Will Commercial Real Estate Crash? 

 

There has been a lot of talk in the media within the last few weeks about commercial real estate being the last shoe to drop in the recession.  Is this real and should you expect it to happen?  Absolutely.  But it isn't something that is coming.  It's something we're already in the middle of. 
 
Residential real estate is a leading indicator of the economy.  But commercial real estate is a lagging indicator of the economy.  When people feel like home values are increasing, they are more likely to spend.  And they are more likely to borrow against the equity in their house to spend more.  And they borrow on their credit cards to spend even more. 
 
All that demand for goods and services gives companies confidence and they too spend and hire.  When they hire employees, they have to have a place to put them.  So they lease office space.  And they lease warehouses to store and distribute all the goods that consumers will buy.  So everyone is happy.
 
But take that same domino effect and put it in the context of a housing bubble that has burst.  Consumers stop spending.  Company revenues fall.  They stop producing goods.  They lay off employees.  They stop leasing new office and warehouse space.  Not only do they not need new offices and warehouses, they don't even need what they have already leased. 
 
So companies put that space on the sublease market.  To compete with the landlord's vacant space, they have to undercut rental rates...often by 20-50% depending on the amount of time remaining on the lease, the vacancy in that submarket and whether furniture and equipment will be included as part of the deal. 
 
Landlords are then in a bind.  There is little demand for their vacant space and they have to compete with their own tenants' sublease space.  So they drop their rental rates, offer free rent to tenants, and pay bonuses to the tenant rep brokers.  Things get ugly. 
 
I recently represented a client who moved to another building.  The competition among landlords was frenzied.  He got 15 months free rent, a freshly renovated space, all moving costs paid, and his rental rate went down by 30% from what he'd been paying.  Oh, and the landlord paid a 50% bonus commission.  Now it was an 11-year lease, but that is still an amazingly good deal for the tenant.
 
That's the most extreme case I've heard of in this market cycle.  I've been through other cycles over the last 25 years, but one thing remains the same - residential properties feel the pain early and commercial properties feel the pain later.  When the economy is headed down, commercial is affected fairly quickly - often within months.  Companies react relatively quickly to bad news. 
 
When things improve, however, recovery for the commercial market lags.  That's because companies want to be sure the recovery is real before they ramp up production and hire employees.  When they have to add bodies to keep up, they do so with contract workers first.  Eventually, they hire permanent employees and demand for office and warehouse properties increases.
 
Then it's party time again.  Everyone starts spending and the cycle will repeat itself.  How long with that take?  If I knew, I'd be sipping from a glass with an umbrella under a palm tree somewhere instead of writing this column.