Agora Financial’s Rude Awakening

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Laguna Beach, California

• The service sector: leading commercial real estate the way of the
  residential dogs,
• A contrarian take on the NAR’s sentiment and what it portends for the
  housing market,
• News and reviews from the non-experts and plenty more…

Eric Fry, reporting from Laguna Beach, California…

“Our business is still solid,” the commercial mortgage broker in the office
next door declared last August. “I know the residential real estate market is
having some problems, but we’re just not seeing it on the commercial side.”
Two months later, the broker’s office was vacant.

A couple weeks ago, when the former broker returned to his former office to
gather up a few belongings, he stopped by our office to chat for a bit. “What
went wrong?” we asked. The broker shook his head and said, “The business just
died. Credit completely dried up. We had some top-notch projects to finance,
even on great terms, but the banks wouldn’t touch ‘em.”

“The banks wouldn’t lend at all?” we asked.

“Nope,” he replied. “All of the banks that used to finance our deals just
shut off the spigots. The lenders are just running scared, plain and simple.
They’re trying to preserve capital. They’ve stopped lending to anyone except
for AAA borrowers. And that was not our business.”

“Wow,” we replied sympathetically. “That’s rough…So what happens next?”
“No idea,” he shrugged. “No idea.”

Hmmmm, we thought to ourselves, maybe WE have an idea. Maybe the commercial
real estate market is about to step into the same tar pit that swallowed up
the residential real estate market. Maybe the best real estate to own in
America will soon be NO real estate.

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The Echo-Bust
By Eric J. Fry

The U.S. economy is as unsteady as an intoxicated prom date…and so is the
commercial real estate market. Maybe one of these festively attired beauties
will manage to hold the other one up. But chances are better that both of
them will stumble around on their high heels for a while longer until,
eventually, they both tumble into a pathetic heap.

The U.S. economy – to continue our metaphor – is already too far gone to
offer any reliable support to anything. The room is already spinning, so to
speak. What, therefore, will become of the commercial real estate market?
Without the economy’s shoulder to lean on, how will she manage to stay on her
feet?

Let’s examine the evidence, both anecdotal and empirical, to find answers to
these questions. First, a troubling anecdote: The National Association of
Realtors (NAR) sees no problems on the horizon. Instead, the NAR anticipates
“healthy” commercial real estate trends throughout 2008.

From a contrarian perspective, the NAR’s blind confidence feels more ominous
than comforting.

“The fundamentals in commercial real estate remain healthy with only slight
increases in vacancy rates expected for the office and industrial sectors
during 2008,” declares the most recent “Commercial Real Estate Outlook” of
the National Association of Realtors (NAR). “With jobs still being created,
the demand for office space remains positive…”

The NAR’s Chief Economist, Lawrence Yun, also exudes optimism. “Vacancy rates
in the retail and multifamily sectors are projected to tighten in 2008,” he
predicts, “with rents rising in all sectors.”

The NAR does admit that “credit restrictions have recently slowed overall
investment activity.” Nevertheless, Patricia Nooney, chair of the Realtors
Commercial Alliance, says, “Even with the credit crunch there’s been no
significant impact on institutional investors…”

If, therefore, the real estate experts at the NAR remain so hopeful,
shouldn’t we non-experts embrace their outlook? In a word, no.

Hope is dangerous when it feeds deceptions…

In May of 2005, CNBC aired a segment about the housing market entitled,
“Bubble: Fact or Fiction?” The CEO of the National Association of Home
Builders (NAHB) argued the “fiction” side of the debate, while yours truly
advocated the “fact” side. The NAHB’s CEO, Jerry Howard, never deviated from
the party line. The housing market is fine, he insisted.

Summarizing Mr. Howard’s contribution to this riveting CNBC debate, the NAHB
Web site stated: “Jerry went head-to-head with Eric Fry, author of the
investment column known as ‘The Rude Awakening,’ on the network’s Power Lunch
program…Jerry emphasized the solid fundamentals of housing, including low
inventories, strong household formations and other demographic factors. Host
Bill Griffeth was compelled to agree that ‘We are seeing legitimate reasons
for this market to continue to be hot right now.’…As for markets where
prices have outstripped incomes, Jerry cited a recent FDIC report that
downplays the risk of a bubble bursting. Instead, says the FDIC, price growth
will tend to flatten or slow for a while until incomes can catch up.”

Unfortunately, Mr. Howard’s forecast did not pan out. Instead, the
residential housing market began to implode almost as soon as the two of us
unhooked our microphones and stepped away from the CNBC cameras.

Financial markets do not listen to industry cheerleaders. In fact, financial
markets like to embarrass industry cheerleaders. That’s just the way the
world works. The markets also like to embarrass overly confident financial
journalists and anyone else who dares to issue a specific forecast. (That’s
why we try not to tell the financial markets what to do. Our forecasts are no
better than Mr. Howard’s).

Since the real estate industry’s top dogs failed to recognize the end of the
housing boom, might they also be missing the end of the commercial real
estate boom? A prudent investor must consider that possibility.

A prudent investor might also wish to consider the historic relationship
between economic activity and commercial real estate trends. The Institute
for Supply Management’s (ISM) Non-Manufacturing (Service Sector) Business
Activity Index illustrates this close relationship.

 

Service sector trends tend to lead commercial real estate trends, both to the
upside and to the downside. For example, the ISM Non-Manufacturing Index
dropped sharply after the tech bubble burst in late 2000. Over the next three
years, the office vacancy rate in Midtown Manhattan more than doubled, from
less than 5% to more than 11%. Nationwide vacancy rates mirrored the
Manhattan trend. Indeed, many cities suffered much higher rates. As economic
activity rebounded, however, the vacancy rate retreated to nearly 6%.

But economic activity is slumping again. Yesterday morning, the ISM reported
a stunningly poor reading of 41.9 for its “Non-Manufacturing (Service Sector)
Index of Business Activity” – the lowest level in seven years. This ugly
report did not merely provide a handy excuse to hack 370 points off of the
Dow Jones Industrial Average; it also provided a legitimate reason to doubt
the underlying strength of the commercial real estate market.

Now that the ISM Non-Manufacturing Index is falling – in fact, it is
plummeting – office vacancy rates should start rising anew…unless the NAR
knows something that we non-experts don’t.

Check in tomorrow for another non-expert glimpse of the commercial real
estate market.

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[Rude Endnote: Being the curious bunch that we are, we’d like to know what
you think about the outlook of the commercial real estate sector in the U.S.
Is this belle of the ball likely to win prom queen? Or will she be making an
ignominiously early exit on account of the “spiked punch?”

Send your forecasts to us here and watch this spot in coming days.

Cheers,

Joel Bowman
Rude Awakening