Core Strength in CRE

The consumer price index increased 0.6% in May, the Labor Department noted last Friday. Excluding food and energy, it advanced a modest 0.2%. Wall Street economists had expected a 0.5% rise in the headline and 0.2% core increase.

The surprising strength of the retail market, which came in twice as high as economists predicted, reinforces the ongoing shift of financial market and policymaker attention toward inflation risks and away from the risk of an imminent downturn in the economy, a move I wrote about in last week’s blog.

The strong report helped to boost the dollar, which rallied against both the euro and yen. The U.S. Dollar Index, which tracks the currency’s value against a basket of six foreign denominations, recently rose 0.9%, or 0.66 point, at 73.90.

As a whole, these reports indicate a U.S. economy that is, at best, tentative. Our core economy continues to post modest gains, which is good news for business and industry and has enabled CRE to remain fundamentally strong.

Real estate fundamentals remain solid with vacancy rates near the set points and with workman-like rent growth. CRE delinquency rates – at 0.5% – remain at near-historic lows and reflect generally healthy occupancy and income growth. The unknown continues to be the uncertainty in the economy, which is creating some deterioration in selected markets across the country. Clearly there has been deceleration in the first quarter of 2008, which has resulted in negative net absorption – not seen since the last downturn.

Overall vacancies edged up slightly to 14.3% in the first quarter from a cyclical low of 13.6% at the end of last year. With an uncertain economy, business turned cautious more quickly. Companies planning relocation or expansion have tabled their plans temporarily. Others are watching and waiting to see if there is more downward pressure on rental rates. Companies, if they are able, are waiting on the sidelines.

One factor that differentiates 2008 from the previous downturn in the national office market is that there are fewer construction projects online across a majority of markets. Private nonresidential-construction spending in April was at a seasonally adjusted annual rate of $388 billion, up 1.6% from March 2008 and up 15.4% from April 2007. Most of this construction was earmarked in the lodging sector. This time the industry is not saddled with too much inventory; it is weighted down with an anchor of poorly managed and priced debt. Fortunately, this is a situation that can be cured more rapidly.

Regionally, the commercial office market remains solid, and in many cases is still growing, albeit more slowly. In Houston for example, the nation’s fifth largest office market with 183.05 msf of total office space, overall occupancy stood at 88.2% — 91.1% in the CBD—and Class A space was 92.4% leased.

In Dallas, the area’s office leasing market began strong in the first quarter of 2008 with 834,200 square feet of positive net absorption, which primarily was driven by the Class B sector. Overall vacancy rates remain stable, signaling that current availability is meeting demand. For the first quarter of 2008, rental rate growth inched up slightly from the fourth quarter of 2007.

At 412 million sf of office space, New York City still is seeing modest rent growth of about 8.8%. In the Midwest, Chicago posted a modest positive absorption of 70,000 sf in the CBD during the first quarter. Total vacancies in the CBD were at 13.3%.

Although there is core stability in the industry, transactions must be completed in order to generate solid growth. Clearly, the CMBS market, which may be the driving force behind the recent boom years in the real estate capital markets, has completely changed in the last nine months. The widening of spreads, combined with a low tolerance for risk, has resulted in an industry that has seen virtually no activity for those who rely on securitized mortgage products.

As a result, U.S., banks — constrained now because of weak balance sheets — will have to start lending again. The good news is that with their borrowing costs relatively low, banks can repair the damage relatively quickly. Over the remainder of 2008, cash buyers including institutional funds and foreign buyers, may be expected to increase their market share among all purchasers. And as often is the case, the market will trim and prune itself and the result will be a stronger industry.