As Vacant Office Space Grows, So Does Lenders’ Crisis

Vacancy rates in office buildings exceed 10 percent in virtually every major city in the country and are rising rapidly, a sign of economic distress that could lead to yet another wave of problems for troubled lenders.

Photo By: Steven Roemerman

With job cuts rampant and businesses retrenching, more empty space is expected from New York to Chicago to Los Angeles in the coming year. Rental income would then decline and property values would slide further. The Urban Land Institute predicts 2009 will be the worst year for the commercial real estate market “since the wrenching 1991-1992 industry depression.”

Banks and other financial companies have not had the problems with commercial properties in this recession that they have had with residential properties. But many building owners, while struggling with more vacancies and less rental income, will need to refinance commercial mortgages this year.

The persistent chill in lending from banks to the credit markets will make that difficult — even for borrowers who are current on their payments — setting the stage for loan defaults.

The prospect bodes ill for banks, along with pension funds, insurance companies, hedge funds and others holding the loans or pieces of them that were packaged and sold as securities.

Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a lobbying group in Washington, is asking for government assistance for his industry and warns of the potential impact of defaults. “Each one by itself is not significant,” he said, “but the cumulative effect will put tremendous stress on the financial sector.”

Stock analysts say commercial real estate is the next ticking time bomb for banks, which have already received hundreds of billions of dollars in capital and other assistance from the federal government. Big banks — like Bank of America , JPMorgan Chase and Morgan Stanley — each hold tens of billions of dollars in commercial real estate securities. The banks also invested directly in properties.

Regional banks may be an even bigger concern. In the last decade, they barreled their way into commercial real estate lending after being elbowed out of the credit card and consumer mortgage business by national players. The proportion of their lending that is in commercial real estate has nearly doubled in the last six years, according to government data.

Just as home loans were pooled, then carved up and sold to investors as securities over the last two decades, commercial property loans were repackaged for the financial markets. In 2006 and 2007, nearly 60 percent of commercial property loans were turned into securities, according to Trepp, a research firm that tracks mortgage-backed securities.

Now that the market for those securities has dried up, borrowers cannot easily roll over the loans that are coming due.

Many commercial property owners will face a dilemma similar to that of today’s homeowners who cannot easily get mortgage relief because their loans were sliced and sold to many different parties. There often is not a single entity with whom to negotiate, because investors have different interests.

By many accounts, building owners have been caught off guard by how quickly the market has deteriorated in recent weeks.

Rising vacancy rates were expected in Orange County, Calif., a center of the subprime mortgage crisis, and New York, where the now shrinking financial industry dominates office space. But vacancies are also suddenly climbing in Houston and Dallas, which had been shielded from the economic downturn until recently by skyrocketing oil prices and expanding energy businesses. In Chicago, brokers say demand has dried up just as new office towers are nearing completion.

“The economic recession is so widespread that we believe virtually every market in the country will see a rise in vacancy rates of between 2 and 5 percentage points by mid-2009,” said Bill Goade, chief executive of CresaPartners, which advises corporations on leasing and buying office space.

There is no relief in sight for Orange County, where subprime lenders and title companies once dominated the market but are now shedding space because their business has dried up, and big banks are now shrinking because of a wave of mergers. The vacancy rate has soared from 7 percent at the end of 2006 to 18 percent, a rate that the Tampa area should match this month, local real estate brokers say.

In New York, where rents had risen the highest as financial companies gobbled up office space, vacancy rates are floating above 10 percent for the first time in years.

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What looked like the worst possible case a few weeks ago for Chicago now appears to be the most likely outcome, said Bill Rogers, a managing director at Jones Lang LaSalle, a real estate broker. The vacancy rate, which was fairly stable at 10 percent, is now rising quickly and could hit 17 percent in 2009, he said. “A lot of companies are trying to shed excess space ahead of what is expected to be a worse market in 2009,” Mr. Rogers said.

Newmark Knight Frank, a real estate broker, expects the vacancy rate in Dallas to rise to 19 percent this year, from 16.3 percent.

Houston, like Dallas, held up while many other cities were showing the strains of an economic slowdown. But job growth and the brisk business of oil and gas exploration have come to an abrupt halt.

CONTINUED : Underwater buildings

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