U.S. recession may hit commercial property-investors

NEW YORK (Reuters) - As the chances of a U.S. recession increase with each new batch of economic data, some investors are worrying that commercial property could follow residential housing down the path of steep decline, leaving behind unpaid debt that would be difficult to unwind.

"Real estate is a derivative of the economy and credit. If the outlook for those two items is not good, that obviously affects real estate," UBS analyst Alexander Goldfarb said on Friday. "Clearly, expectations of growth have changed significantly."

A crisis in the credit market has led to tighter lending requirements forcing some sellers to dramatically reduce prices and in some cases to take properties off the market.

Simultaneously, demand for space is down compared to 2006 when pent up demand by businesses was still causing them to snap up space. According to preliminary data by real estate services firm CB Richard Ellis Group, the fourth-quarter of 2007 vacancy rate for U.S. offices, the largest commercial real estate group, inched up to 12.8 percent from 12.6 percent from the third quarter.

While U.S. downtown office vacancies remained unchanged at 10.3 percent, suburban office vacancies rose to 14.2 percent from 13.9 percent in the third quarter.

In 2007, the amount of space tenants rented over and above the amount of space they vacated (called net absorption) fell 24.5 percent, according to Property & Portfolio Research (PPR). The firm expects this to fall another 15 percent in 2008.

BOOM TIMES GONE

Since 2003, the U.S. commercial real estate market had been riding a wave of high prices as investors, loaded with cheap debt, bought shopping centers, apartment houses, distribution centers and office buildings. As interest rates fell, prices soared. And rents went through the roof with demand.

But the boom times are gone. On Friday, the U.S. Labor Department reported that employers added only 18,000 jobs in December and that the unemployment rate reached 5 percent, its highest rate since October 2001.

That sent the MSCI U.S. REIT Index, a yardstick used to measure real estate investment trust share performance, to 803.04, its lowest level since November 2005.

Weakness in commercial real estate demand is concentrated in previously hot housing markets in Florida, Southern California, Phoenix and Las Vegas, PPR said.

"Housing-related employment declines in those areas have impacted the demand for office space," said Joshua Scoville, PPR director of Strategic Research.

Like their counterparts in housing, some commercial real estate buyers financed their purchases with interest-only loans, banking on a near-term sale or better refinancing terms to repay the original loan. But those buyers could face trouble as demand declines and real estate prices slip.

"A lot of the deals that were underwritten in 2006 and the first half of 2007 will go belly up," Scoville said.

Many of the loans used to finance those deals were packaged and sold as commercial mortgage-backed securities, that were later repackaged into commercial real estate collateralized debt obligations.

Yet prospective buyers, such as those circling credit-strapped Centro Properties Group, owner of 700 U.S. shopping centers, may not get bargains because while there is still money to be spent on commercial property but unlike the housing market, the commercial market is not flooded with supply.

"There's a lot of vulture capital looking for distressed deals," he said. "You're not going to see properties trading at 50 cents on the dollar. It's going to be anywhere from 85 to 90."

In New York City, for example, is "actually net down 18 million square feet in office space in the last 15 years," said Darcy Stacom, vice chairman of CB Richard Ellis.

One reason for the tighter supply of commercial properties is that construction costs are high because of high commodity prices.

"You never really got a lot of construction to begin with," Scoville said, adding that tighter credit is making it more difficult to get construction loans.

Still, if the U.S. economy goes into recession, tight supply may not be enough to keep the commercial property market steady, said Karl Almstead, vice president of Turner Construction. "There may be too many factors to focus on supply," he said.

(Editing by Toni Reinhold)