Office market turmoil ahead

After spending more than a year in suspended animation, the commercial real estate industry is expected to hit bottom in 2010 with a wrenching thud.

Owners of business properties such as office buildings, warehouses and malls will suffer a surge of painful defaults, write-downs and workouts with their lenders as the market finally faces up to the reality of its diminished conditions, according to a report set for release today.

The long-awaited blood bath, however, will benefit investors who are able to swoop in to take advantage of record bargains.

Unlike the formerly overheated housing market, which is in the process of being purged through foreclosures and sellers’ growing willingness to lower their asking prices, the business of buying and selling commercial real estate has been stuck in neutral since the recession kicked in.

So far, potential sellers have been loath to lower their prices, and banks have been unwilling or unable to lend money for purchases. Even financially strapped owners who are unable to keep up their mortgage payments haven’t had to let go because their lenders don’t want to take back distressed properties in a down economy.

Banks instead have often been willing to renegotiate loan terms, a practice drolly referred to as “extend and pretend,” as both lenders and debtors hoped the market would turn around.

The era of wishful thinking is about to end, according to industry professionals who participated in a study by consulting firm PriceWaterhouseCoopers and the Urban Land Institute, a real estate industry trade group and think tank.

“The recession,” said Richard Kalvoda, a partner at PriceWaterhouseCoopers, “is now impacting the fundamentals of real estate.”

A key fundamental, for example, is office leasing. As white-collar companies lay off employees or go out of business in the tough economy, they no longer need as much office space. Landlords, in turn, lose rental income and find it harder to make mortgage payments.

With vacancy growing -- about 51 million square feet of space is empty in Southern California -- and rents falling, commercial property values are in the midst of the biggest drop since the Great Depression. Industry experts predict properties will have lost 40% to 50% of their value from the peak of mid-2007 by the time the market presumably reboots next year.

Retail and office properties will take the biggest hits, the report said, as nervous consumers curb spending and companies delay rehiring. Many landlords who are barely hanging on now will lose their grip in 2010 -- and some investors can hardly wait.

“Our report participants find that a sense of nervous euphoria is growing among liquid investors who can make all-cash purchases,” said Stephen Blank, a senior resident fellow at the Urban Land Institute. “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.”

Among those poised to leap is real estate fund manager Xavier Gutierrez of Phoenix Realty Group. The New York-based firm is sitting on $450 million it has ready to buy real estate, including $170 million earmarked for the Los Angeles area. The money will be invested on behalf of pension funds and insurance companies, he said.

The current real estate scene is “definitely grim,” he said, but the outlook for three years from now and beyond is much better.

Southern California has a young population that is still growing from new births and immigration. Apartments may be the first commercial real estate category to recover as a large cohort of people in their 20s leave home or stop doubling up with roommates when their economic status improves, Gutierrez said.

The region also is well-positioned for recovery in international trade through the ports of Los Angeles and Long Beach and local airports, he said.

Hotels, which have been particularly hard hit by the recession, can also bounce back quickly when the economy improves, said Kalvoda of PriceWaterhouseCoopers. Office buildings, which are dependent on hiring, and malls, which are dependent on consumer confidence, probably will take longer to recover.

Real estate industry leaders who are meeting at the Urban Land Institute’s annual gathering in San Francisco are more optimistic than they were at this time last year because they can see the reckoning finally on the horizon, said Richard Green, director of the USC Lusk Center for Real Estate.

“The mood is considerably lighter,” he said.

Green is concerned, though, about whether bankers will do what he thinks they should.

“One thing that is worrisome is that banks are still delusional,” he said, extending weak loans while hoping for a turnaround that will preserve older, higher property values.

“There are people out there who need to realize that we need to take the hurt and move on,” Green said. “People who have moved on see an opportunity.”

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