Nationwide, the office vacancy rate rose to 15.9% in the second quarter, up from 12.5% at its low for the cycle in the third quarter of 2007. As the graph below from REIS (by way of http://www.calculatedriskblog.com/) shows, the office vacancy rate is rising fast, but has not yet reached the levels seen in the last two recessions.
The 1991 recession was largely caused by overinvestment in the commercial real estate (CRE) market, so if we get to those levels we are in serious trouble. I suspect we will be in serious trouble before all is said and done. Note that the office vacancy rate tends to peak well after the recession finally ends, and then only starts to decline gradually.
With particular respect to offices this is not very surprising, since that is the same behavior that unemployment shows. People out of work mean empty cubicles. The graph also reflects this in how high the vacancy rate was at the top of the last cycle relative to the top in the late 1990’s.
The most recent expansion was notable for its extremely poor performance in creating jobs relative to all previous economic expansions. Still, through last year, CRE construction was a major offset to weakness elsewhere in the economy. With the vacancy rate rising fast, looks for a sharp slowdown there. That space that is being finished up is simply coming on to a glutted market. Yet another factor in why this recovery, when it comes, will be weak.
With rising vacancies come falling rents, which landlords sometimes try to disguise with incentives like months of free rent and remodeling allowances. This you need to look at effective rents, which include those incentives. In the second quarter, REIS found that nationwide the effective office rent fell 2.7% to 23.42 a square foot, following a 2.3% decline in the first quarter. The asking rent was down by 1.4%. On a year over year basis, effective rents are down 6.7%.
This also means there will be pressure on the valuations of CRE. While perhaps an extreme case, this story is of note. It tells of a downtown San Francisco office building that sold for $400/sq. ft. in 2006 that recently sold for just $172/sq. ft. — a 57% decline.
Small to midsize banks ($1 to $10 billion in assets) tend to have very large exposures to CRE. That is one reason that the FDIC will likely have to keep up its very busy pace (seven just last week) of bank closures. More directly, falling rents (and cash flow) and declining asset valuations can hardly be described as good news for REITs like Duke Realty (DRE), Boston Properties (BXP) or Vornado Realty (VNO).
Read the full analyst report on “DRE”
Read the full analyst report on “BXP”
Read the full analyst report on “VNO”
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