Office Market Continues to Struggle

A recent wave of distress hitting Atlanta has translated into new opportunities for investors and thus resulted in their movement off the sidelines and back into the market. Investors have been actively seeking office buildings, which are offering the most opportunities in the current cycle. In fact, sales of distressed office properties at steeply discounted prices increased 65% from mid-year 2010 through mid-year 2011. Retail properties are also facing high levels of distress. Meanwhile, the industrial and multifamily sectors face the least amount of distress moving into 2012.

The Atlanta office market was the hardest hit of the four major property types and continues to struggle as weak permanent employment growth and reductions in square footage needed per employee will keep vacancy above 20% through year's end. Effective rents continue to fall, albeit at a slower pace, and concessions remain very high as tenants find bargains and remain firmly in control of the market. On a positive note, high vacancy has virtually shut down the development pipeline, as only 564,000 square feet of space came on line in the 12 months ending in midyear 2011, representing a scant 0.1% increase in competitive for-lease stock.

Currently there are 90 office properties, representing $2.2 billion in loans, listed as distressed, the result of continued weakness in the sector. Atlanta CMBS office loans have a delinquency rate nearly twice the national average. Twenty percent of office loans are delinquent, with more than half of those already in foreclosure or REO. A significant number of office-building loans have matured, but are non-performing as servicers struggle with the best course of action in a very challenging environment. The heightened level of vacancy has crimped the overall office investment sales market, but the third quarter saw an increase in distress sales of both traditional and medical office properties that may encourage further marketing of distressed assets in the coming months. Those properties trading have done so at significant discounts, which should drive investor interest.

While the deterioration in Atlanta retail fundamentals has ended, the market has yet to see a significant rebound in occupancy as retailers remain hesitant to expand and smaller/mid-sized companies continue to face challenges as consumer sentiment remains muted. After a few nominal declines, vacancy climbed once again in Q2 and Q3, ending at 12.2%, with neighborhood and community centers experiencing rates closer to 15%. The continued struggle in retail has led to many troubled properties, with more than 125 assets listed as distressed by the end of Q3, representing $783 million in loans. Loans originated through CMBS are contributing to the majority of distress in the retail sector, with 33 properties in foreclosure or REO and another 27 retail properties 90-plus days delinquent. Overall CMBS delinquency is at 10.6%, about half of the multifamily sector, but significantly above the national retail total, which is below 8%. Much of the retail product that has been foreclosed on is in the suburbs where, similar to the multifamily sector, the properties were built based on certain population and employment-growth assumptions that have not materialized due to the recession.

The Atlanta industrial market continues to struggle as the vacancy rate remains stubbornly high, above 13%, and average rents continue to fall in almost every submarket. A sizeable portion of the sector was intrinsically linked to the housing picture and the continued weakness in that sector has created a challenging leasing environment for property owners. Those owners have reported success in leasing space to telecommunications companies, but the pace has not been enough to generate marked improvement in the overall industrial sector. Surprisingly, industrial is the least distressed of the four major property types, both in number of transactions and dollar volume.

The industrial sector has historically experienced more conservative underwriting, and even loans made through the CMBS market are consistent with the overall averages. Just five CMBS industrial loans were delinquent at the end of Q3, equaling 11% of the total market and in line with the national figure. Overall, 60 industrial properties are distressed with an original loan balance of more than $400 million. The limited number of distressed properties has not produced many asset sales, but as more properties head further down the delinquency ladder, volume is projected to increase in early 2012. With occupancy not expected to see significant improvement by then, these distressed assets should come to market with opportunistic pricing for investors willing to take the risk.

The rebound in employment growth in Atlanta over the past 12 months has increased demand for rental housing, which pushed the apartment vacancy rate down to 8.7% at the end of Q3. While still above average and significantly higher than the national average, this does represent a substantial reduction from the high vacancy point of 11.5% reached in 2009.

With a vastly reduced construction pipeline, Atlanta is well positioned to see further gains in occupancy in the coming year, with the associated rent gains across all property classes. Unfortunately, for many properties the improvement in market fundamentals has come too late, as more than 160 apartment properties, representing $1.8 billion in original balances, are distressed. The situation among loans originated through CMBS is more severe with nearly 19% of all apartment properties in distress, representing more than 21% of total originated dollar volume. While a significant portion of distressed deals are already in foreclosure or REO, slightly less than one-third of the total outstanding distress is listed as 90 days plus, which barring last-minute restructuring will produce another glut of foreclosures and REO. Many of the properties facing those possibilities are found in the outer ring of suburbs, where the path of growth was supposed to lead before the recent recession. The turnaround of these properties will be extremely challenging, but with prices on these assets at opportunistic levels, investors, who believe in the long-term growth of Atlanta, will find attractive assets with substantial long-term upside potential.

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