Although many economic observers believed that a quick U.S. victory in the war against Iraq would cause a surge in U.S. stock prices and rapid recovery of business investment, neither of these results has occurred. It now appears that uncertainty about the war has been replaced by even greater uncertainty about what the peace will be like. Furthermore, the economic stimulus package proposed by President George W. Bush is not likely to exert much positive impact upon the economy, especially in the short run when such a push is most needed.

All this is bad news for commercial property markets, which are likely to remain plagued by high vacancy rates and low and declining rents throughout 2003 and well into 2004, if not longer.

Investors Remain Bullish

Amazingly, the continued deterioration of conditions in office and industrial space markets has not dampened the enthusiasm of pension funds and other investors trying to buy well-occupied properties with long-term leases. Such properties are still being hotly bid for among institutional investors and wealthy individuals loaded with capital looking for someplace to go. The result is a decline in cap rates for high-quality properties as their prices are bid upward.

To some extent, this fall in cap rates is a logical consequence of continued very low interest rates in capital markets generally. When property buyers can borrow money at floating interest rates of under 3 percent, they can afford to bid high prices for existing properties that are fully occupied with strong credit tenants and generating healthy rents. Even long-term mortgage rates are at record lows. That means individual investors not handicapped by institutional rules against high leveraging can wring out very high returns on equity from low cap rates by engaging in heavy borrowing — if they can find lenders willing to bear high loan-to-value ratios.

A second factor propping up commercial property prices in spite of deteriorating underlying market conditions is the continued flight of capital away from stocks and bonds and into real properties. After a disastrous 2002, the stock market has moved mostly sideways since the beginning of 2003, in spite of the rapid victory in Iraq. Investors have tons of capital looking to find a home. High-quality real estate properties — including many real estate investment trusts (REITs) — have done well compared with the alternatives.

Flawed Fiscal Policy

The president's proposed stimulus package is not really designed to create a short-term stimulus — which is what we need now. Rather, it is deliberately designed to create huge federal deficits in the long run to pressure Congress to reduce non-defense discretionary spending and cut the size of the federal government. That is what the President wants, but it is not what most Americans want now while state governments are slashing budgets, laying off workers and cutting services.

What we need is short-term government spending, including federal aid to state governments, to stimulate both consumption and investment and stop job layoffs. Moreover, neither political party is willing to confront the huge long-term problem of declining funds for Social Security and Medicare.

Under these conditions, there is no clear path to rapid economic recovery in commercial space markets. In spite of high demand among investors to buy well-positioned properties, prices of highly vacant properties or those with rents about to roll over have plunged to levels unacceptable to potential sellers — so transactions have evaporated.

I do not believe the general economy is going to shift into fast enough recovery to change this situation during 2003 and at least some of 2004. It is a great time for owners of well-occupied properties to sell them. It is also a great time for potential users of large chunks of space to either sign long-term leases at low rents or buy half-empty buildings for a song.

But for almost everyone else in commercial property markets, it is time to batten down the hatches and ride out this economic storm.

Anthony Downs is a senior fellow at the Brookings Institution in Washington, D.C. He can be reached at anthonydowns@csi.com.