How can so many be so wrong...what part of the equation aren’t they getting?

Implications: With Unemployment on the way up this can mean only one thing, office and retail vacancies will be on the rise. As this writer has often written over the past 18 months, commercial real estate is a lagging indicator. The lag is over and the market has finally started to catch up to the reality of what has been going on in the credit and housing markets. Those that either pretended there was not going to be a problem or honestly thought the fundamentals where not going to be affected by all of the above have to answer to those that made decisions based on their so called expert advice. Their integrity must now come into questioned. This goes along with the overall crisis in confidence connected to the credit markets which will now spill over to the commercial real estate markets. This ultimately is what this writer had been warning about. And yes a few bad apples can spoil the bunch.  

Analysis:  Commercial Real Estate brokers and other industry “experts” are a lot like politicians. They know people have short memories and can live in a perpetual state of plausible denial. You will now see those that only a few months and even weeks ago suggested the office sector was going to be OK due to the solid fundamentals of the sector. They pointed to the “lack” of overbuilding in many markets which would help save the day.  

The problem with this thought process is its totally flawed. Lets begin with the statement that markets are not over built. If you take New York and Washington DC the number one and two ranked markets in the United States, both have just run into the proverbial wall. The vacancy rates in both markets are on the rise, and as the article points out the rise has gone from a trickle to a steady stream. There are millions of square feet under construction in both markets with NO significant pre-leasing having been accomplished. Overall vacancy for the DC proper market of new construction is 80%. This represents approximately 13 million square feet in DC alone. If this is not over building then I don’t know what is meant by that term. You also can look at any market that had a housing construction boom, say Las Vegas, and you will see a commensurate amount of vacant new commercial construction.      

The next statement to be analyzed is the vacancy rates have been stable and low. That may have been up to this point; however the writing was on the wall for over a year. Now tenants are leaving space when their leases expire or are just staying in place.  

In just today’s Wall St Journal it was reported that retail vacancy is the highest its been in 14 years (1994). Retail has been the first to reflect the declining economy as the unemployment rate has steadily increased. No surprise there...  

As far as office tenants, the last option that tenants have is placing their space on the market for “sublease”. The article points out correctly, subleases put downward pressure on overall rents both in the market and for individual buildings in particular. The article confirms this writer’s prediction of rents going down, by way of ever increasing rent concessions such as free rent, more tenant improvement dollars etc. The next concession that will be resurrected from the early 1990’s especially for all those empty newly constructed office buildings will be landlords taking over a tenant’s remaining lease as an inducement to move into their new buildings.  

The problem this time around, companies of all shapes and sizes are extremely skeptical of the commercial real estate market and are afraid of making a wrong decision, meaning pulling the trigger too soon and/or thinking perhaps waiting a while longer to make an even better deal. The market is almost at paralysis.

In addition many of the construction lenders are hesitant to advance more money to these projects. Add the landlords who have in place financing on their existing buildings and will need to get loans to cover tenant improvements. These loans will most likely be in the form of Mezzanine Financing. These loans are tantamount to second mortgages, except the loan is secured against the entity and not the real estate. These loans typical have a much higher interest rate and many Mezzanine loans are in the mid to upper teens rate wise.  


The next shoe to fall will be those recently bought office buildings in which investors paid incredibly high prices at very low returns with suspect financing and unrealistic rent projections. As once again this writer had suggested it won’t take much vacancy to put those landlord’s under water.  

If you look at what has happened to some of the largest commercial real estate buyers such as Tishman, who bought from MetLife, Stuyvesant Town and Peter Cooper Village in the heart of New York City based on very aggressive financial assumptions, they have burned through their “interest reserve” and will soon be looking for more capital. The conversion time table is now deemed to be have been too aggressive.  

The point of the matter is the entire integrity of the commercial real estate service sector now will be brought into question. Tenants thinking “why didn’t they wait, why did their broker push so hard for us to sign a lease?” “On what basis were the rent projections based?” There will be questions after questions asked, and the so called experts will hide behind the old safeguard statement “Who could’ve predicted this”...

Well to all the readers of GLG we had predicted this in the strongest terms possible.    

Businesses need to be reminded that often bad decisions are made during good times. The reason is human nature, why should one stop doing something that is profitable even though there is no logic or basic reason for their actions, and you can point out that for the long run their actions are flawed. Just take a very hard look at Lehman Brothers and the testimony of their CEO Mr. Richard Fuld Jr. today in Congress.
I'm guessing they had wished they never got so cocky and full of themselves and had been much less aggressive in thier investment approach. But hindsight is 20-20...but not in our case.