'90s real-estate crash unlikely in today's market

July 17, 2005|By Jay Hancock

MANY interesting and alarming things have happened to the economy in the last 15 years. But we haven't had a good old-fashioned commercial real-estate crash, the kind that had bank regulators popping Pepcid while half-finished office buildings languished for months or years.

Are we paving the way for one now?

Commercial real estate valuations are coming on strong even as rents and occupancies in many markets are only so-so. Of more than 200 Maryland-based mutual funds, six of the top 10-best performing in the second quarter were real estate funds, according The Sun's quarterly survey.

Bloomberg's index of office-property real-estate investment trusts has appreciated by 16 percent since the beginning of the second quarter. Bloomberg's index of retail REITs rose by 20 percent in the same period, and hotel REITs went up by 12 percent.

"There's just been a flood of capital that's come into the market in the last two years," especially from REITs and pension funds, says Dan Fasulo, director of market analysis for Real Capital Analytics, a New York firm that tracks commercial property values.

Even so, commercial real estate is not the most dangerous-looking sector of the economy and seems nowhere near where it was in, say, 1989.

Office buildings, hotels and malls are classic boom-and-bust businesses. When monetary authorities open the spigots as they did in the 1980s and again in the 1990s, the money often goes straight into commercial buildings, and a commercial property slump and a banking crisis are often hallmarks of a recession.

The commercial-property crash of the late 1980s and early 1990s, which was especially severe in the Baltimore-Washington corridor, caused the savings-and-loan crisis and prompted a banking consolidation that included the absorption of Maryland National Bank by what is now Bank of America.

But since the last real-estate disaster there have been numerous other hot investments to soak up the liquidity. First Internet stocks, telecom stocks and stocks generally, then commodities and residential real estate, and, through the whole thing, bonds.

That's one reason the 2001 recession was so mild. Without a real-estate bust, the banking sector stayed amazingly healthy and there was never a credit drought of the kind that aggravates many recessions.

Now, of course, residential real estate has gone berserk, with homes in many markets appreciating 50 percent or more in the last five years. Lately commercial property is moving in the same direction, although not nearly to the same degree.

"I thought a couple years ago it was going to level off or plateau," says Edwin F. Hale Sr., whose development company is adding hundreds of thousands of square feet in office space on the east side of Baltimore harbor, and whose First Mariner Bank is also exposed to commercial real estate via loan collateral. But, he says, "I've been buying and the prices have continually gone up."

For the first five months of 2005, $32 billion in office buildings - worth at least $5 million apiece - were sold, according to Real Capital Analytics. That's up more than 40 percent over the comparable five-month period last year.

"In 2001 and 2002, the private buyers dominated the landscape for office buildings," said Real Capital's Fasulo. "But probably in the beginning of 2004, we started to see a shift where private investors became net sellers and institutions and REITs stepped up and became net buyers. REITs have been tremendously successful in raising money from Wall Street."

The National Association of Realtors projects that U.S. office space will grow by 56 million square feet by the end of 2006, nearly 2 percent. It shows office rents growing by more than 4 percent annually, but vacancy rates of around 15 percent in many markets raise questions about whether that is realistic.

Even so, this isn't the time to panic about commercial real estate.

Driven by soaring federal spending, Baltimore-Washington is one of the stronger markets in the country, says Fasulo. And the national economy doesn't seem in danger of falling into recession anytime soon, the Federal Reserve's unrelenting increases in short-term interest rates notwithstanding.

Even if it does, the banking sector - the nurturing marrow of any economy - still seems relatively unexposed to any exuberance in commercial real estate.

As in the 1990s tech-company bubble, much of the action in commercial property is being driven by Wall Street. To be sure, REITs, brokers and even the bond market could be roiled by a commercial real estate shakeout. But that wouldn't be as bad as a banking crisis. And to the extent that they are involved in offices and retail, banks seem to be playing much more conservatively.

"In the late '80s and early '90s there was a lot of speculative construction going on" - buildings going up with no pre-signed tenants, says Vicky Wagner, a financial services credit analyst at Standard & Poor's. "We're not really seeing that today, at least with the developers that the banks are funding."

Plus, she said, "banks today are requiring a lot more equity."

So at least some investors are still heeding the lesson from 15 years ago, which is forever in modern finance. Imagine that.

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