The Commercial Real Estate Crash

It
once seemed unstoppable. Now, the Seattle-area commercial office space market
is headed for a rough period of adjustment. But while many developers and investors
are feeling the pain, others see plenty of new opportunities.

The
vacancy rate, which was already at 18.5 percent in Seattle’s central business
district at the end of the third quarter of 2009, according to Cushman &
Wakefield, could climb to anywhere from 20 percent to 30 percent, brokers now
say.

Bellevue’s
central business district is in slightly better shape than Seattle’s, with an
overall vacancy rate in the third quarter of last year at 14.8 percent, thanks
to greater pre-lease commitments for new buildings and Microsoft’s expanded
presence there, according to Matthew Gardner, principal of Gardner Economics
LLC in Seattle. Still, those numbers are high following the long run during
which vacancy rates in many markets in the region fell below 10 percent.

And
the market is headed for tougher times. Amber Waltner, a research associate
with Cushman & Wakefield, expects rising vacancy rates to push average
market rents down by another 4 percent by the end of the year.

“The
current glut of office space in the Seattle market is due primarily to two
factors: overbuilding and the bankruptcy of Washington Mutual,” says Sean
Barnes, senior vice president of Seattle-based Jones Lang LaSalle Americas Inc.
In 2009, more than 1.1 million square feet of existing office space hit the
market in large part due to the collapse of Washington Mutual. In addition,
another 2.3 million square feet of office space was added to inventory through
new construction with planned delivery in 2009 and 2010.

Craig
Kinzer, principal of Kinzer Real Estate Services in Seattle, says many
companies have built new headquarters in the past couple of years, which opens
up space they were previously leasing, “so you have excess supply, not just
from developers building, but from entities that are putting out space
themselves.”

In
addition, says Dan Lowen, president of Seattle-based Caerus Realty Capital LLC,
most companies have cut back staff as a result of the recession, noting that
these businesses, in turn, are locked into long-term leases of up to five to
seven years. Some of those firms are attempting to sublease excess space right
away, but Lowen says it generally takes time for the space to come back on the
market as a vacancy until the tenant signs a new lease for less space. Layer on
to this situation the fact that Amazon.com is vacating its headquarters
building on Beacon Hill, in Union Station and in the Columbia Tower as it moves
into its new South Lake Union campus “and you have a recipe for substantially
higher vacancy rates,” Lowen explains.

Craig
Kinzer thinks the vacancy rate could eventually be “in excess” of 30 percent.
“When you go building by building, and you assume negative absorption [overall
absorption being the change in occupied built space for a given period of time],
you get to 30 percent,” he says. “We’ll probably hit bottom here in Seattle
sometime in 2010.” And it will take the market another two or three years to
adjust, he predicts. In the meantime, Kinzer says firms are reducing their
square footage and using existing space more efficiently.

Some
of the big winners in this scenario are the tenants, who can take advantage of
the stagnant market to negotiate lower rents. “Rents are going to be low and
it’s going to be a tenant’s market for quite awhile,” Kinzer says.

Adds
Caerus Realty Capital’s Lowen, “The winners over the next few years will,
without question, be tenants.” Net effective office rents (after calculating
the effect of tenant improvement allowances and concessions like free rent)
will continue to fall as vacancy climbs, Lowen notes. “Landlords see the vacant
space available in the newly built office buildings, existing buildings like
the WaMu tower and the pending vacancy from Amazon.com, and they know that they
have to do whatever it takes to renew their existing tenants rather than risk
long-term vacancy as they wait for the market to recover,” he says. Tenants
should negotiate and “blend and extend” their current lease term while dropping
the rental rate, provided they are confident in the amount of space they will
need over the next few years, he adds.

“One
key is that landlords need to begin to feel the pain of carrying vacant space
and once they become hungrier, the opportunities for renegotiations will
present themselves,” says Barnes of Jones Lang LaSalle.

Landlords
and banks may be the ones who suffer through the office market churn the most.
“The biggest losers will be landlords who paid peak pricing for their buildings
between 2005 and 2007, and who used a significant amount of debt,” says Caerus’
Lowen. Most of those high leverage deals were initially made with debt service
coverage ratios that barely exceeded the property’s net operating income and
were based on the idea that the economy would continue to soar and rents would
climb. If these owners lose tenants, or rents fall beyond the level that they
can pay their debt service, the owners risk defaulting on their loans and could
be foreclosed on by their lender. Many of those landlords or large companies
are from outside the region, such as Boston-based Beacon Capital Partners,
which owns several properties including the Columbia Center and other
properties acquired at the peak of the market.

Gardner
Economics’ Gardner says, “As loans [for landlords] become due, I fear they
won’t be able to refinance them.”

Broderick
Smith, vice president at Urban Visions, a real estate development and brokerage
firm in Seattle, says landlords and building owners who used high amounts of
leverage in the 2005 to 2007 boom years may encounter an “equity gap” when it
comes time to refinance, due in large part to tighter lending criteria from
banks. Though a building may still be able to cover its debt service at
maturity, other factors have shifted in the capital markets. These changes make
it challenging to replace a note with terms similar to one written in the
stronger climate, Smith says. Landlords will have to bring new equity to deal.

What
will happen to the banks when faced with building owners and landlords who
can’t pay? “If a bank ends up taking an asset back, it may be less willing to
unload assets at ‘fire sale’ prices after watching how much money investors
made in the ’90s buying bank-owned real estate,” says Smith. “Either way, we do not anticipate banks
will own more commercial real estate in the coming years. The fact of the
matter is that they are not in the business of owning real estate. They will
want to get the real estate off their books.”

Lowen
says lenders in some cases will work with the borrower to renegotiate the debt,
but in other cases, will foreclose and liquidate the building to recoup as much
of their loan as they can. He observes that most lenders today, with the
explicit approval of the FDIC, are practicing “extend and pretend,” whereby
they push out the maturity date of loans in hopes that values will recover, or
that another lender will refinance their position later. “Unfortunately, this
practice is futile,” Lowen says. “The result will be aggregating together all
the ‘zombie owners’ who are under water on their loans but still control their
property and creating ‘zombie banks,’ which, to the untrained eye, may seem
well capitalized, but, in reality, do not have the strength of the balance
sheet to extend new loans.”

Still,
there are companies like Caerus that see opportunity. “Today is a great time to
invest for those who have capital available,” Lowen says. “Low prices and an
economic recovery on the horizon will make the next few years a very attractive
time to invest in commercial real estate.”

One
of the commercial market’s biggest deals of the year was announced
mid-November, as an affiliate of Hines, a Houston-based international real
estate firm, sold the so-called Expedia Tower in Bellevue to Newton,
Mass.-based HRPT Properties Trust. The deal, for a reported $168 million, was
significant in large part, according to Lowen, because the tower is about 84
percent leased through 2018 by Expedia. While the Bellevue office market is
expected to perform better than Seattle’s, during the next two years, Lowen
says HRPT has the advantage that Expedia is paying an above-average market
rent. HRPT’s investment may yield nicely, providing Expedia renews at the end
of the lease or if a soft market prevails at lease end, Lowen notes.

A
recent report, “Emerging Trends in Real Estate 2010 Forecast” by
PricewaterhouseCoopers, states “those that are patient, daring and selective
could score generational bargains on premium properties from both distressed
sellers and banks that are clearing out unwanted bad loan and real estate owned
portfolios.” But the key will be having cash to buy, the report notes.

Mark
Schuster, CEO of the Schuster Group in Seattle, raised $40 million late last
year to take advantage of the current market. His firm is looking to buy seven
to 10 properties, including residential, mixed-use and commercial locations.
Investors continue to consider real estate a good investment, Schuster says.
“It’s still brick and mortar,” he explains.

Schuster
is also optimistic about Seattle. He says he concentrates on the fundamentals, and
Seattle has them: a center for international trade, a strong port, a diverse
employment base, and an attractive culture and physical setting that make
people want to move here.

Employment
is the key that drives commercial office space use, brokers note, and until
companies begin hiring again, the situation will be fluid. Generally, brokers expect hiring to
increase moderately during 2010, then to grow in 2011. “We still have a lot of
people to get back to work,” Schuster says.