Commercial Real Estate Markets

In late November, Congress passed and President Bush signed into law the Terrorism Risk Insurance Act of 2002. But as 2003 dawns, the commercial real estate industry still faces the lack of federal guidelines for toxic mold liability. In addition, the economy's stagnation is forcing many states to consider raising taxes, which could directly affect the industry.
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Terrorism Insurance
With this new legislation, the federal government will cover 90 percent of losses related to terrorist attacks for claims greater than $5 million. The three-year program is capped at $90 billion for the first year, $87.5 billion the second year, and $85 billion in the final year.

Unaffordable insurance coverage has hindered the recovery of the commercial real estate market. Last year, an estimated $3.7 billion in commercial property deals were lost and another $4.5 billion were delayed due to unavailable or unaffordable terrorism insurance, reports the Mortgage Bankers Association of America.
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In order to obtain proper coverage, property owners purchased multiple policies, sometimes as many as 20, for different exposure levels at premium rates costing 20 cents to 25 cents per $100 of real estate value instead of the 5 cents per $100 of value prior to Sept. 11, 2001.

The recently passed bill does not cover losses from the World Trade Center attacks, which are estimated at $40 billion in claims.

Toxic Mold
Toxic mold is another liability issue facing the commercial real estate industry. Federal legislation introduced in 2002 outlined the definition, detection, and remediation of toxic mold in residential and commercial buildings. While action was not taken on the bill, similar legislation should be reintroduced this year. In addition, some states such as California adopted laws granting plaintiffs the right to sue the building industry over toxic mold. Texas is poised to offer legislation that regulates companies offering toxic mold testing, assessment, and remediation. Several other states are considering similar legislation.
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The commercial real estate industry must pay particular attention to disclosure and inspection requirements and liability limits for brokers. To protect its members in the absence of law, the National Association of Realtors asks Realtors to use a prepared toxic mold statement of disclosure. Information on the recommended disclosure language can be found on the CCIM Government Affairs Web page (www.ccim. com/govt/default.html).

State Tax Increases
Last year, state tax revenues plunged by almost 10.4 percent, according to the Nelson A. Rockefeller Institute of Government. Only Ohio and New Mexico registered revenue increases. To counteract this trend, states will consider increasing the taxes of stable industries and raising revenue sources such as transaction, license, and commission fees. Such tax policies leave the commercial real estate industry vulnerable to new financial burdens, especially since the market shift from investing in stocks to investing in real property.

For example, Florida placed a proposed constitutional amendment on the Nov. 5, 2002, ballot, which would have created a committee to review all sales tax exemptions. In a legal challenge that went to the Florida Supreme Court, Florida Realtors convinced the court to remove the amendment based on its unconstitutionality. Fortunately for the Florida real estate community, this attempt to raise revenues by eliminating exemptions failed; however, these types of policy directions will continue this year as states encounter unbalanced budgets.

Stable Value Despite Softening Demand
As a result of low interest rates, commercial real estate investors gained exceptional leverage last year, keeping values surprisingly stable as rents and vacancy rates softened. Lenders enjoyed a satisfying spread in mortgage coupon rates over Treasuries of comparable maturity, and borrowers found opportunities in purchasing at overall capitalization rates that were 200 to 250 basis points higher than prevailing mortgage rates. In many ways, the commercial property markets were shielded from the immediate effects of an adverse economy.

However, the duration of this exemption remains uncertain. Rising vacancy rates and softening rents have weakened commercial property markets nationwide. For example, in the office market, declining employment has led to negative net absorption and an increase in available direct and sublease space. Offices had negative net absorption of 19.2 million square feet per quarter in 2001. By third-quarter 2002, the occupancy slide slowed to 5 million sf, but it still was enough to push vacancy above 16.8 percent, according to Grubb & Ellis' U.S. Market Trends.

But a remarkable feature of this real estate cycle is construction activity's quick response to signs of economic weakness. For instance, office development is down 40 percent in the past two years, and industrial construction has dropped 70 percent since peaking in 1998. Only multifamily continues to see moderate increases in development.

A look at the specific property markets reflects the delicate balance between supply and demand in recovering sectors and the struggle between short-term uncertainty and the stronger long-term outlook for markets still bottoming out.

Restoring Long-Term Balance
Real estate finds itself in a challenging time. However, that is not a reason to give over to a gloom-and-doom perspective. The U.S. economy is the world's engine -- never more so than at the start of the 21st century. Once that engine finds its next gear, there will be plenty of demand for commercial property to house the economic activity producing some $10 trillion dollars of GDP annually. By the end of 2003, the nation should start to hit its stride again. If the real estate industry can maintain equilibrium in the short run, the balance of this decade should be very good indeed.

Market breadth was the salient feature of last year's retail sector, a healthy sign of continued liquidity for shopping properties. Hot money looking for quick, high yields and a rapid exit is not as prevalent as it was in the mid-1990s. With the dominant regional malls largely under the control of a few publicly traded operating companies, retail real estate investors are focused on thousands of community and neighborhood centers and on select redevelopment opportunities in secondary malls. Urban retailing opportunities still are available in a handful of 24-hour cities, but the competitive environment requires a clear strategy and strong operating experience for successful entry.