| Tom Howorth is feeling the impact of the crumbling real estate market.

The architect’s firm has dwindled from 18 people to 11 since mid-2007 as clients have postponed or canceled major projects. The situation appears to be getting worse. Colleagues in other parts of the country, who had been faring better, now tell Howorth they are also starting to see a sudden, steep drop in business.

“People have lost confidence,” says Howorth, a principal at Howorth & Associates Architects. “Whether it’s a church that doesn’t know what their membership is going to be able to do [with its building fund] … to universities whose endowments have taken a huge hit, to individuals who are saying, ‘Look at what’s happened to real estate values,’ to developers who aren’t even thinking about spending money in this economy.”

Contractors, investors and developers are bracing for what could be the worst real estate crunch since the early 1990s, when the industry built a small city’s worth of speculative office buildings that later went begging for tenants. Commercial property sales plunged 73 percent last year, according to Real Capital Analytics. Vacancy rates are rising, and hundreds of large properties are in default. The American Institute of Architects’ billing index, a leading indicator of construction six months ahead, is at a record low. Unemployment in the construction industry is 15.3 percent, well above the average 7.2 percent jobless rate.



Different Times

The 1990s crisis was sparked by federal tax breaks that encouraged overinvestment and overbuilding. This time around, the real estate frenzy was fueled by cheap credit, which allowed investors and developers to bid up prices of existing properties. But the economic fallout could be similar: rising bankruptcies and unemployment and slower economic growth at a time when the economy is already reeling from a historic housing depression.

“This is a rolling problem that’s only going to get worse,” says Jeffrey DeBoer, president of the Real Estate Roundtable, estimating that about $400 billion worth of commercial real estate mortgages will come due by the end of 2009. Investors and developers might have trouble refinancing many loans, due to tight credit and falling rents and property values.

“Businesses need to be able to access the credit market when their debt comes due and their business needs require. Right now, they’re not able to,” DeBoer says.

The Roundtable is part of an industry-wide coalition that’s pushing the Federal Reserve and Treasury Department to create a special lending program to resuscitate the commercial mortgage-backed securities market. The industry says such a move would provide liquidity and restore confidence to a sector of the credit market that has essentially frozen. The Treasury Department and Fed have not issued a formal decision, but Treasury noted in November that a similar program aimed at auto, credit card and student loan lenders could be extended to include commercial mortgage-backed securities.

In a recent analysis, Citigroup noted that the sharp drop in the commercial mortgage-backed securities market is putting more pressure on banks, forcing them to extend existing loans. But the Citigroup analysts said problems are well below the levels of the 1990s, and banks should be able to manage the commercial mortgage-backed securities that are coming due.

Though the problems in the non-residential sector of the real estate market aren’t likely to be nearly as calamitous as the housing market collapse, they could contribute to a deeper and longer recession. The non-residential real estate decline could shave about a third of a percentage point, or $30 billion, from U.S. economic growth in 2009, says Aaron Smith, senior economist at Moody’s Economy.com.



Rising Delinquencies

Banks held more than 50 percent of commercial real estate loans in the second quarter of 2008. Smaller, regional lenders have a relatively larger exposure to the commercial real estate market than large money center banks, Smith notes. The charge-off rate for such loans is about 1.1 percent, but is quickly rising.

Government regulators moved to tighten standards for commercial real estate lending several years ago as the market heated up. The Fed, for example, imposed more stringent guidelines for banks that had a large concentration of commercial real estate loans.

Some lenders, who initially fought the move, now say it was helpful. But they also say the current tough stance of bank regulators is making it hard for them to extend new credit, and may be adding to market uncertainty.

“We’ve had situations where we’ve shown the (federal bank) examiners a particular appraisal on a property, but they’ve not accepted it and told us the property was worth less than the appraisal,” says James McPhee, vice chairman of the Independent Community Bankers of America.

“It’s been difficult for us to get a handle of what is expected … with the devaluation of real estate, I think people are somewhat confused as to what values we dare use,” says McPhee.

How bad will it get?

Robert Murray, vice president for economic affairs at McGraw-Hill, says the downturn will get worse in the coming year, but may not end up being as dramatic as the 1980s-1990’s real estate implosion. The outlook depends on what happens to the overall economy.



Some Hope?

Office construction peaked at about 218 million square feet of new space in 2007, compared with a high of 350 million square feet during some years in the 1980s. With the exception of retail, “I don’t really think there was overbuilding to the extent of the late ‘80s and early ‘90s,” Murray says. “In the case of retail, it was partly due to [shopping malls] springing up where new housing developments grew; also a movement to open-air shopping centers.”

Murray expects commercial real estate construction, measured by square footage, to decline by 24 percent or more in 2009, after falling an estimated 24 percent in 2008. The retail segment, stores and shopping centers, which fell 33 percent in 2008, will decline another 29 percent in 2009.

Office space will plunge in 2009 by 26 percent – though Murray cautions that the office market is becoming increasingly vulnerable as unemployment rises. The hotel industry will move from a 3 percent dip in 2008, to a 30 percent drop in 2009.

Still, Goldman Sachs recently upgraded its outlook for hotel stocks. Noting a 70 percent increase in the number of hotel projects abandoned or deferred in the past 12 months, Goldman Sachs analyst Steven Kent said a more realistic supply outlook should help stabilize earnings for the industry.

The pain is becoming widespread.

Charles Hendricks, a partner with the architecture firm The Gaines Group, says he still has enough work to carry his office through the first quarter of 2009, and possibly the first half of the year. The six-person firm specializes in environmentally sustainable architecture, doing light commercial projects and residential work.

“Our clientele is pretty well protected from the ebb and flow, and still moving forward,” Hendricks says. “As the economy slows down … we’re doing more renovation; people are staying in place.”â–
