The commercial real estate market has strengthened since 2004 as growing demand for space collided with limited new supply. But a new report from Boston-based Property & Portfolio Research (PPR) notes that fundamentals growth as evidenced by vacancy and rental rates lost momentum at midyear. The August 3 report analyzed the 54 largest U.S. commercial real estate markets.

While the overall trend lines were all weak, differences were apparent between property classes. In the second quarter, for example, apartment and warehouse vacancy rates were flat at 5.8% and 8.6% respectively. Retail vacancies jumped from 10% at the end of March to 10.2% at midyear. And while office vacancy continued to decline, it did so at just half the rate of the previous two quarters (falling 10 basis points to 14.8% during the second quarter).

So are market fundamentals really unwinding? Or is this simply a quarterly lull? The answer won’t be clear until at least early 2008. But one troubling sign was tepid economic growth in July. Last week, the Labor Department reported that non-farm payrolls increased by just 92,000 in July, down from 126,000 in June (and 188,000 in May). Monthly job growth through July this year has averaged 136,000, which registered well below the monthly average for that period.

Of course, this suggests that third quarter economic growth may be muted. The timing isn’t great, either: As vacancy declines begin to plateau or reverse course, many commercial landlords are finding it tougher to raise rents. In the office market, for example, quarterly rent growth of 2.1% in the second quarter will top out the cycle, reports PPR. Office rent growth is expected to drop off to 1.7% in the third quarter, too. Retail rent growth already peaked during the last quarter of 2006. And quarterly rent growth in the warehouse and apartment markets both peaked during the second quarter at 1.3%.

“As with vacancies, there will be differences among markets,” notes the PPR report, which pegs the following markets and asset classes as faring best over the next few months: Denver and San Francisco apartment, Nashville and Denver office, Kansas City and Minneapolis retail and San Antonio and Memphis warehouse.

Based on PPR’s somewhat gloomy midyear report, it’s perhaps not surprising that average capitalization rates (or initial yields) are finally stabilizing. During the past few months, apartment cap rates have actually ticked upwards. Apartment caps were also driven down in 2004 and 2005 by successive waves of condo conversion activity, but converters have largely vanished since then. Data from Manhattan-based Real Capital Analytics actually shows that average caps for CBD office buildings were lower than apartment properties—likely because investors perceive better rent upside in the downtown office market.

The PPR data also supports that view. While the total number of office markets with rising vacancy rates has steadily increased, the office sector still boasts the lowest number of markets with rising vacancies of all property classes. During the fourth quarter of 2006, 43 of 54 office markets posted vacancy declines. But in the second quarter of 2007, just 23 office markets posted vacancy declines.

One example was Orange County, where the weak mortgage industry is clobbering demand for office space: Office vacancy shot up to 13.8% from 12% during the second quarter. Many of the companies that underwrote the housing boom are based in Orange County. Mortgage fallout also drove vacancies higher in the Inland Empire, Orlando and Phoenix. Beyond market-specific vacancies, the credit crunch is also having a major effect on investor and lender sentiment.

“I think most of us are in a wait & see mode right now,” says Anthony Graziano, managing director at New York-based property valuation and counseling firm Integra Realty Resources.

Graziano isn’t overly concerned about lackluster employment growth in July since the totals are routinely revised upwards. What does worry Graziano, however, is the deteriorating credit climate.

“I think many people are surprised that this credit pullback didn’t occur sooner,” he says. “But now that it’s happening the next 12 to 18 months will be a cautious stretch.”