurred a housing bubble nationwide never took hold in Manhattan.

The residential market may see price stability by early 2010 and some price appreciation by late 2010, Chandan said, noting that the extent of government intervention could play a role in the shape of the recovery.

For instance, the residential recovery could be hampered when Fannie Mae and Freddie Mac reduce their market participation, as they are scheduled to do in 2010, he said.

Also, the criteria for obtaining conforming mortgages presents a Catch-22 that may need to be modified, Chandan said. As written, buyers can only obtain a Fannie-approved mortgage at an apartment complex where a certain percentage of units are in contract. However, buyers who qualify for Fannie mortgages are not included in that percentage, making the percentage difficult to achieve and preventing buyers from qualifying for Fannie mortgages. Sound confusing? It is, and unnecessarily so, Chandan said.

“There are a lot of things that make the conforming mortgage products tougher to make available in New York,” he said.

Still, even with outstanding questions about government policy, Manhattan’s residential real estate market looks poised for an earlier recovery than the commercial market, he said.