Skyscraper Prices Might
Start Returning to Earth

After an unprecedented boom that saw values of skyscrapers and other commercial real-estate properties double and even triple in price, there are signs that investors and lenders are turning cautious.

Is the buying frenzy nearing its peak?

For the better part of two years, the commercial real-estate market has hummed at a fevered pitch. Prices for single buildings began popping the $1 billion mark as buyers flipped buildings and wracked up huge profits. Tishman Speyer, one of the largest landlords in New York, recently sold the New York Times building in midtown Manhattan for $525 million -- three times what it paid in 2004 -- without making any improvements to the building.

Many transactions were done with dazzling speed. In New York, real-estate tycoons Harry Macklowe and his son Billy Macklowe agreed in less than two weeks to pay $7 billion for eight New York buildings that were "flipped," or quickly sold, by Blackstone Group after the private-equity firm bought Equity Office Properties Trust for $23 billion.

"We do sweat details, but understood the nature of this had to be based pretty much on speed," Billy Macklowe said at the time.

Driving the boom were low interest rates and easy loan terms -- similar to the home-buying boom -- that allowed buyers to borrow as much as 95% of the value of the building, compared with roughly 75% historically.

In recent weeks, lenders have become worried that prices have gotten so high that buyers wouldn't be able to raise rents high enough to pay off their loans. In response, the interest rates that buyers have to pay have risen, and banks have demanded that buyers put up bigger portions of the purchase price.

The changing climate is making it difficult for some buyers to line up financing, even after putting up millions in nonrefundable deposits.

Despite the tightening, prices for buildings are not falling. Indeed, records continue to fall. On May 25, the private-equity real-estate arm of Goldman Sachs Group Inc. agreed to sell the office portion of 660 Madison Ave., a New York office building, to an Italian firm, Gruppo Zunino, for the highest price per square foot -- $1,471 -- ever recorded in the U.S. for that type of property, says Douglas Harmon, senior managing director of Eastdil Secured, who brokered the transaction. Goldman Sachs declined to comment.

But a person close to the buyer says that the contracted price of $375 million is "still being negotiated," and that Gruppo Zunino must conclude other deals for this one to go through.

At the root of the buying frenzy was a change in the way investors viewed real estate. In the past, buying a building was like buying a bond -- you were purchasing a stream of income for years to come. If rents or the value of the building went up, that was gravy. More recently, investors started treating buildings like stocks, betting that they could sell them later at significantly higher prices. Loans were being underwritten based on predictions of future cash flow.

"It used to be people bought for the current rents, and the upside was a surprise," said Cedric Philipp Jr., managing director of Commercial Mortgage-Backed Securities Structured Finance Group for Moody's Investors Service. "Now, they are banking on the upside."

For tenants of these buildings, that means landlords will keep trying to raise rents, which were up an average of 9.9% at the end of the first quarter, compared with last year. But in some cities, a building boom that has coincided with the buying boom is giving tenants alternatives.

Even as rents in the nation's office buildings increased 2.8% on average for the first quarter of this year, office absorption -- the net gain in occupied space -- was off, compared with the same time last year, according to data from Reis Inc., a New York-based real-estate research firm. That's a clue that landlords could have trouble pushing rents substantially higher in the next few quarters.

In downtown Washington, sales have been predicated on double-digit rent growth in the next two years, followed by sustained above-average rent growth for several years after that.

"Past experience tells us that's just not realistic," says Thomas Carr, a partner at Federal Capital Partners in Washington. For example, sales have been based on projected rents of $80 per square foot, even though leases can be still signed today in high-quality buildings downtown for $45 per square foot, and new buildings are going up across the city.

One reason for the boom has been the growth in the commercial mortgage-backed securities market, where pools of commercial loans are packaged together and sold as securities. On April 11, Moody's Investor Service sent up a warning flare, saying that lenders had gotten too aggressive and underwriting standards had become too lax.

That warning scared investors and forced bankers to raise yields on CMBS offerings to attract investors.

For example, as of May 19, a moderately risky (rated Baa3 by Moody's) commercial mortgage-backed bond typically paid a "spread" of 2.5 percentage points over the relevant borrowing rate for a commercial bank, up from about two percentage points a month earlier, according to Credit Suisse Group. Wachovia Bank, one of the largest commercial real-estate lenders, had to pay an even larger spread -- 2.8 percentage points -- to sell a recent CMBS offering.

"We don't make the market. We find the market," says Bill Green, managing director for Wachovia.

Now, though, buyers are finding it harder to purchase a building and leverage it up to such high levels. For example, RFR Holding LLC, the New York based-firm headed by contemporary-art collector Aby Rosen and his partner Michael Fuchs, is purchasing a group of buildings in Stamford, Conn., from Blackstone -- part of its Equity Office assets.

But RFR, which had planned to put about $50 million in cash into the deal, is now reaching out to institutional investors to raise more equity on the $830 million purchase.

"Some people are getting hit, taking more of a hit than others. We are not suffering as others maybe, but we have to readjust a little bit," says Jason Brown, president of RFR. He says that RFR still intends to close on the deal by the end of June.

Some in the market had questioned the economics of the Stamford transaction. At $500 per square foot, the price RFR paid dwarfed the previous record of $334 paid for properties in that city on the commuter-train lines northeast of New York. Moreover, Blackacre Capital Management, a subsidiary of Cerberus Capital Management, turned down a slice of the deal's debt because it believed the buildings were only worth $380 per square foot.

Demand for real estate remains strong among foreign buyers eager to take advantage of the weak dollar, and among institutional investors, who have roughly $1.8 trillion -- as much as four years' worth of money -- queued up ready to invest in real estate.

-- Serena Ng and Gabriel Kahn contributed to this article.

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