Commercial Real Estate
Maintains Its Strength

By Jennifer S. Forsyth
From The Wall Street Journal Online

With America's housing market clearly cooling, will commercial real estate start to swoon?

Hardly. The national office market, which cratered after the tech bust in 2000, has recovered and is the strongest it has been in five years. The shopping-mall market has stayed strong because consumer spending held up better than expected. And hotels had their most profitable year ever in 2005, partly because of strong business travel.

In fact, the commercial markets benefited from the former froth in the residential-property market because the boom in residential construction limited the amount of land that could be used for other purposes. In some markets, the conversion of apartments, hotels and, to a lesser extent, office buildings, into condominiums reduced the risk of oversupply -- one of the biggest hazards in commercial real estate and one that contributed to the sector's crash in the late 1980s.

Despite the widely varying types of commercial properties -- and the fact they are partly driven by different factors -- it isn't uncommon for people to assume if houses aren't selling, commercial markets must be at risk, too. So common that the faulty assumption itself could be self-fulfilling, says Robert White Jr., president of Real Capital Analytics, a New York-based real-estate information firm. "I so worry...that if they get burned on their condo in Miami, they are going to stay away from any other commercial real-estate investments for the next decade. Those markets are completely different."

Home-ownership trends are tied directly to income and interest rates, says Glenn Mueller, an investment strategist for Dividend Capital Group, a Denver-based real-estate investment-management firm. And home buying was made unusually affordable in the past few years by low interest rates and the popularity of mortgage-financing options such as interest-only loans. This led to high demand, much speculation and lots of new building. But as interest rates began to rise, it became more difficult for people to afford or even to qualify for loans. That has produced a glut of homes and condos in some markets.

Of course, interest rates affect commercial mortgages as well. Cheap debt has been one reason why there have been so many bidders on the commercial buildings sold over the past few years, pushing prices to record levels and yields to unprecedented lows.

Unlike the residential market, in which investors are most often private individuals, commercial investors are more diverse and not nearly as tied to mortgage rates. Dr. Mueller also points out that some of these investors include institutional buyers such as pension funds that pay cash instead of borrowing money. There's also still strong demand for commercial real estate, particularly among foreign investors. "We just don't see any slowing of investor interest, particularly in retail and hotels," says Deborah Jackson, executive managing director of New York-based Weiser Realty Advisors LLC.

In addition to condo conversions helping to reduce the supply of office space outright, residential construction has contributed to the high cost of land and materials in many U.S. markets. In many cases, because of high construction costs, it was cheaper to buy an office building -- even at high prices -- than to build a new one. Without much new speculative development, vacancy rates have dropped in almost every major market and landlords have been able to get more for rents.

In Miami, for example, residential units in the central business district increased 55% since 2000, while the office increase was 9.5%, according to Jones Lang LaSalle, a real-estate services firm. Even if developers contemplated a new office building, the construction companies were likely tied up with residential jobs until recently, says Jubeen Vaghefi, a Miami-based managing director for Jones Lang LaSalle. All the while, the South Florida economy has been steadily improving. Those forces combined to boost the office market there.

To be sure, the office recovery is uneven. Longtime struggling office markets such as Dallas, while improving, still have high vacancy rates from previous overbuilding, as do areas such as Cleveland and Detroit, where job growth has been limited.

Real estate also remains a cyclical industry, and it is early in the office sector's recovery. Investors who paid sky-high prices for commercial buildings, especially those who financed using floating-rate debt or interest-only loans in the early years, are dependent on their optimistic growth projections to deliver.

Yet, with generally improving fundamentals such as reduced vacancy and higher rents and few worries about overbuilding in most markets, the office sector should continue to improve in the near term, if job growth doesn't take a dive. "We're still in that race between increasing interest rates and increasing fundamentals," Stephen Blank, senior resident fellow of finance with the Urban Land Institute, says of the commercial market. "It appears to me that we are going to skate through this."