Wednesday, April 7, 2010

Historic Office Vacancy Rates Drag Down Commercial Property Values

Due to the weak jobs market, the vacancy rate for office space in the US has climbed to 17.2%, the highest level in sixteen years. This increase in vacancy is accompanied by falling rents, which is reducing cashflow to property owners and office building values. See the following article from Expected Returns.

It's quite fitting that on the same day children receive gifts from the fictitious Easter Bunny, we get more news in support of the fictitious economic recovery. We are already being duped into believing the oxymoronic "jobless recovery" thesis; now we are to believe that economic activity has picked up while office vacancies are rising and rents are falling. Ladies and gentlemen, welcome to the Twilight Zone economic recovery. From Reuters, Office Vacancy Rate Hits 16-Year High:

The U.S. office vacancy rate rose to 17.2 percent, a level unseen since 1994, as the market lost about 11.6 million net square feet of occupied space during the first quarter, according to the report released on Monday. The U.S. vacancy rate inched up 0.2 percentage points from a quarter earlier and was 2 percent higher than a year ago.

"As labor markets stabilize, we expect occupancies and rents to require another 12 to 18 months before showing signs of improvement, given typical lags in commercial real estate," Reis director of research Victor Calanog said in a statement. "Even as occupancy continues to deteriorate, we're observing signs of renewed leasing activity across different metros."

The U.S. office vacancy rate hit a cyclical low of 12.5 percent in the third quarter 2007.
Apparently a 38% rise in office vacancies since the inception of the recession is evidence of an economic recovery. I would love to hear the logic behind this one. Probably something along the lines of "since it's so bad, it can't possibly get worse." Not like this isn't something I heard month after month while we were headed straight into the economic inferno.

Rationally-minded folks understand that few indicators are more correlated with business activity than office vacancy rates. In fact, the cyclical low in office vacancy rates immediately preceded the start of the recession.

Rents Falling, Bank Losses Mounting

Rental rates fell an average of 0.8 percent in the first quarter, a less steep decline that seen last year. Asking rent fell 4.2 percent from a year earlier. Factoring months of free rent and landlord contributions to space improvements for each tenant, effective rent was down 7.4 percent from a year earlier.

Both asking and effective rent were off 0.8 percent from the fourth quarter 2009. The fact that effective rent is no longer falling at a greater rate than asking rent is an indication that landlords may have offered enough concessions to stimulate leasing activity.
Falling rents go hand in hand with falling property values. Since commercial property is valued based on a cash flow basis, and since operating income naturally falls with rising vacancies, commercial property is likely to remain on a downward trajectory. In a clear sign that businesses are hurting, rapidly falling rents are doing little to stop the rise in office vacancies.

Banks are on the hook for losses stemming from rising vacancies in commercial properties. This is one of the main reasons why bank failures in 2010 will likely exceed the 140 bank failures in 2009. Banks will continue to take on a defensive stance in extending credit as losses mount on loans granted at the peak of the housing bubble, and as economic activity stalls in the real world. As a result, small businesses will be starved of the very credit they need to survive. The downward cycle will repeat until we clear the debt from the system.

This article has been republished from Moses Kim's blog, Expected Returns.

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