Up in the Air
Economy's Downdraft Is Blowing Through Commercial Real Estate

By Dana Hedgpeth
Washington Post Staff Writer
Wednesday, November 5, 2008

Benjamin B. Lacy and his wife Debra sipped beer and munched on beef carpaccio a few weeks ago in Munich at a commercial real estate gathering. In recent years, the Lacys have advised Germans to invest about $1 billion in office buildings, helping pump up the regional market.

But not this time.

"Everybody showed up and we had nice dinners and drank lots of good beer," he said. "But underneath was a fear of doom and gloom. We were talking up deals but the undercurrent was, 'What is going on in the U.S.?' "

For the Lacys, who run a real estate investment and advisory firm, it was another stark signal that the global financial crisis is hitting the commercial market.

With few lenders doling out money these days, commercial real estate sales -- including office, mall and warehouse properties -- are expected to be less than half of last year's record-setting $514 billion, according to Real Capital Analytics of New York. More than $14.5 billion in deals have been canceled or pulled away from this year, including about $1 billion in the Washington region, according to Cassidy & Pinkard Colliers.

In addition, growing layoffs and falling profits mean companies are giving up office space at rapid rates. Nationwide, more than 19 million square feet of space -- enough to fill more than 300 football fields -- has been emptied by office users this year, the most since the months after the Sept. 11, 2001, attacks. Locally, about 1 million square feet of office space is dark and empty, according to Reis Inc., a New York-based real estate research firm.

PriceWaterhouseCoopers and the Urban Land Institute concluded in a recently released report that "U.S. commercial real estate faces its worst year since the wrenching 1991-1992 industry depression."

Analysts say that nationwide, rents are stagnant and will probably drop. Vacancy rates at offices, shopping malls and hotels are expected to rise, and billions of dollars of loans are coming due next year.

"This is a record-setter because it transcends real estate," said John Germano, managing director of the mid-Atlantic region for CB Richard Ellis, one of the country's largest commercial real estate firms. "You've seen companies that real estate depends on like Merrill Lynch, Lehman either be retrenched, sold or go under."

Things will get worse if unemployment rises nationwide and consumers continue to cut back on spending, according to analysts. Stores and businesses would lease less space, probably resulting in a glut of office space and lower rents.

"We haven't had the second shoe drop," said Dan Fasulo, a managing director at Real Capital Analytics, the real estate research company. "You're going to see more tenants closing up shop."

"If we get pushed into a recession, all bets are off. This is affecting everybody," he said. There are a few large, blue-chip projects around the country that are having troubles -- a sign that has brokers, developers and lenders in the industry worried that even deals in good, solid locations with established developers behind them are at risk.

For example, in Harlem, Vornado Realty Trust -- one of the city's biggest commercial landlords -- is suspending plans to build a 23-story, $435 million headquarters for Major League Baseball's cable network after it didn't secure additional tenants and financing, according to people with knowledge of the deal.

In Chicago, a marquee, $500 million project of offices, retail and a hotel at the city's landmark Union Station is years behind schedule after a deal to get a loan from Eurohypo, a real estate bank in Frankfurt, Germany, fell through, leaving the developer to try to secure another. "They pulled it back," said developer Hossein Youssefi of his deal with Eurohypo. He said the deal was going to be 85 percent leveraged financing, but Youssefi said Eurohypo told him they were "going to be in a holding pattern." He's trying to get another loan but said he couldn't elaborate on the details because of a confidentiality agreement. "We are hoping it happens," he said. "Nothing these days is finalized."

Some real estate companies and well-heeled investors are hurting.

General Growth Properties, the nation's second-largest shopping mall owner and owner of Tysons Galleria and Landmark Mall, replaced its chief executive, and some analysts fear the company is overleveraged and selling off properties. General Electric, which has one of the largest real estate portfolios in the world, said it had a 62 percent decline in its third quarter profit on real estate -- to $244 million from $640 million -- and is selling off some of its assets.

In the Washington area, there is a concern that new developments won't break ground, as it is harder for developers to get loans. The sales market, which had been considered a hot spot for out-of-town and foreign investors, is slowing from last year's unprecedented run, when 170 buildings -- worth $10.1 billion -- were sold in the Washington area. That compares with 51 buildings worth $3 billion for the first nine months of this year.

One major fear is that Washington, long considered a bulwark because of its steadily growing economy anchored by the federal government and the spinoff of related businesses leasing office space, is growing "increasingly vulnerable, as leasing activity has eased to its slowest pace in over a decade," said Sigrid Zialcita, director of research at Cushman & Wakefield.

The office vacancy rate in the region is hovering around 10.9 percent. If unemployment rises, that rate will probably go up, analysts say.

"D.C. is used to having favored-nation status where it is usually insulated from downturns," said Brian McVay, executive vice president at Cushman & Wakefield's Washington area office. "We're now going to see some of the pain here like everywhere else. "If you haven't broken ground on something, the chances of you doing it anytime soon are slim."

Some deals are getting financed, but they are typically smaller and have multiple lenders. In some cases, a building that houses a government tenant often has an easier time getting a loan because it is not as subject to market ups and downs.

At the $1 billion Portals project in Southwest, the building's owner, Republic Properties, typically would have refinanced the original commercial mortgaged-back security loan on the property as it was coming due or gotten a single bank to lend the money.

But since commercial mortgage-backed deals are all but gone and lenders are reluctant to make large loans, Republic went to 40 or 50 banks to find lenders. The building is about 40 percent leased and has a solid tenant with the Federal Emergency Management Agency.

Last month, Republic landed a $212 million loan with Cal National Bank of Los Angeles and a fund of Prudential real estate. Cal National only put up $120 million, so Republic got a $92 million mezzanine loan to bridge the gap. Mezzanine debt, much like a second mortgage on a house, is much more expensive to borrow, ranging from 11 to 18 percent these days.

"Everything is harder," said David Webb, a senior managing director at Cassidy & Pinkard Colliers who helped put together the deal. "Everybody is extremely cautious and over conservative. You really don't know who will be there when it's time to close the loan."

Developer Douglas Jemal said he would normally have bought and sold 30 buildings and properties by this time in a year, but has only moved a handful. In the past three months, he's done none.

"This is worse than in the late 1980s and 1990s," he said, recalling fire-sale prices after the savings and loan crisis. "Real estate was depressed then, but banking institutions didn't stop lending. Now you can't get money even for a good deal."

He's been trying to move forward on his plans to redo the old Wonder Bread factory near the Shaw-Howard University Metro stop in the District but cannot get financing from his usual lenders, which include Wachovia, Wells Fargo and PNC.

In Rosslyn, Bethesda-based JBG had planned to start construction on an office tower without signed leases from tenants. But the project is delayed because of financing troubles.

Lacy said he hasn't done a really big deal with German investors since April, when he sold an office building at 2099 Pennsylvania Avenue NW for $864 a foot, which at the time was one of the highest rates in the city.

"We've kicked a lot of tires, but nobody's acquiring anything," he said. "The music's stopped. Lending's slowed to a trickle."

"People are moving to the sidelines to wait and see what happens," said Matt Klein, president at Akridge, a longtime D.C. development firm that has participated in large-scale projects like Gallery Place. "There's a concern factor of not wanting to be a buyer when there's downward movement in the market. There's a saying that 'No one wants to catch the falling knife.' "

Staff researcher Julie Tate contributed to this report.

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