The 2008 Outlook for U.S. Commercial Real Estate

As we enter 2008, the outlook for U.S. commercial real estate is perhaps more questionable than it has been for many years, since there are several matters currently pending that will have a major effect on the real estate market as the year progresses. The main question, of course, has to do with the situation in the credit markets. Since the sub-prime crisis arose in the residential market, the credit markets in the United States, and in many of the principal industrialized countries of the world, have been in disarray. And the credit markets, of course, have a significant impact on commercial real estate where mortgage debt is used to finance a large percentage of property purchases.
The sub-prime crisis has, in turn, led to questions about the future of the U.S. economy and whether or not a recession is in the offing. A recession might affect the basic fundamentals of the real estate market – occupancy rates and rental growth. The American consumer has provided one of the principal supports for the continued increase in the U.S. economy in recent years, but the consumer is now the principal victim as housing prices decline and sub-prime mortgages are foreclosed upon, calling into question that source of strength.

There are, of course, some potentially positive factors in the outlook as well. The basic fundamentals of the commercial market remain quite strong, with high occupancy rates and rising rental rates. Those factors could, of course, be affected by a slowdown in the economy, but since there is little or no overbuilding in the office, retail or industrial markets around the country we remain fairly optimistic about these basic trends. In addition, the poor, beleaguered dollar is certainly another source of strength for the economy and for the U.S. commercial real estate market. Exports are one of the strongest components of the economy today and are expected to continue growing throughout most of 2008. And many foreign investors are being attracted to the U.S. real estate market since properties can be purchased at what are, in effect, discount prices.

In Falcon Real Estate’s view, the U.S. economy will slow during 2008, but it is too early at this point to predict whether an actual recession will occur. The U.S. real estate market will also experience a slowdown, with rising capitalization rates, at least until the credit markets begin operating normally again. But with occupancy rates remaining high and new construction being subdued, we believe that the fundamentals of the commercial real estate market will remain positive. Considering the problems in the credit markets, investors who are able to approach the U.S. market either on an all-cash basis, or with a significant cash down-payment, will have a considerable advantage when making a purchase.

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The Credit Markets

The excesses that occurred in the sub-prime residential mortgage market in the United States have made it difficult to obtain mortgages on even the highest quality commercial property since all major conduit lenders have, in effect, been out of the market. The Federal Reserve Board and the European Central Bank have taken the lead in trying to re-inject liquidity into the credit markets, but until some degree of confidence is established that all of the necessary write-downs have been taken, it appears likely that obtaining credit will remain a problem. However, it must be emphasized that mortgages are available, with lenders generally willing to provide loans at about 50% to 60% of value, rather than at 70% or above as before the crisis. But obtaining interest-only debt has become difficult, and lenders are requiring larger reserves covering various contingencies, such as leasing and capital improvements. At the same time, lenders are quoting interest rates based on spreads of up to 300 basis points over comparable maturity U.S. Government bonds, as opposed to spreads of 100 basis points or even less prior to the crisis.

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