Strong Economy Keeps CRE Loans Out of Trouble

At the end of the third quarter, the commercial real estate sector continues to hold up well, even as the residential real estate side continues to be impacted by the aftereffects of imprudent subprime lending practices. The good commercial real estate performance is largely due to a fundamentally sound economy, which has so far resisted sliding into recession on account of the housing market problems and credit crunch fallout. And the pre-emptive moves by the Federal Reserve to an easier money policy, by easing up on short-term interest rates at their September meeting, can't have hurt. The slow reemergence of the dotcom sector is another plus factor for the U.S. economy.

While this is all positive for commercial real estate financing right now, it still remains to be seen what will happen when the excesses of lax underwriting during the peak of the cycle catch up with this sector. And as reassessment of risk causes investors' expected returns, or cap rates, to go up, property valuations are likely to suffer impacting refinancing prospects.

Two commercial real estate market reports from the Washington-based National Association of Realtors and from Moody's Investors Service, New York, are both positive about the sector. The NAR reports that vacancy rates are low, and rent growth is healthy, in most commercial real estate markets as the sector continues to benefit from a fundamentally sound economy. In fact, a record $257 billion was invested in commercial real estate in the first seven months of 2007, up from $146.7 billion in the same period of 2006, according to the Realtors' trade group. And this total does not include transactions valued at less than $5 million, or investments in the hospitality sector. Also, the re-emergence of technology-related investments is seen as fueling demand for industrial space.

The multifamily housing market appears to be impacted by an influx of single-family homes being offered for rent, which has caused a decline in the demand for apartment rentals. In addition, condos are being converted into rental units, particularly in markets such as Washington, D.C., and several areas of Florida. At the same time, the NAR sees potential first-time homebuyers hesitant to enter the homeownership realm and staying in the rental market and supporting multifamily fundamentals. Multifamily vacancy rates are likely to average 5.9% in the fourth quarter, the same as the fourth quarter of 2006, and then ease to 5.6% by the end of next year. Average rent is expected increase 2.9% this year and 3.8% in 2008, after a 4.1% rise last year.

Recovery in the retail market has been held back by high levels of new supply, according to the NAR, but developers appear to have got the message. The office sector is the most favored by investors, with strong rent growth this year. Demand for space is expected to remain strong into 2008, and areas with strong job growth are benefiting the most. In the industrial market, while the main driver of demand continues to be the need for warehouse and distribution space, particularly in ports and distribution hubs, the rebirth of the technology sector is also seen fueling demand for flex space, particularly in markets such as San Jose, Calif., Portland, Ore., Seattle and Phoenix.

And Moody's Investors Service reports in its third quarter market report on real estate markets that five of seven commercial property types followed by the credit rating agency performed well in the third quarter of 2007, a positive reflection on real estate markets.

Overall, 50 of the 60 geographic markets followed by Moody's are performing well, with the remaining ten turning in a middling performance.

The two property types that are not doing so well are the suburban office sector and the full-service hotel sector. Moody's believes the hotel market might have reached a peak, as demand growth over the next year is expected to soften in line with potentially slower macro-economic growth.

On Moody's 0 (worst) to 100 (best) rating scale, the overall commercial real estate composite score for the U.S. is 72, the same as last quarter. The five worst markets in the U.S., with the previous scores in parentheses, are Jacksonville, Fla., 39 (45); Trenton, N.J., 43 (33); Wilmington, Del., 44 (48); West Palm Beach, Fla., 44 (54); and Las Vegas 45 (46).

Both the suburban office sector, which scored 47 in the third quarter, and the full-service hotel sector, which scored 64, are in a middle range. And the multifamily sector gained three points in the third quarter, moving to a score of 83. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/