The Sub-Prime Crisis and U.S. Commercial Real Estate

The basic fundamentals in the U.S. commercial real estate market have rarely been as strong as they are today. Occupancy rates are rising in virtually every geographic market and in all classes of real estate. At the same time, rents are increasing significantly across the country. And it is still very difficult to justify new construction since building costs are at record highs. With the U.S. economy remaining in an uptrend, and with little or no new construction, the basic fundamentals are unlikely to change in the foreseeable future.
The major negative affecting the commercial market is the crisis that has hit the credit markets. The sub-prime mortgage problem is one that arises solely out of the U.S. residential market, but this problem has had an extraordinary effect on the willingness of lenders to provide financing for even the highest quality commercial transaction. The dramatic action taken by the Federal Reserve Board in lowering both the federal funds rate and the discount rate by 50 basis points was probably necessary to keep the credit markets from coming to a complete standstill.

There is also, of course, the question of perception. Many potential investors are unable to distinguish between the problems in the residential market and the sound fundamentals in the commercial market. This perception is compounded by the fact that the press rarely attempts to distinguish between the two markets and therefore the problems of the residential market are attributed by unsophisticated observers, both in the U.S. and abroad, to the commercial market.

Given the prevailing uncertainty in the commercial market, which is primarily the result of the serious problems in the credit markets, some increase in capitalization rates has to be expected. It will also be more difficult for some investors to acquire properties since financing conditions have become more stringent. However, in Falcon Real Estate’s view there will still be attractive investment opportunities, particularly because of the changed conditions in the credit markets. Many of these opportunities will be due to the inability of some investors to re-finance their properties on the same terms as when they were acquired.

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The Basic Fundamentals of the Commercial Market:

All segments of the commercial real estate market in the United States have been experiencing exceptionally strong fundamental conditions. The U.S. economy has been in an uptrend for almost five years and, as a result, demand for office, industrial and retail space has become very robust across the country. In fact, growth in the second quarter of 2007 accelerated to an annual rate of 3.8%, the highest rate in over a year. This has led to declining vacancy rates and rising occupancy rates in most of the major markets in the U.S. At the same time, rental rates, which had been stagnant or rising only relatively slowly for several years, have moved into a sharp uptrend. Normally conditions such as these would lead to a significant increase in new construction. The last major recession in the U.S. real estate market was caused by the vast overbuilding that had occurred, primarily in the office market, during the late 1980’s and early 1990’s. At the present time, however, with the tremendous building booms that have been occurring in China, India, Dubai and Eastern Europe, the cost of steel, glass, cement and other building materials are at or near all-time highs and developers find it is still too expensive to engage in speculative building. Rents are rising in the U.S. but in most markets they have not yet reached the point that will justify speculative construction.

At this point, it is difficult to see any significant change in the basic fundamentals of the market. The Federal Reserve Board, as indicated by its recent action in cutting interest rates, seems committed to maintaining the economy on a growth trajectory. In addition, the current conditions in the credit markets will make it far less likely that developers will be able to obtain financing for new construction, certainly not on terms as favorable as would have been available until a few months ago. Therefore, it would appear that even with a somewhat slower rate of growth in the economy, occupancy rates and rental rates in the commercial market should remain at high levels.

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