Commercial Real Estate Lags in Recovery

by JT McGee

I’ve always thought that commercial real estate was on its way out.

As companies like Border’s, Circuit City, and other stores close, big box retail outlets face new vacancies. In the office space, more people do more work from home, limiting the space necessary to do business. I still think most commercial property in the United States will be converted to residential properties.

How hard can it be to turn a strip mall into a row of townhomes? It has to be cheaper than building townhomes from the ground up.

Office Space by the Numbers

The Wall Street Journal shows how the landscape has changed for commercial real estate projects. Vacancies are up, especially in big box centers, and rents are still falling from a peak set in 2008.

With the exception of major deals in second-tier cities, the office market faces the same economic realities of the big box retail real estate business. In Miami, neither a hot location nor third-rate Midwestern locale, some 20% of all office space is unoccupied. Vacancies were half as high in 2007, before the real estate bubble burst.

The Big Concern

The biggest concern for investors is a changing cost structure. Much like air travel, real estate is a commodity product. Should a large amount of commercial projects go under, the whole cost structure could shift as foreclosed property is sold at a significant discount to its bubble valuation, pushing rents down.

Consider this scenario: you’re a real estate investor with a $2 million property acquired in 2008. Down the street, someone picks up a similar property with the same cash flow potential for $750,000. In what climate would you – the person with $2 million in debt service – compete with someone who has much lower costs.

How to Play Commercial Property

Personally, I think the best way to bet against commercial property is to bet against highly-levered commercial property REITs. Avoid betting against health care REITs or other specialized REITs with much more secure operating cash flows. Instead, REITs invested heavily in retail centers are likely to feel the pinch well before other firms that deal with niche, specialized property.

Alternatively, there are always the building and construction firms. Virtually every construction site uses a product from Hitachi Construction Machinery or an alternative from a company like Caterpillar. A play on CAT is as good as a play on real estate construction and capital spending, since no one is going to buy office construction equipment unless…well, they intend to build more office space. Up or down, the future for office construction is inherently intertwined with the products used to make more office space.

Stagnant, but not dead

I see commercial real estate stagnating, but never really going away. For example, I live near a major shopping mall/shopping center, and because of its prime location, vacancies are 0. However, as you travel towards older neighborhoods, vacancies go up considerably. My office, which is in an older part of town just a few miles away, has several vacancies – vacancies that won’t be filled for months, if not years. (I’m one of only a few people in the whole building.)

So if anything we’re likely to see premium office and commercial property demand a premium price. But office space and commercial property that is in lesser-desired areas (or areas which aren’t 100% awesome) is likely to see a very depressed price due to higher vacancies.

I suspect the vacancy problem will be worse one year from today than right now. As soon as RadioShack and BestBuy go bankrupt – the former going well before the latter – we’ll see a huge shift in vacancies and rental costs. There is just way too much office space out there right now.

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