Predictions for 2008
Get Subprime Treatment

For investors looking to buy commercial property in 2008, a real-estate economist gives this advice: steer clear of the markets that were hit hardest by the housing downturn.

Each year, Bob Bach, senior vice president of research for Grubb & Ellis, a Chicago-based real-estate services firm, analyzes economic trends, real-estate fundamentals and demographic information to make his predictions of the best markets to invest in for each of the main commercial sectors: apartments, industrial, office and retail. But for 2008, Mr. Bach made some tweaks: he purged those markets that have been hard hit by foreclosures related to subprime mortgages or by oversupply in condominium development -- even if his formula would have indicated those cities should be included otherwise.

In contrast to the residential market, fundamentals for commercial real estate -- such as occupancy and rental-rate growth -- have held up fairly well over the past 12 months. Yet, the threat of recession is now raising questions about how long that health can be sustained. Already, commercial valuations are beginning to drop.

Those concerns are magnified in areas where the housing bust is beginning to affect the regional economy. For example, in Miami -- a condo-glut showroom -- roughly 23,000 units sit unsold and 25,000 more are expected to come online in the next two years. That has implications for the apartment market, as desperate landlords try to rent the units they can't sell. Already, "rapid deterioration in the local housing market has caused 'repartments' and shadow supply to push vacancies up to 4.2 percent in the third quarter," writes Boston-based Property & Portfolio Research in a new report.

Although Mr. Bach's mathematical formula should have put Miami on the list as a place to invest in apartments, he booted it. "I just couldn't, in all good conscience, recommend south Florida," he says.

Foreclosures on homes weren't traditionally one of Mr. Bach's indicators. Until 2007, foreclosures across the country have been low for many years, However, he recognized the landscape had changed for 2008 and even though the commercial markets still look good -- their numbers tend to lag behind consumer spending and job growth -- he took the weakest housing markets into account.

In addition to Miami, Phoenix, Las Vegas and the so-called Inland Empire -- a two-county industrial area east of Los Angeles -- weren't included on the Grubb & Ellis list for most sectors as they too have been hit hard by falling home prices. Phoenix, Miami and the Inland Empire did make the industrial list, though there's concern that a slowdown in imports could impair growth. (See related article.)

Interestingly, while the Inland Empire and Orange County -- essentially the suburban ring around metropolitan Los Angeles -- form the epicenter of the subprime implosion, Los Angeles itself tops the recommended list in almost every category. That's due in part to the lack of available land, the cumbersome entitlement process and continued job growth, says Carl Muhlstein, Los Angeles-based executive vice president of Cushman & Wakefield, a real-estate brokerage firm.

As a result, prices for commercial property in Los Angeles have held up, even as they are softening elsewhere across the nation.

In a demonstration of how much the real-estate terrain changed over the past year, fully five of the 10 markets that Grubb & Ellis recommended for both office and apartments were newly added for 2008.

Several recommendations could be seen as surprising. For example, San Francisco joined the office-sector list in 2008, with Mr. Bach pointing to a predicted 10% increase in asking rates this year.

But some investors might be leery. San Francisco office transactions in 2007 closed at an average of $424 a square foot -- a record price, according to Real Capital Analytics.

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