Housing Trouble Spills Over into Commercial Real Estate

Thursday, Dec. 20, 2007 | The slump that has plagued the San Diego County housing market is beginning to show on the commercial side.

The trouble defies the industry mindset, prevalent even up until a few months ago, that commercial and residential real estate share little more than a surname — that the health of the real estate market for apartment investors, offices and industrial space would remain untouched by the housing market’s troubles.

“I think we’d all like to think that the meltdown in the housing market hasn’t affected the commercial side,” said Kraig Kristofferson, senior vice president with CB Richard Ellis. “But the reality is people look at real estate in one big basket, often.”

In a direct correlation, the cutbacks in the San Diego operations of local and national homebuilders and other housing-related companies sap some demand for commercial space.

National homebuilder Lennar, for example, recently listed 50,000 square feet of its office space for lease to other tenants in order to cut costs, said Jason Hughes, principal with local firm Irving Hughes. And then there are mortgage companies, title companies, escrow companies — going out of business or cutting back on staff, and space, he said.

“It goes on and on,” Hughes said. “Anyone that says that residential is not affecting commercial is nuts, because it simply is. There are a ton of tenants who are in a difficult situation because of the housing market, residential real estate offices are closing their doors. … And that’s happening at the same time as the credit crunch.”

That the commercial market has weakened is a sign that the housing market woes are not entirely self-contained, as some economists have hoped. Increased costs for office buildings might mean increased costs for businesses, thereby rising prices on services and goods produced here. And that the commercial sector’s weakness took longer to show up underscores the period of uncertainty this housing downturn has thrust the county into.

On the buying side of the commercial deals, the credit crunch that hit earlier this year has dwindled securitized financing. That’s the finance structure especially popularized during the decade’s housing boom that dices mortgages and repackages them for sale to investors on the stock market. The same investors who thirsted after such mortgage securities also pumped money into similar loans for buyers of apartment buildings, offices and industrial properties.

With heavy losses sustained by such investors this summer due to soaring defaults on subprime and other mortgages, those investors grew skittish. Some lenders backed by them have stopped funding loans altogether.

“The credit crunch has probably taken out 75 percent of buyers who were out kicking tires a year ago,” Hughes said.

And for those investors who can piece together financing from a variety of sources, that money now comes at a higher cost. At the same time, buyers know that rents are staying fairly stable. Many hope the credit crunch will prove temporary.

“There’s more risk now associated with commercial real estate than there was, say, six to 12 months ago,” said Grant Freeman, managing director of Staubach Capital Markets in Irvine. “It’s being seen in current transactions that are either falling out or being re-priced. A lot of buyers are standing on the sidelines waiting for the next couple of months.”

Because companies generally sign years-long leases for office space, rent prices don’t typically fluctuate as rapidly as they do in residential leases to keep up with annual shifts in costs. The “cap rates,” a type of price-to-cash flow ratio, are increasing significantly for commercial buyers, meaning they’re getting pickier over price and location and other potential deal-breakers.

“When money is more expensive, people can’t afford to pay as much, and when rents don’t change, you don’t get as much cash flow,” said Chris Pascale, senior vice president with CB Richard Ellis. “The stream of cash flow is fixed in a lot of cases.”

In another subsector of commercial real estate, values are shifting in apartment buildings after years of significant increases in prices from investors looking to convert apartments and sell them as individual condos.

Robert Vallera, principal with local firm Commercial Realty Advisers, referred to an apartment property about to close in El Cajon that is selling for “perhaps 25 percent below where it would’ve sold two-and-a-half years ago.”

“Apartment prices a few years ago, mid-decade, were primarily based upon condo-conversion economics,” Vallera said. “We’re seeing some properties come on the market now where the prices have made a substantial correction.”

Just as the housing slump has weeded out short-term flippers, investors in commercial real estate are now facing longer commitments when deciding to invest in properties, Vallera said.

But the conditions are catching some novice investors unaware. There’s a correlation between landlords of office space and home sellers in the residential market, Hughes said. The office landlords are holding onto ideas of rising rents from a few years ago, just like sellers remember what their homes were worth at the peak of the boom. Meanwhile, building owners face rent price competition from individual tenants looking to sublease some of their space.

“These landlords aren’t coming to grips with reality,” Hughes said.

The economic uneasiness in the region and the nation, stemming largely from trouble in housing, has unavoidable repercussions on commercial real estate.

“[Would-be buyers] read the paper just like everybody else,” said Brandon Keith, another principal with Commercial Realty Advisers. “If it’s their first commercial purchase, they maybe think, ‘If housing prices are going down, then maybe commercial prices will, too.”

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