A number of unfavorable market forces are closing in on commercial real estate investors, threatening to compromise asset values in 2008. After a tremendous run in which commercial real estate values in the U.S. rose 90% over a five-year period, prices fell 1.2% on average from August to September 2007, according to Moody's Investors Service. Transaction volume has taken a much bigger hit, plummeting 70% to $4.4 billion in October versus the same period a year ago, reports Real Capital Analytics.

Buyers and sellers are waiting for the other side to blink. The highly leveraged investors who helped to bid up prices before the credit crunch struck this summer have been relegated to the sidelines, while the equity players still in the game aren't willing to pay the lofty prices many sellers are hoping to obtain for their assets.

Flattening real estate vacancies also are putting downward pressure on prices and making it difficult for many owners to meet their goals for rental growth. Vacancy rates have ceased to improve across all property types, with the national office vacancy rate reaching a plateau of 14.7% in the third quarter, down from 15.3% a year ago, reports Property & Portfolio Research. That marks the end of 15 straight quarters of declining office vacancies.

Across the property types, vacancies are not expected to improve until at least 2009, according to the Boston-based market research firm. In fact, economists say the nation is closer to recession than it has been at any point since 2001, with the consensus calling for 2% to 2.5% GDP growth in 2008 — a snail's pace compared with the 3.9% growth posted in the third quarter of this year.

The U.S. created 166,000 jobs in October, a modest figure by historical standards, but continued housing contractions and write-downs by financial services firms have most forecasters projecting fewer than 100,000 new hires per month in 2008.

That hiring rate might sustain a healthy absorption rate in a more robust economy, but slowly growing companies will be reluctant to expand their leased space amid today's economic uncertainty.

Owners and managers who fail to adapt to the changing economic climate may have difficulty increasing rent to meet revenue projections as the market shifts to favor tenants. Sellers who attempt to cash out quickly by selling at a reduced price before conditions worsen risk even greater deterioration of their capital next year because real estate is unlikely to lose value as quickly as cash.

That's because the U.S. currency has been losing ground against the euro and accelerated its decline when the Federal Open Markets Committee lowered the overnight Fed funds rate to 4.5% on Oct. 31 (See sidebar p. 28).

“It's time to get defensive,” says Josh Scoville, director of strategic research at Property & Portfolio Research. “We are in a time when the capital markets are working against investors.”

Preparing for battle

Today's tepid market conditions will soon provide a hunting ground of buying opportunities, according to Warren Diamond, CEO of American Real Estate Management LLC in Tinton Falls, N.J. In October, his company refinanced five of its properties to extract approximately $30 million in cash. Diamond plans to use those proceeds to expand the firm's portfolio, which currently encompasses 4 million sq. ft. of self-storage and mixed-use projects in the Northeast and California.

“We saw an opportunity to place these mortgages on the properties and stockpile cash because we believe there are going to be buying opportunities throughout 2008,” Diamond says. “We believe people are going to be selling at distressed prices.”

Yet, there's little evidence of distress so far. Delinquencies in the commercial mortgage-backed securities market fell by one basis point to an all-time low of 0.28% in October, reports Fitch Ratings.

But the recent past belies cracks in the armor that will widen as the economy slows. Case in point: 20 newly delinquent apartment loans worth $78.7 million boosted the dollar volume of multifamily CMBS delinquencies by 10.4% in September. Experts offer four approaches to avoid investment losses in the current market:

1. Wait it out — Commercial real estate prices are in the midst of a correction, and many buyers and sellers aren't seeing eye-to-eye. Lenders insist that credit is available to qualified borrowers, but more conservative underwriting that now eschews interest-only periods and speculative income, and demands greater debt service, has reduced the amount leveraged borrowers are able to pay for commercial real estate.

Reduced liquidity had an immediate effect on September sales volume, which fell 26% from year-ago totals to less than $8.5 billion for office properties, according to Real Capital Analytics. More deals fell out of contract in September than were placed under contract, and volume across all property types dropped 25%. Rather than agree to sell at reduced prices, many owners simply took their properties off the market.

Forecasters say sales volume will begin picking up again in 2008, when sellers align their expectations with leveraged buyers' ability to pay. Many owners would be better off shelving their sales plans pending healthier market conditions, says Dr. Mark Dotzour, chief economist at the Real Estate Center at Texas A&M University. Why? Because rising oil prices and a shrinking dollar suggest the nation is heading into a period of accelerating inflation, so cashing out now is inviting losses in purchasing power.

“History shows that quality real estate tends to hold its purchasing power about as well as any asset you can buy,” Dotzour says. “We might see some price pressure on commercial real estate, but five to 10 years from now, I would expect commercial real estate to be a lot more valuable than it is now.”

2. Shore-up the portfolio — Avoiding losses in a market downturn begins at home, within the investor's portfolio. Does the existing cash flow cover debt service, or was the mortgage on the property calculated with significant rent increases in mind? Relatively slow economic growth in 2008 will make large rent hikes difficult in all but the most robust markets, so owners may need to re-evaluate their leasing strategies.

Owners with significant vacancy in their properties would be wise to fill those spaces soon, before weakening economic growth reduces demand for the space, says Robert Bach, chief economist at brokerage Grubb & Ellis. “Move the leasing needle from the ‘aggressive’ to the ‘competitive’ setting; lock in tenants, try to get that deal, so that if we do see a recession, you can ride through it,” Bach says. “It's better to be competitive now to secure rent for your empty space.”

Even if an owner plans to sell a property in the coming year, making the effort to land tenants will pay off by bringing a wider range of bidders to the table, according to Earl Webb, CEO of capital markets at real estate services firm Jones Lang LaSalle. That's because leveraged buyers can still obtain financing for properties with an existing cash flow, but not for one that will require future leasing to meet debt service.

If a property is 15% to 30% vacant in a market with solid fundamentals, Webb is advising his clients to lease the space before taking the property to market. “If the market is mediocre in fundamentals, say in a secondary market with low absorption, then you're probably just as well off rationalizing the increasing cap rate and selling.”

3. Hunt for bargains — Like Diamond of American Real Estate Management, some investors are protecting their portfolios by going on the offensive and seeking acquisitions. The investors prowling today's market for deals form a stark contrast to the highly leveraged buyers of 2006 and 2007, however, and are more likely to be pension funds, insurance companies or other equity players, says Dr. Sam Chandan, chief economist at research firm Reis.

“They're looking at commercial real estate as an income-producing asset versus one that will exhibit significant price appreciation over a short amount of time,” Chandan says. “It's an asset you hold, not one that you flip.”