As 2003 nears its end, the key issue for commercial real estate is a potential disparity in timing between increases in interest rates and lagging demand for space. If rates rise faster than demand, owners of commercial properties could feel a squeeze on cash flows.

Commercial property markets are being affected by two opposite forces. On the positive side is the massive amount of equity and debt capital seeking real property investments. This excess supply of money has driven interest rates to record low levels. Even though the 10-year Treasury rate rose 120 basis points from June to August, borrowing rates are still so low that almost any existing or proposed real properties that generate gross revenue flows produce positive spreads.

True, lenders are keeping loan-to-value ratios lower than in the late 1980s and underwriting tenant credits more carefully. And commercial developers burned by plunging rents and occupancy since 2000 are not adding much to existing space, except in multifamily markets. In short, available space supplies are not rising much, but they are already so huge in the office, industrial and hotel sectors that rents have barely begun to stabilize.

Why are interest rates still so low? General weakness in economic activity, a Federal Reserve policy to keep short-term rates low, and the lack of attractive alternative uses of money are the primary reasons. Stocks in general still seem too risky to many investors in light of the value plunge since 2000. Bonds pay very low interest and seem risky if rates keep on rising. Until the stock market provides clear evidence of a new bull market, a lot of money still favors the relative stability of real properties. A few stock market gurus think a new bull run has already begun, but I remain skeptical because high-tech stock prices are so far ahead of earnings performances.

Such uncertainty on Wall Street has created an ideal market in which to sell well-occupied real properties at low cap rates, a temporary condition to be sure. Other positive forces include tax cuts, higher defense spending, continued strong consumer demand from the 93%-plus workers still employed, the ongoing stimulus to housing construction and sales from low interest rates, and recent declines in the value of the dollar. These factors caused real Gross Domestic Product (GDP) to expand at an annualized rate of 3.1% in the second quarter.

Negative Forces

On the down side are several forces preventing any rapid recovery in commercial property markets. One is the slow growth of employment. The number of non-agricultural jobs has fallen 1.9 million since 2001, and almost no job gains have accompanied recent GDP increases. Slow job growth is typical in early recoveries, but unusually snail-like in this one. A major reason is that many jobs, both office and industrial, are being outsourced to cheaper labor markets in Asia, Eastern Europe and Ireland as big businesses cut costs. Lots of those jobs aren't coming back.

A second negative factor is the immense amount of vacant office and industrial space. This includes not only a national office vacancy rate of 16.6% in the second quarter of 2003, according to CB Richard Ellis, but also unreported “shadow space” held empty by those who originally rented it or own it. Though rents seem to have stabilized in most markets and space inquiries are picking up, demand will not be strong enough to permit landlords to raise rents until well into 2004.

Another negative force is the weakness of whole economic segments such as airlines, hotels, resorts, telecommunications, textiles and many high-tech activities. They, too, are gradually picking up business, but at very slow rates. Some industries may never again achieve the level of prosperity they enjoyed in the 1990s.

A Question of Timing

Increases in general economic activity eventually cause both rising interest rates and greater demand for space. The crucial question is if interest rates, which have ballooned over the past few months, will rise before space demand increases. If so, the expense of operating properties will outpace rising revenues from higher occupancy and rents, and property owners will be squeezed.

This possibility is likely because space supplies are so huge and demand is rising so slowly, and because so much space is being financed with short-term floating rates. I believe this timing disparity will indeed occur, probably in 2004.

However, because most real estate investment trusts (REITs) that own property have low leverage, they will ride out this squeeze without jeopardizing their solvency, though some may cut dividends. More highly leveraged owners should prepare for this possibility by strengthening their financial reserves or cutting debt. I do not foresee any widespread catastrophe in commercial property markets. But increased stress and shrinking margins will prevail for a while. Get ready for them.

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