End of the Office Party Is Coming - WSJ

The next shoe? After years of plunging residential property valuations, commercial real estate is heading into the danger zone as office vacancies rise, stores close and hotel bookings fall. This could mean another body blow to already struggling financial institutions. Alan Todd, head of research on commercial-mortgage-backed bonds at J.P. Morgan Securities, projects commercial-property losses of as much as $250 billion over the next 10 years, or about 7% of the $3.4 trillion outstanding debt. That would rival the roughly 9% cumulative loss rate during the real-estate carnage of the early 1990s. Commercial real-estate values have fallen since the beginning of the credit crunch, by as much as 20%, due to more expensive and less available financing. Financial institutions have already taken more than $15 billion in commercial property-related write-downs this year. There are bullish points. Unlike the early 1990s, the commercial market hasn't suffered years of overbuilding. Defaults on commercial real-estate debt remain less than 1%, compared with more than 10% at the worst point of that earlier collapse. Rents and vacancy rates have so far remained solid, enabling most properties to pay their debt service. The major exception has been construction loans to single-family home builders and condo developers. As of the second quarter, about $51 billion of the $627 billion construction loans outstanding -- or 8.1% -- were at least 30 days past due. That compares with 2.4% in the year-earlier period. But fundamentals are now weakening for other commercial property, as well. Businesses are dumping office space at the fastest pace since the months after the Sept. 11 terrorist attacks. Malls and shopping centers are seeing spikes in vacancies as retailers like Linens 'n Things and Starbucks Corp. close stores. Analysts at Goldman Sachs estimate that, on average, vacancy rates could approach the levels of the early 1990s, rising from the current 10.8% to 13.4% next year. Of particular concerns are the apartment, office and industrial sectors. As cash flow is crimped, more landlords are going to default on mortgages. Others are going to face a crunch when their debt needs refinancing. Green Street Advisors Inc., a real-estate research and consulting firm, estimates that about a third of the $600 billion in commercial-mortgage bonds outstanding will come due between 2010 and 2012. With values declining, interest rates rising and lenders reluctant to part with cash, many borrowers will have to pay off at least part of their loans, find partners or give up the property. At the margin, pressure may be relieved by the $700 billion government bailout fund, which includes commercial real estate debt as an asset the Treasury could buy. But it will not be a solution. Commercial real estate is another accident waiting to happen.