Commercial real estate: Crawling toward recovery

Commercial real estate matters because it's a proxy for a city's economic health. When an economy grows, companies expand into new offices, warehouses and storefronts. Vacancy rates fall, property prices rise, and developers launch new projects. But when an economy shrinks or stagnates, all of those factors reverse, leaving a city with the half-finished office parks and "see-through" shopping centers that now plague greater Phoenix. W. P. Carey Real Estate Professor Karl Guntermann has made two additions to the ASU-Repeat Sales Index (ASU-RSI). The new commercial indices look at other business factors and how they have affected the real estate market over the past 20 years. And in the latest Greater Phoenix Blue Chip Economic Forecast, co-editor and consultant Elliott Pollack discusses the consensus forecast for Phoenix real estate.

If nothing else, people who care about commercial real estate in greater Phoenix can take cold comfort in this: the worst is probably over. But Karl Guntermann, professor of real estate at the W. P. Carey School and author of the ASU-Repeat Sales Indices (ASU-RSI), cautions that renewed good times — including lower vacancy rates and rising property prices — are probably several years away.

In commercial real estate, Phoenix isn't skipping toward another boom but rather crawling back to normalcy. "Prices are still declining, but not at the 40 percent a year rate that we saw last year," said Guntermann. "So commercial real estate prices haven't stabilized yet. When they do, that'll set the stage for recovery."

Guntermann wouldn't hazard a guess at when stability might come. Economic conditions in the region remain too uncertain. "Nationally, the economy's recovering," he said. "Arizona and Phoenix aren't showing a lot of sign of that. We still have office vacancy rates around 25 percent," compared with a normal level of 10 to 12 percent.

This week, Guntermann, who has long tracked residential real estate prices, introduced two new price indices for greater Phoenix, the Commercial Repeat Sales Index (CRSI) and the Two-Fourplex Repeat Sales Index. Guntermann and the W. P. Carey School will publish the indices quarterly. To create them, he collected data on commercial and two- to fourplex sales going back more than 20 years. He's using the indices to identify leading and lagging indicators of commercial real estate growth.

Indexing commercial conditions

In a report accompanying the new indices, Guntermann explained how his commercial index suggested that the local market's chaos had started to subside earlier this year. "[The index] began to decline dramatically by the end of 2008 and the decline accelerated throughout 2009," he wrote. "The first two quarters of 2010 show somewhat of a leveling off."

Commercial real estate matters because it's a proxy for a city's economic health. When an economy grows, companies expand into new offices, warehouses and storefronts. Vacancy rates fall, property prices rise, and developers launch new projects. But when an economy shrinks or stagnates, all of those factors reverse, leaving a city with the half-finished office parks and "see-through" shopping centers that now plague greater Phoenix.

A sign that the commercial real estate market may be headed to rebound is an economic indicator that Guntermann tracked in his report — the relationship between corporate earnings and prices. He compared ups and downs in total forecasted corporate earnings per share for companies in the Bloomberg Arizona stock index with zigzags in his price index.

He reasoned that "changes in a company's expected earnings, as reflected in financial forecasts, would be associated with changes in their demand for real estate, either through acquisition or leasing." And that's what he found. Over the last 20 years, rises and falls in forecasted corporate earnings augured the same for commercial real estate prices.

Most recently, for example, forecasted earnings peaked in 2006, while commercial real estate prices continued upwards for a couple of more years and then topped out. "The peak in [forecasted earnings] toward by the end of 2006 was an early signal that economic activity and, hence, the commercial real estate market were headed for a slowdown," Guntermann wrote.

"[Forecasted earnings] began to increase in early 2009 and the trend since then has been positive. If the historical pattern is followed, the bottom in commercial real estate prices occurred at the end of 2009." Guntermann also tracked the relationship between prices and employment.

Here, the shimmies and shakes were harder to interpret. The two trends appeared to move in tandem, but one didn't consistently lead the other. "Changes in employment very often lead to changes in commercial prices both during expansions and contractions but in some cases the relationship is reversed or the turning points occur concurrently," Guntermann wrote.

Bottom feeding?

An anecdotal harbinger of a turnaround in the Phoenix commercial market may be the uptick in interest by professional real estate investors, Guntermann said. Real estate investment trusts — publicly traded companies that buy and hold properties — have begun to poke around the market, he said.

At the depths of the commercial real estate crash, they weren't interested because they had no sense of the true value of properties. With the prices no longer freefalling, investors "can make some estimates on what things will be worth five years from now," he said. These investors might be looking to bottom feed, scooping up properties at what they judge to be bargain levels, he explained.

If so, they may need to be patient about seeing a return. "It could take a couple more quarters or a couple more years before you can see a positive price trend again," he said. A wildcard in the recovery is the amount of real estate now controlled by banks and other lenders, Guntermann said.

As they've foreclosed on properties, they've built up hefty stockpiles. "Lenders aren't going to dump all of that stuff on the market at once because that would hurt their balance sheets," as a gush of supply pushed down prices, he said. "But with that overhang, it's hard to see prices starting to go up that rapidly."

Greater Phoenix Blue Chip

Elliott Pollack, CEO of the economic and real estate consultancy firm Elliott D. Pollack and Company and co-editor of the Greater Phoenix Blue Chip Economic Forecast, agreed with Professor Guntermann's assessments. He said that commercial real estate prices may have reached their bottom and that conditions should begin to improve — but slowly.

It is possible that prices could deteriorate further, though. The latest Greater Phoenix Blue Chip Forecast, which draws on the insights of about a dozen economists and executives in the region, was posted yesterday. Some sectors, of course, will recover even more sluggishly than others.

Consider, for example, office buildings. "We're sufficiently overbuilt there that I don't think there will be a spec office building built in Phoenix for 3 to 5 years," Pollack said. The latest Blue Chip forecast predicts that office vacancy rates will remain well above 20 percent at the end of 2012. Retail faces much the same problem.

Retailers and developers put up buildings in anticipation of new Phoenix residents who never arrived; migration into the region collapsed when the economy slowed. Thus, here, too, vacancy rates will remain high — above 11 percent — according to the latest forecast.

Doldrums in commercial real estate reflect the painful reality of the worst recession in generations, perhaps since the Great Depression. "We've had major employment declines three years in a row," Pollack said. "We were overbuilt in housing and commercial and nobody projected how bad the market was going to be."

Several factors collided to hurt greater Phoenix more than most regions in the United States. The credit crunch made banks reluctant to lend, and falling real estate prices sapped people's home equity. That combination — difficulty landing a mortgage and the possibility of taking a big loss on home — prevented people from selling their homes and relocating.

"So people couldn't retire and move to Phoenix or move to Phoenix and get a job, and our population flows slowed dramatically," Pollack explained. "One of the industries that Phoenix's growth depends on is growth itself. A lot of people's jobs — real-estate agents, property assessors, even plumbers and electricians — depend on providing services to the new people moving here."

The Residential ASU-Repeat Sales Index (ASU-RSI):

• Overall, house prices dropped 2 percent in August compared to August 2009, the first overall decline since March.
• The ASU-RSI has been relatively stable for a year suggesting that, barring a dramatic change in the economy, price fluctuations will be moderate going forward.
• Foreclosure prices declined 4 percent in August. Weak prices in the foreclosure sector may mean there is insufficient demand for the steady stream of foreclosed properties that are entering the market monthly.
• Prices for non-foreclosed properties dropped 9 percent, continuing a trend. Data does not support optimism in that sector, Guntermann writes.
• Lower priced homes rose 3 percent in August, less that the rate of increase in previous months when annual gains were 8 to 13 percent.
• Higher priced homes are still falling in price, down 4 percent for August.
• For the sixth consecutive month, the townhouse/condominium sector fell, by 17 percent in August.
• The overall median price in August was $122,000 compared to $132,500 in June — a drop, but still within the range for the past year.
• The median price for foreclosed properties was $119,000 in June but dropped to $110,000 in August, about the median price of a year ago.
• Non-foreclosed prices dropped $1,000 from June to $155,000 in August. The range for this segment for the past year has been $155,000 to $165,000.
• Median prices for the lower and higher price sectors are also remaining within the range typical of this year. Fairly large declines in the past two months still leave prices at the lower end of their recent ranges.