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Commercial Real Estate Maintains Its Strength Despite a Cooling Housing Market

Jul 2006

As reported by the Wall Street Journal, with America's housing market clearly cooling, will commercial real estate start to swoon? Hardly. The national office market, which cratered after the tech bust in 2000, has recovered and is the strongest it has been in five years.

In fact, the commercial markets benefited from the former froth in the residential-property market because the boom in residential construction limited the amount of land that could be used for other purposes. In some markets, the conversion of apartments, hotels and, to a lesser extent, office buildings, into condominiums reduced the risk of oversupply -- one of the biggest hazards in commercial real estate and one that contributed to the sector's crash in the late 1980s.

Despite the widely varying types of commercial properties -- and the fact they are partly driven by different factors -- it isn't uncommon for people to assume if houses aren't selling, commercial markets must be at risk, too. So common that the faulty assumption itself could be self-fulfilling, says Robert White Jr., president of Real Capital Analytics, a New York-based real-estate information firm. "I so worry...that if they get burned on their condo in Miami, they are going to stay away from any other commercial real-estate investments for the next decade. Those markets are completely different."

Of course, interest rates affect commercial mortgages as well. Cheap debt has been one reason why there have been so many bidders on the commercial buildings sold over the past few years, pushing prices to record levels and yields to unprecedented lows.

Unlike the residential market, in which investors are most often private individuals, commercial investors are more diverse and not nearly as tied to mortgage rates. Dr. Mueller also points out that some of these investors include institutional buyers such as pension funds that pay cash instead of borrowing money.

In addition to condo conversions helping to reduce the supply of office space outright, residential construction has contributed to the high cost of land and materials in many U.S. markets. In many cases, because of high construction costs, it was cheaper to buy an office building -- even at high prices - than to build a new one. Without much new speculative development, vacancy rates have dropped in almost every major market and landlords have been able to get more for rents.

In Miami, for example, residential units in the central business district increased 55% since 2000, while the office increase was 9.5%, according to Jones Lang LaSalle, a real-estate services firm. Even if developers contemplated a new office building, the construction companies were likely tied up with residential jobs until recently, says Jubeen Vaghefi, a Miami-based managing director for Jones Lang LaSalle. All the while, the South Florida economy has been steadily improving. Those forces combined to boost the office market there.

Real estate also remains a cyclical industry, and it is early in the office sector's recovery. Investors who paid sky-high prices for commercial buildings, especially those who financed using floating-rate debt or interest-only loans in the early years, are dependent on their optimistic growth projections to deliver.

Yet, with generally improving fundamentals such as reduced vacancy and higher rents and few worries about overbuilding in most markets, the office sector should continue to improve in the near term, if job growth doesn't take a dive. "We're still in that race between increasing interest rates and increasing fundamentals," Stephen Blank, senior resident fellow of finance with the Urban Land Institute, says of the commercial market. "It appears to me that we are going to skate through this."