Much like a powerful HBO special, the commercial real estate industry produced plenty of drama in the first half of 2007 — even without Tony Soprano. The first nail-biter ended in early February when shareholders of Equity Office Properties approved a $39 billion takeover offer by The Blackstone Group following a fierce bidding war with investors led by Vornado Realty Trust.

The massive holdings of EOP combined with its colorful chairman Sam Zell, once a champion of REITs and now a media titan, made it a deal to remember. EOP's portfolio contained 108 million sq. ft. of office space spread across key markets nationally. But in a flash, the biggest REIT in the land was pushed off the stage and carved into pieces for sale. Ironically, buyout shop Blackstone launched an IPO of its management partnership in June, though shareholders won't have any direct say in the real estate holdings.

Any hopes for a quick rebound to the housing slump were dashed in the first quarter when “subprime” became a household word. The soaring number of defaults on high-risk home loans cast a dark shadow over residential lenders and Wall Street practices. Subprime lender New Century Financial Corp. filed for bankruptcy protection, and mortgage REITs suffered with total returns of negative 14.26% year to date through mid-April.

So, what's next? “The reality is that the housing correction that's occurring now has always led to a recession,” warns economist Edward Leamer, director of the UCLA Anderson Forecast. Leamer points to two exceptions: 1951 when federal spending on the Korean War offset housing weakness, and 1967 when spending on the Vietnam War had a similar effect. “The historical record is rather ominous with regard to the prospect of recession ahead.”

Indeed, GDP grew only 0.6% in the first quarter, and monthly job growth through May was averaging 133,000 vs. 188,000 a year ago. Consequently, Leamer expects the Fed to make two quarter-point reductions in the Fed funds rate — currently pegged at 5.25% — before the end of the year.

But Donald Ratajczak, a consulting economist for Memphis-based investment banker Morgan Keegan & Co., says the Fed is on hold. “There is a 25% probability it could raise rates, a 70% probability it won't do anything, and a 5% probability it could lower rates just because I don't like to say zero.”

Investors' big challenge is the rising cost of capital. The 10-year Treasury yield has risen about 50 basis points this year to 5.1% in late June. “Valuations will get weaker, if interest rates continue to rise as they have,” says Leamer. “That's got to take a toll on every asset, including apartments and offices.”

A bulging development pipeline also is a concern. With cap rates so low, Ratajczak says, the development community often interprets that as a sign that rents are strong, which justifies more construction and leads to overbuilding.

In short, the second half of 2007 is shaping up to be an action thriller.