Already suffering ill effects from a persistent credit crunch, the commercial real estate industry in 2009 faces the likelihood of weakening fundamentals and more distress. With refinancing sources scarce, struggling property owners who are unable to make their mortgage payments will be forced to work out new terms with lenders or return the keys to the bank.

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Across property types, what is shaping up to be a prolonged recession is already dragging down occupancy rates and cash flows as tenants grow averse to new lease commitments. Three consecutive quarters of negative absorption drove up the national office vacancy rate to 13.7% in the third quarter from 12.6% a year earlier, according to Reis, a New York-based real estate research firm. Meanwhile, the national retail vacancy rate climbed to 8.4% from 7.3% during the same period.

Even the typically dependable apartment sector hasn't been immune to the economic and financial strife, with the vacancy rate climbing 40 basis points over the past year to reach 6.1% in the third quarter.

“Demand for space has weakened for all property types,” says Sam Chandan, chief economist at Reis. “While localized pockets of strength remain, national vacancy rates are increasing in every property sector.”

Symptoms of failing fundamentals are emerging. Just last month, two large conduit loans sliding toward default sent ripples through the market for commercial mortgage-backed securities (CMBS). One was a $209 million mortgage backed by two Westin hotels in Tucson, Ariz., and Hilton Head, S.C. The other loan was a $125 million financing of Promenade Shops at Dos Lagos, a retail center in Corona, Calif.

Lender J.P. Morgan underwrote both loans in 2007 using cash flow projections that the properties have been unable to meet, prompting analysts to flag the deals as likely to default.

At press time, Chicago-based mall giant General Growth Properties was negotiating with multiple lenders for more time to restructure its $27 billion debt, including some $900 million in mortgages that were set to mature at the end of November.

If the credit crunch persists, investors can expect to see similar default scenarios unfold in 2009 and 2010. More than $81 billion in CMBS loans will mature during that period, challenging property owners to extend their mortgages or obtain replacement financing.

While the delinquency rate for CMBS loans 60 days or more past due was just 0.51% in October, that rate is expected to reach 75 basis points by the end of this year, according to Fitch Ratings. Some analysts expect the delinquency rate for CMBS loans to exceed 1% in early 2009 and then climb to 2% or even 3% in 2010.

Further deterioration in real estate fundamentals will force many investors who are still clinging to lofty asking prices to swallow a bitter dose of value correction. At the same time, buyers will have to settle for annual returns based on existing and potentially weakened income streams rather than on the skyrocketing price appreciation that made commercial real estate golden earlier in the decade.

Perhaps the most striking aspect of the outlook for commercial real estate is how quickly the consensus view in the industry changed from optimism to pessimism, observes Robert Bach, chief economist at Grubb & Ellis.