The Commercial Office Market: An Illusion of Recovery

May 22nd, 2014
in uncategorized

by Keith Jurow, Capital Preservation Real Estate Report


In several articles, I have referred to the so-called housing recovery as an illusion. That image aptly describes what has occurred in the commercial office real estate market. Let's take an in-depth look at why the recovery in the office real estate market is nothing more than an illusion.

Follow up:

The Collapse That Never Was

I have often discussed how the commercial real estate bubble reached insane proportions in 2007. Let me explain why.

Between 2001 and 2007, commercial real estate sales soared. From a mere $81 billion in sales in 2001, they reached a record $522 billion by 2007. Underwriting standards completely collapsed in 2006 – 2007. In 2010, the Congressional Oversight Committee reported that close to 90% of all Commercial Mortgage Backed Security (CMBS) loans originated in 2006 and 2007 were interest-only or actually had negative amortization.

Because the federal government bailed out the Savings & Loan industry with American tax dollars after the S & L fiasco, commercial banks learned nothing from this bubble. They proceeded to pour money into commercial mortgage lending and holdings of commercial mortgages skyrocketed from $550 billion in 1990 to $1.55 trillion at the peak in 2007. This had become a disaster waiting to happen.

After the collapse of Lehman Brothers in the fall of 2008, the banking system plunged into its deepest crisis since the depth of the Great Depression in 1932-1933. Federal regulatory authorities and the US Treasury Department then decided that a scheme had to be devised to create at least the appearance of bank stability or the entire system might come crashing down.

In April 2009, the Federal Accounting Standards Board (FASB) changed the standards for when banks had to write down impaired loans. The banks were required to write down only loans which were "other than temporary impairments." Even better for the banks, they were left to determine when a loan on their books was more than just temporarily impaired. That was like letting the batter decide when a pitch was a strike.

The banks have really used this opportunity to self-evaluate their portfolios in their own interest. In its Big Picture report for 2013, Real Capital Analytics showed that the total of the distressed commercial loan portfolio of all banks at the end of 2013 was a mere $33 billion. That was down by a whopping 18% from a year earlier. Remember that the total commercial loan portfolio for all banks stood at $1.55 trillion at the 2007 peak and much of that quickly went underwater.

By the fall of 2009, the FDIC had changed its policy and encouraged what it called "prudent commercial loan workouts" to prevent massive foreclosures of shaky loans. The banks got the hint and began a policy of loan modifications which derisively became known as "extend and pretend."

Regardless of how you see this "extend and pretend" sleight-of-hand, it was – in a way – a stroke of genius. Buyers were enticed back into commercial real estate and this helped to halt the decline in real estate prices. Although much of this renewed buying in 2010 and 2011 was all-cash purchases, the market did seem to stabilize.

For the appearance of normalcy to return, two more things were necessary. Lenders had to believe that risks had subsided. One last thing – most key players in commercial real estate had to develop a kind of amnesia about all those so-called performing loans which borrowers could not really pay back. If no one talked about them, that would also work. Just like in the story of The Emperor's New Clothes.

The Buyers Are Again Out in Full Force

Since the beginning of 2010, there has been a fairly steady increase in the dollar volume of commercial real estate sales. Take a look at this chart from Real Capital Analytics.

You can see that annual sales volume has returned to the level of 2005. That year was already well into the real estate bubble and only two years from the peak of the madness.

This purchase activity has been very concentrated in roughly ten major markets. Take a good look at this table.

Investors have poured money into these ten major metros many of which could be called tech-centric. Nearly 50% of all commercial real estate sales dollars were lavished on these ten markets in 2013. Because these metros are all large markets, they have a great weight in property price indices. This next graph shows how much they have pushed up the commercial real estate price index.

The Uselessness of Averages

Wall Street economists and statisticians love to use averages when discussing financial matters. I find them quite useless in describing what is really happening in real estate markets.

For example, let's take the issue of vacancy rate for office markets in the US. Highly-respected data provider Reis reported that the national office vacancy rate at the end of 2013 was a still-lofty 16.9%. That was down only 20 basis points from a year earlier.

However, SNL Financial reported in March 2014 that the national vacancy rate was actually 16.6%. It pointed out that this was the lowest in five years and concluded that 2014 would be a year of "expanding office recovery."

Last October, Reis pointed out that only half of the 82 primary markets which they cover showed any increase in total office space occupancy that quarter. That should have been a warning that growth was anemic.

Although Reis admitted that the overall market was "generally sluggish," seven of the top ten markets for effective rent growth were able to "outperform national averages" because they were either tech or energy centered – San Francisco, New York, San Jose, Houston, Austin, Seattle and Denver.

Nine of the "tech-centric" markets (with only 15% of the total office inventory) generated roughly 40% of the total increase in office occupancy from the third quarter of 2010 to the third quarter of 2013. These nine metros were Austin, Boston, Denver, Portland, Raleigh-Durham, San Diego, San Francisco, San Jose, and Seattle.

Given this strength in only nine key office markets, Reis concluded that the near-term outlook for the office market in general was "modest at best."

Cassidy Turley is a large provider of commercial real estate services with offices in 60 markets nationwide. Their Office Trends Report for the fourth quarter of 2013 showed a net absorption of 51.6 million square feet of office space in 2013, up only slightly from the previous year.

Similar to Reis, they emphasized that absorption was dominated by seven metros with heavy tech or energy concentrations – New York, Dallas, Houston, San Jose, Atlanta, Denver, and Boston. Those seven markets accounted for a whopping 46% of the total nationwide office space absorption last year.

By digging deeper, I learned that 14 out of the 80 metros which the report covered actually had negative absorption including Los Angeles, suburban Virginia (i.e., part of the DC metro), Memphis and Tucson. The entire West was weak with absorption in 2013 only half of what it was two years earlier.

In a report issued in the fall of 2013, Cassidy Turley had pointed out that even within Manhattan – where space absorption was the highest in the nation and asking rents were rising faster than anywhere else except San Francisco – the frenzy was heavily concentrated in the tech and media heavy area known as Midtown South. Rents in that small part of Manhattan had already surpassed the previous highs of 2008.

Cassidy Turley also noted that nearly 30 leases were recently signed in that part of Manhattan for $100 per square foot (psf). Boston Properties -- an office REIT which owns dozens of high-quality Class A properties in Manhattan -- only received an average of roughly $56 psf for its portfolio in 2013. The insanity in Manhattan never ceases to amaze me.

In spite of this domination of office market strength by only seven major metros, Cassidy Turley confidently asserted in its January report that "the stage is set for the recovery to morph into something more robust." It pointed out that rental rates are "beginning to creep upward, albeit slowly." Without offering an explanation, the report concluded that "By the second half of next year, the majority of the country will see rents pushing upwards."

Key to Understanding Office Space Absorption

In its What's Hot in Commercial Real Estate report issued last summer, Cassidy Turley emphasized that all of the office space absorbed nationwide since 2010 was in newly-built or newly upgraded properties. These were buildings that had been constructed or rehabbed since 2007.

Around the country, tenants were chasing after these newer office buildings. The vacancy rate for new or upgraded space had been cut in half since 2010. Unfortunately, Cassidy Turley pointed out that the vacancy rate for the vast majority of what it called "traditional space" was languishing at recessionary highs. We are talking about 80,000 office buildings in the US which were more than twenty years old and comprised roughly 60% of the nation's total inventory.

This reality of what was occurring in office markets around the US is completely lost when pundits zero in on the slight decline in the nationwide average office vacancy rate. A small sliver of office markets in a few strong metro markets was where the hot action was. That tells you nothing about the vast majority of office buildings and the desperate search for tenants by their owners.

Are Office REITs Still A Good Investment?

Let's now take a good look at a few of the major players in the office property market and evaluate if any of them are sound investments now.

SL Green Realty

SL Green Realty (SLG) is the largest owner of office properties in Manhattan. Founded in 1997 as a REIT, they own 32 office properties located primarily in midtown Manhattan and totaling 23.2 million square feet. They also own 32 office properties in the surrounding suburbs of Westchester County, Brooklyn, Long Island, Connecticut and New Jersey.

The shares of this REIT have been on a roll since the bottom of the crash in early 2009. Take a look at this five-year chart from

Wait a second. There is one small problem. The chart omits what happened after the real estate bubble peaked in early 2007. Let me fill you in. The shares of SLG hit an all-time high of 151.8 at the end of January 2007. As with other equity REITs, it then proceeded to crumble. The share price bottomed in late February 2009 at 8 – that's right … 8. This is a decline of nearly 95%. Think about that.

Because the trading volume was enormous at the bottom, nearly all investors who purchased before the fall of 2008 were completely crushed. Those smart investors who were buying at the bottom have made out just fine... so far.

Had anything precipitated the collapse of the shares? Absolutely! In August 2006, SLG had purchased a major rival – Reckson Associates Realty – for a whopping $4 billion in cash and stock. In addition, it assumed $2 billion of Reckson's debt.

Was the purchase reckless? Not according to Bruce Moser, the CEO of giant Cushman & Wakefield. An August 4, 2006 article in the New York Times quoted him as saying this: "When a sophisticated investor like SL Green makes this kind of a commitment, it's just a huge vote of confidence in the strength of the office marketplace."

Unfortunately for shareholders, the market did not agree with Mr. Moser. Rents in Manhattan began to crumble in late 2008 and prices of properties along with them. In April 2009, CoStar Group reported that the 15 largest markets saw leasing activity plunge by an average of 46% from a year earlier. Class A office prices had declined by an average of 51% from the peak in early 2008.

In hindsight, the purchase of Reckson was obviously ill-timed. What SLG received was a piddling five midtown Manhattan office properties and some offices buildings which gave them an entrance into Stamford, CT and Westchester County.

The Manhattan properties were purchased close to the peak of the real estate bubble. The office markets in lower Fairfield County, CT and Westchester have remained weak. SLG's 10-K Annual Report for 2013 reveals that its entire Westchester and Connecticut office portfolio had a vacancy rate of 19.5% at the end of last year.

A recent article published by CoStar in early April pointed out that the office leasing market throughout the tri-state NY area is "anemic." The CEO of RXR Realty – which was formed by the executives who had sold Reckson Associates – explained that lease renewal rates for 2014 were expected to be down sharply from last year.

Mack-Cali Realty (CLI) is another major player in the tri-state office market. The same CoStar article refers to CLI's 2013 Annual Report. Rents that were renewed by tenants in 2013 were lower than the prior lease rents by an average of 7%. They projected that these declines could continue beyond 2014.

Mack Cali viewed the office rental market as so weak that this REIT has been actively selling some of its office properties and repositioning the portfolio into multi-family properties.

What else do we learn from the 10-K Annual Report issued by SLG for 2013? Income from continuing operations was $134 million, a decline of 30% from a year earlier. Net income for 2013 was $1.10 per share. With a dividend payout of $1.49 for the full year, how can SLG cover it without eating into available cash? Are investors unable to see that the dividend yield is simply phony and unsupportable as the office rental market weakens?

Cash and equivalents held at the end of last year were a mere $206 million. With the rental market of its entire suburban office portfolio so weak now, lease renewal problems could further cut into its cash flow.

Investors don't seem to be concerned about any of this. One very influential online financial website recently changed its position on SLG from hold to buy. That is incredible!

The shares of SLG hit a 52-week high of 104.6 on April 24. The P/E ratio stood at 119.7. Given the current condition of SLG as I have described it and the clear softening of the office rental market outside of Manhattan, how can anyone justify that share price? You can't ... it is that simple.

If you are a current holder of SLG, I believe it would be wise to sell the shares ASAP. Let some buyer overpay for them. If you are thinking of purchasing SLG shares, forget it -- far too risky.

Mack Cali Realty

As long as I mentioned Mack Cali (CLI), let's talk a look at this office REIT next. Its main office properties are located in the northeast states of NY, NJ, CT and PA.

As with the other office REITs, CLI was clobbered during the post-bubble collapse. Its shares plunged from a peak of 56 in January 2007 to a low of 13 in November 2008.

CLI's 10-Q Report for the first quarter of 2014 was just released on April 24. Pretty grim! It suffered a net loss of $0.17 per share after barely eking out a profit of $0.13 in the previous quarter.

CLI explained that the office market continued to be weak throughout its eastern markets. The vacancy rate for its entire portfolio climbed to 16.4% in the first quarter, up from 14% only a year earlier. Even worse, rents declined by an average of 4% for renewed leases. They believed that rising vacancy rates and declining rents may continue through 2014 and beyond.

Because of these problems, CLI was forced to sell 24 office properties in 2013 to raise cash. Additional properties were on the block this year. It also had to draw $70 million in the first quarter from its revolving credit facility on top of a drawdown of $153 million in the previous quarter.

Notwithstanding this borrowing, it ended the quarter with cash on hand of only $58.7 million. Like other REITs, it continued the foolish strategy of paying dividends it could not afford -- $30 million in the first quarter.

In spite of this poor outlook and precarious financial situation, CLI closed at 20.5 on April 24. Although this was down substantially from its 52-week high of 28.5, why would anyone pay this much for a REIT that is selling off properties to survive?

My Advice: If you own CLI, unload all shares now before it bleeds to death.


In the latest issue of my Report, I analyzed six other office REITs. I was unable to find even one which offered the possibility of a decent return for investors. As I saw it, they were terribly overpriced with very high P/E ratios. Yet Wall Street has been silent about the serious weakness in office markets outside of Manhattan or San Francisco.

My advice to you: Don't delay in taking action. Office renting will weaken badly over the next 12 – 18 months. The liquidity in suburban and smaller urban office markets will decline and buyers will be much harder to find.

This article appeared previously at Advisor Perspectives

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