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Commercial Real Estate Deals Decline in Cooling of U.S. Property Rebound

The U.S. commercial real estate market has slowed in the past three months as the sputtering economy and a pullback in debt financing limited deals, cooling a recovery from Washington to California.

A total of $49.8 billion of commercial property changed hands in the third quarter, down from $58.5 billion in the previous three months, according to a report released today by Real Capital Analytics Inc. The 15 percent decline is the second-biggest since the first quarter of 2009, the real estate research firm’s data show.

Deals slowed after concern deepened that the debt crisis in Europe may spread and the U.S. economy may enter another recession. Smaller markets are being hurt by less availability of commercial-mortgage bonds. The retreat may be an indication of a market awakening to the fact that it was getting ahead of itself, said Susan Wachter, professor of real estate and finance at the University of Pennsylvania’s Wharton School.

“You can’t turn an ocean liner around on a dime,” Wachter said in a telephone interview. “The market itself realized that deals were getting done at pretty pricey points, and at the same time you had all of the events that undermined confidence.”

Growth probably won’t accelerate “as long as conditions are as unsettled as they are,” Wachter said.

Commercial Recovery

In contrast to the U.S. housing market, where sales are near the same level as when the recession ended two years ago, commercial property demand has rebounded, particularly in the so-called core markets of New York, Washington and San Francisco. Commercial real estate transactions in the second quarter were more than double their level from a year earlier and quadruple the post-recession low of $12.9 billion in the first quarter of 2009, according to Real Capital.

Commercial real estate prices were little changed three of the last four months as “fear” crept into the market, Green Street Advisors Inc. reported on Oct. 6. Prior to the slowdown, prices had recovered three-quarters of the value lost after credit markets froze in late 2008, according to the Newport Beach, California-based property research company, which compiles its data from real estate investment trusts.

Third-quarter deals for office buildings, hotels, industrial properties, apartments and shopping complexes were up 38 percent from the same time in 2010, according to Real Capital’s report.

All Property Types

“While this growth is respectable, it falls well short of the gains posted at mid-year,” the company said in the report. “The slowing was evident across all property types and most markets as well. Nevertheless, sales have totaled $143.5 billion year to date, already surpassing the full-year 2010 total.”

Part of the sequential decline stemmed from large portfolio transactions in the second quarter, which included Blackstone Group LP (BX)’s $9 billion takeover of Australian mall owner Centro Properties Group’s U.S. shopping centers. Portfolio deals totaled $9.36 billion in the third quarter, down from $17.8 billion in the previous three months, according to Real Capital.

Sales showed “some surprising strength” in the third quarter, Dan Fasulo, managing director of New York-based Real Capital, said in an e-mail. Still, he said he expects volume to be “tempered” until Europe’s debt issues are clarified, and the market for commercial-mortgage securities recovers.

Bigger Decline

Preliminary data from a competing research firm, Washington-based CoStar Group Inc., showed an even bigger decline in third-quarter sales, with transactions tumbling 29 percent from the second quarter to $62.6 billion. Real Capital only counts deals of $2.5 million or higher, while Washington- based CoStar has no minimum size. CoStar is still entering data, so the decline will likely be smaller than the current number, said Aaron Jodka, manager of U.S. market research.

“The U.S. economy and the global economy are very much on shaky ground,” said Stephen Malpezzi, professor of real estate and urban land economics at the University of Wisconsin’s business school in Madison. “Commercial real estate doesn’t exist in a vacuum and it’s only going to recover to the extent there’s confidence amongst businesses -- the users of commercial real estate -- and that, in turn, depends on the consumer.”

Standard & Poor’s on Aug. 5 cut its credit rating for the U.S. to AA+ from AAA, while the Federal Reserve said last month that there are “significant downside risks” to the economy. Europe’s sovereign debt crisis poses a “serious” risk to U.S. growth, the Federal Reserve Bank of San Francisco said in an Oct. 17 paper.

CMBS Pullback

Financing for deals has tightened. Borrowing costs in the market for commercial mortgage-backed securities have jumped more than a full percentage point since the second quarter, according to an index from Barclays Capital Inc.

The $600 billion CMBS market had provided the cheap debt financing that drove commercial real estate to record highs in 2007, and sales of the securities were starting to come back gradually until late July. The market got a jolt that month when S&P pulled its rating on a $1.5 billion commercial-mortgage bond sale by Citigroup Inc. and Goldman Sachs Group Inc., which had already overhauled the transaction after investors demanded better collateral protection.

The CMBS turmoil has hurt secondary markets such as Minneapolis; Austin, Texas; and Raleigh, North Carolina, said Spencer Levy, a Baltimore-based executive managing director on the U.S. capital markets team at CBRE Group Inc., the world’s largest commercial real estate brokerage. There have been fewer bidders and lower offers, he said.

Important to Markets

CMBS “conduits weren’t the only lender there, but they were more important than in primary markets,” Levy said. Many secondary markets are already suffering due to poor job and economic growth, he said.

Uncertainty about potential U.S. bank losses from Europe’s debt crisis is sapping confidence and halting sales dependent on CMBS, particularly in smaller markets, according to Michael Knott, managing director at Green Street. Real estate investment won’t match levels seen in previous quarters of 2011 until “some lasting peace” is reached in the euro zone, he said.

Among bigger cities, property deals rose in the third quarter in New York, while falling in San Francisco, Los Angeles, Boston, Chicago and Washington, the major markets considered to be the drivers of commercial real estate sales volume, according to CoStar.

Manhattan Deals

The sales increase in New York was 1.1 percent, to $9.19 billion, CoStar data show. That was enough to be the largest volume since the fourth quarter of 2007, when $10.3 billion of property changed hands, part of an unprecedented surge of sales fueled by readily available securitized debt.

“August’s unusually high volatility in the capital markets helped to tenderize sellers more than scare off buyers” in New York, said Doug Harmon, senior managing director of Eastdil Secured LLC.

Harmon and his colleague Adam Spies brokered three of the biggest single-building transactions of the quarter, as measured by CoStar: a $980 million deal for a partial interest in 1633 Broadway, an office tower north of Times Square; a $920 million deal for the Starrett-Lehigh Building in Chelsea; and the $719.5 million purchase of 200 Fifth Ave., an office building across from Manhattan’s Madison Square Park in the Gramercy area.

“New York properties behave better in good times and bad,” Harmon said in an e-mail. Manhattan real estate offers more stability relative to other possible investments due to its limited supply, minimal construction and its attractiveness to a spectrum of global companies, he said.

Office ‘Headwinds’

New York isn’t immune to the pause in the markets. Manhattan office prices were “virtually unchanged” in the four months through September, Green Street reported Oct. 6. Demand could face “headwinds” as Europe’s debt crisis and job cuts in financial services, a key driver of office and residential demand, take their toll, the company said.

In Washington, where government demand once made the city seem recession-proof, property sales slid 8 percent to $3.5 billion in the third quarter, the third straight quarterly decline since hitting their post-recession peak of $5.2 billion in the last three months of 2010, according to CoStar.

A decline in job growth, along with the debate on the federal debt ceiling, has caused some hesitation on the part of buyers, said Kevin Thorpe, chief economist of real estate brokerage Cassidy Turley. Washington has fallen to No. 5 in employment growth among U.S. cities this year after being in the top three for the prior two years, according to the company.

Back to Safety

“There has been a change in recent weeks and that change is a shift back towards ‘core’ products,” Thorpe said. “We were reaching a point where investors were getting increasingly comfortable with buildings located out in the suburbs even with a little more risk. Since then, it’s been a slow shift back towards safety.”

Office markets with technology, social media and energy firms will continue to see investor demand, said Kenneth Rosen, chairman of the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley.

In San Francisco, transactions decreased 27 percent in the third quarter from the previous three months, according to CoStar. A bright spot was Silicon Valley, the technology center south of the city that’s home to Facebook Inc. and Google Inc., said Todd Shaffer, senior vice president at the Santa Clara, California-based broker Cornish & Carey Newmark Knight Frank.

Filling Vacant Space

A “fever” of property sales and leasing has reversed a space glut in the valley that two years ago had 43 million square feet (4 million square meters) of empty offices, Shaffer said. Silicon Valley’s overall vacancy rate fell 5.7 percentage points in the year through September to 15 percent, with office markets in Mountain View and Cupertino showing rates below 6 percent, according to the broker.

Nationwide, office rents and occupancy rates climbed in the third quarter from a year earlier, led by technology-heavy cities, Reis Inc. reported earlier this month. Apartment leasing also increased, while the gains in net occupied space slowed from the previous quarter, according to the New York-based firm.

Among retail properties, regional shopping-mall vacancies rose to 9.4 percent, the highest in at least a decade, Reis said. Retail also led the decline in third-quarter sales, with transactions falling to $8.2 billion from $15.7 billion in the second quarter, when Blackstone’s Centro purchase boosted the deal total, according to Real Capital.

“Assuming nothing changes, the European situation and the U.S. fiscal situation stay in flux, you’re going to see continued choppiness in real estate capital markets,” CBRE’s Levy said.

To contact the reporters on this story: David M. Levitt in New York at dlevitt@bloomberg.net; Hui-yong Yu in Seattle at hyu@bloomberg.net; Dan Levy in San Francisco at dlevy13@bloomberg.net

To contact the editor responsible for this story: Kara Wetzel in New York at kwetzel@bloomberg.net

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