An office tower, a hotel and a retail plaza — currently under construction — reflect scaled-down plans for the CityScape high-rise development in downtown Phoenix. A number of businesses might back out of the project, including the anchor tenant in a 27-story office tower. A planned hotel and the construction of 1,000 condos have been put on hold.Millions of square feet of retail, industrial and office space in the greater Phoenix area is sitting vacant, yet even more space is slated to hit the market by the end of the year in what economists fear will be a prelude to the collapse of the commercial real estate market in Arizona and across the nation.
The vacancies will ultimately lead to foreclosures, possibly in the billions of dollars nationwide, if the economy fails to recover quickly and jobs continue to disappear.
“I expect it to get much worse in the next two years,” said Jim Rounds, an economist at Scottsdale-based Elliot D. Pollack Co.
“This is really going to be the story going forward, probably by the summer. We’re going to be hearing more and more about problem commercial real estate loans.
“It’s kind of like getting punched when you’re already down. This is what’s going to happen in this economy, and I don’t think people are paying enough attention to it.”
It’s unclear what kind of an impact a collapse in the commercial real estate market would have on the economy, but experts say it could stall an overall recovery. Until the magnitude of the problem is known, the indirect impacts will be a matter of speculation.
“This is where the big unknown is at the moment. There are projects that are failing, but we don’t know how many of them there will be,” said Jay Butler, director of realty studies at Arizona State University.
And those who make their living in the commercial real estate market are keenly aware of the potential problems on the horizon.
“It’s a very significant focus for everyone in commercial real estate,” said Bob Mulhern, managing director of the Phoenix office of commercial real estate firm Colliers International.
When loans go bad, banks can either renegotiate a deal with the property owners or try to sell it at a price the market will bear, which will drive down prices, Mulhern said.
The numbers in the metro Phoenix area show just how big the problem could be. Vacancy rates in all commercial sectors are on the rise and millions of square feet of development still under construction will exacerbate the situation when the property hits the market.
Data collected by Colliers International shows a 19.1 percent vacancy rate in Valley office space. In 2008, more than 6.3 million square feet of office space was completed, but the amount of leased office space actually contracted and accounted for 680,000 fewer square feet than the year before.
Another 3.6 million square feet of office space is under construction and is expected to hit the market this year.
“It pretty much highlights just how ridiculous this has become,” Rounds said.
Rounds said looking at only the vacancy rate provides an inaccurate picture of the problem’s scope. It actually could prove much worse, considering the figures fail to account for space that is still under contract but is no longer occupied because the company that signed the lease has gone out of business or filed for bankruptcy.
“It could actually be worse than the numbers that we show, and we’re showing pretty bad numbers,” he said.
Supply in the industrial market is just as bloated. Colliers, which tracks industrial buildings larger than 10,000 square feet, reported 2.6 million square feet of previously occupied space in Arizona became vacant in 2008. The vacancy rate for industrial property is at 16.4 percent.
CB Richard Ellis, another commercial real estate firm, reported a 12.5 percent vacancy rate for buildings larger than 5,000 square feet. The company’s 2008 data shows only 630,000 of the 12.3 million square feet that came online last year was absorbed by the market. And another 3.8 million square feet of industrial space is under construction.
Pat Feeney, the senior vice president of industrial properties for CB Richard Ellis’ Phoenix office, said the glut of available space is driving rental rates down. Right now, they’re between 10- and 40-percent lower than last year.
“I think that’s going to continue until you get into an overall vacancy rate of about 8.5 percent,” he said. “Optimistically speaking, we’ve got another two-and-a-half years.”
Figures for the retail market are similarly gloomy. About 7.5 percent of retail space is empty, CB Richard Ellis reported, and only 3.4 million of the 6.9 million square feet of retail space completed in 2008 has been filled. This year, another 6 million square feet will be completed.
In addition, apartment vacancies are on the rise. Cohen Financial, a real estate lender, estimates the vacancy rate will rise to 12.2 percent this year, as apartments are competing with a glut of single-family homes available to renters.
According to the Phoenix Metropolitan Housing Study, 9,800 apartment units were under construction last fall.
The commercial real estate problems, just like everything else tainting the nation’s economy right now, are rooted in the collapse of the residential housing market.
“When housing came crashing down, there’s been a ripple through everything else,” Mulhern said.
John Lenio, who manages the economic incentives group for CB Richard Ellis, saw the commercial real estate market grind to a halt last October, when the stock markets plunged as the foreclosure crisis in the housing market worsened and put the national banking system in peril.
“At that point in time, that’s where business investment stopped — literally stopped — or was pulled back severely,” he said. “Right now, the dust is still so much in the air that we’re finding that the firms that we had ongoing projects with, and even those who we know may have been just kicking the tires, aren’t doing anything because they don’t know what the heck is going on in the world right now.”
A side-effect of the housing meltdown has been a stagnation of credit markets. Without the ability to borrow under reasonable terms, most businesses eyeing expansion don’t have the liquidity to spread out.
“It feels like a vicious circle. I’m going around and around with…these firms, trying to figure out if they see a need to expand and can find money to do it. And right now, I’m getting a ‘no, no,’” Lenio said.
Arizona last faced a commercial real estate crisis in 1986, but the state is headed in that direction again, said Arizona Treasurer Dean Martin, whose office tracks economic indicators and has been warning for more than two year the market would collapse.
“It’s not going to be as bad as ’86, but it’s coming on top of a weak economy. It’s going to feel worse than it already is,” he said. “It’s like catching the flu after running a marathon.”
And it won’t be a local phenomenon. Lenio, who works with firms across the country to help them relocate or expand their operations, has seen the same attitude among businesses across the United States.
“My portfolio is reduced from this time last year a good 75 percent,” he said. “I touch almost every major market in the U.S. When I’m pitching economic development and incentives, brokers are still scraping the bottom of the barrel, because nobody’s calling them with active opportunities.”
If businesses are unwilling or unable to expand, it means commercial projects being built across the country are destined to sit empty once they’re completed. Investors financed the industrial and office space expecting to receive rent that won’t materialize as quickly as expected or at all. That could lead to loan defaults and bank foreclosures on commercial real estate nationwide.
The only way for the existing commercial space to be filled is for the economy to stop contracting and begin adding jobs. But that process will be stunted if the commercial market tanks, especially in a place like Arizona, which could be considered the poster child for over-building during the boom years earlier this decade.
“It probably wouldn’t have been enough to send us into a recession (by itself), but it’s going to be enough to keep us from growing at (the rate) we normally would have recovered at,” Rounds said. “It’s going to lengthen the downturn and make conditions in 2009 worse than they would have been.”
If the nation’s economy begins growing again at the end of the year, it likely won’t be until the last half of 2010 before commercial real estate turns around. The U.S. has been in a recession since December 2007.
“But that assumes there’s no other big bad news that’s going to be coming,” he said. “It’s kind of like being on a ride at Six Flags — you’re going everywhere and you have no clue where the next twist or turn’s going to be.
“You’re just hanging on and hoping you can make it to the end of the day. And that’s what a lot of firms are doing right now.”
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