Commercial Space Starts to Wobble

By ELIOT BROWN, KRIS HUDSON and CRAIG KARMIN

Jittery investors, wary banks, the struggling economy and turbulent financial markets are stalling a two-year rebound in the U.S. commercial real-estate industry.

Across the country, companies that were looking for large chunks of office space have delayed those plans as uncertainty has risen. Among those companies that have changed or are re-evaluating plans areUBS AG, Morgan Stanley and the Quidsi unit of Amazon.com Inc., all of which were looking in New York City.

Enlarge Image

Host Hotels Resorts this month terminated a contract to purchase the St. Regis Monarch Beach resort in Dana Point, Calif., pictured here.

Building purchases are also falling apart because of financing snags. Commercial real-estate values have barely budged since the late spring. And a growing number of projects dreamed up when the stock market and U.S. economy were on the rise now can't get off the drawing board.

"We are today as worried about the economy as we were several years ago," Mortimer Zuckerman, chairman of office landlord Boston Properties Inc. said at a conference earlier this month.

The casualties include a failed sale of the St. Regis Monarch Beach, a resort in Dana Point, Calif., after Host Hotels & Resorts Inc. this month terminated a contract to buy the five-star resort from Washington Real Estate Holdings LLC, according to people familiar with the talks.

Host walked away from the deal due to the negative impact of recent economic instability on hotel values and the properties' projected cash flows, these people said.

Also, fashion designer Tommy Hilfiger's plans to convert the Metropolitan Life clock tower, a 1909 office building near Manhattan's Madison Square Park, into a hotel and luxury condo collapsed this month after Mr. Hilfiger and his investment partner weren't able to secure enough financing, according to people familiar with the situation. The $170 million sale was revealed in the spring.

An executive at Mr. Hilfiger's private office said the designer has the capital but pulled out to pursue "other projects that may make more sense for us."

Some investors view the recent turbulence as little more than a bump before commercial real-estate values resume their upward march toward near-peak levels in areas such as New York City and Washington, D.C. Top buildings in major cities still are attractive to many investors because of ultra-low interest rates, while prices and rents remain lofty in niches such as high-end retail.

"We're still optimistic about the recovery," said Marc Halle, a managing director at Prudential Real Estate Investors, a Prudential Financial Inc. unit that is a major commercial-property investor. "Obviously, the events of the past few weeks have slowed the market [but] not derailed the market."

Still, the two-year recovery was fueled partly by expectations that rents and occupancies would keep rising. Now those trends look doubtful.

In the Washington, D.C. area, one of the nation's strongest real-estate markets, commercial landlords are worried about long-term plans by the U.S. government to cut spending. New York City is being squeezed by turmoil on Wall Street, including announced job cuts.

If the slowdown accelerates, some real-estate experts are worried that the amount of vacant space in office buildings, retail stores and other types of commercial real estate might climb, while rental rates slip. As of June 30, the overall vacancy rate for office space was about 18%, basically unchanged from the post-real-estate-boom peak, according to research firm Reis Inc.

Other analysts are concerned about the possibility of a jump in troubled commercial loans at banks that have spent the past two years digging out from the recession and real-estate meltdown. Troubled commercial real-estate loans have been one of the biggest contributors to the nation's nearly 400 bank failures since the start of 2008, Deutsche Bank AG analysts wrote in a report last week.

U.S. banks might face more headaches over the $1.4 trillion in commercial real-estate loans still on their books.

"Many small and some medium sized institutions remain unprepared for the harsh realities ahead," given their limited capital to deal with billions in troubled mortgages, the Deutsche Bank report warns.

The commercial real-estate market reflects and often magnifies broader swings in the economy. When times are good, growing employment translates into new demand for offices and hotels, rippling through the economy with new construction investments. But when the outlook sinks, new building grinds to a halt, empty space soars and prices fall.

In the first half of 2011, U.S. commercial property sales were one of the brightest spots in the U.S. economy, up 107% over the same period a year earlier, with firms completing more than $93 billion in deals, according to Real Capital Analytics Inc., a real-estate research firm. In July, the sales increase slowed to 16%, and it decelerated to about 13% in August.

A widely followed measurement of U.S. commercial-property values, the Green Street Advisors Commercial Property Price Index, is up just 1% in the past four months. Before then, the index had surged 48% since May 2009.

About 70% of the architecture firms recently contacted by the American Institute of Architects in its monthly survey reported that they have at least one stalled project, according to Kermit Baker, the institute's chief economist.

"The most common reason by a fairly wide margin is the inability of the developer to obtain financing," he said in an interview.