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Real Estate: How Far

There is one big question looming for homeowners and commercial real-estate investors this year: How much worse will it get?

The past year was the most painful in decades for residential real estate, as defaults on loans to less-creditworthy borrowers created a broader credit squeeze. House prices fell, home ownership dropped, foreclosures soared, and the housing market emerged as the soft underbelly of the economy.

Commercial real estate hit its peak early in 2007, when private-equity firm Blackstone Group LP paid $23 billion for office giant Equity Office Properties Trust, and then did an about-face. As credit tightened throughout the economy, commercial-property values tilted downward for the first time in several years.

Housing prices are likely to slide further this year, as credit remains tight and interest rates on many mortgages are set to rise, or "reset," and could trigger more defaults.

The commercial real-estate market, which includes properties such as offices, apartment buildings and shopping centers, could continue to soften as slower economic expansion causes rents to rise more slowly than in the past.

Residential Blues

Relief from the housing woes is unlikely anytime soon. "It will be another very bleak year with the worst of it occurring in the first half," predicts Mark Zandi, chief economist at economic-research site Moody's "Inventory is only growing and needs to be worked off before the market finds some stability," he said.

Through the third quarter of 2007, slightly more than 2.5% of all houses, or more than two million, were for sale and vacant, according to the U.S. Census Bureau. Since the first records were kept in 1965, that figure had never been higher than 2%, until the fourth quarter of 2005.

Demand is likely to stay depressed, keeping prices low, as high-risk borrowers who in the past would have qualified for subprime loans find themselves locked out of the market. Borrowers with little, if any, money for a down payment and those who don't want to document their finances also are likely to find the going tough.

House prices have fallen 6.5% as of October, since peaking in June 2006, according to the S&P/Case-Shiller Home Price index, which measures home values in 20 cities. Daniel Mudd, chief executive of government-sponsored mortgage investor Fannie Mae, expects prices to decline another 4% to 5% in 2008.

Among the hardest hit residential markets is Florida, where thousands of high-rise condominiums under construction are expected to be completed in 2008. Although buyers put deposits on many of those units during the housing boom, developers worry that the drop in property values and credit tightening will cause buyers to renege.

"People won't answer the bell to close," said Lewis Freeman, a Miami bankruptcy consultant who said he is busy with failed condo projects. If enough buyers fail to close, entire projects could be sent into default on construction loans.

This year will be difficult for home builders faced with slow sales. In November, Levitt Corp.'s Levitt & Sons unit filed for bankruptcy-court protection. Tousa Inc., of Hollywood, Fla., said it is considering several "in- and out-of-court restructuring and reorganization" options, including a possible Chapter 11 bankruptcy filing.

Mr. Zandi's models predict a bottom to the housing market sometime in 2008, but only if the economy stays relatively strong. "If it slides into broad-based recession, it won't be until the end of the decade that the market finds a bottom," he said.

Commercial Cracks

Optimism about commercial real estate is tempered by the credit crunch and a slowly expanding economy.

"Rent increases will continue to slow over 2008, as we face weaker demand and slower growth in the broader economy and jobs," said Sam Chandan, chief economist at Reis Inc., a property-research firm based in New York.

About 15% of property investors expect prices for office buildings to rise, according to a survey by real-estate services firm Marcus & Millichap Real Estate Investment Services Inc., of Encino, Calif. Two years ago, 39% of property investors expected price increases.

In 2007, Blackstone's acquisition of Equity Office marked the high point of the commercial real-estate market. The $23 billion deal was the largest real-estate transaction ever in dollar terms. Blackstone quickly turned around and sold many of the properties at prices so high that buyers weren't likely to see big first-year returns on their investment.
he frenzied deal making came to symbolize the frothy valuations investors were paying for commercial real estate.

Moody's Investors Service, a subsidiary of Moody's Corp., in April said lenders' underwriting standards had become too lax during the run-up in prices. The warning scared investors and led bankers to raise interest rates and require borrowers to pour more of their own money into deals.

The change in the credit markets deflated commercial-property values. At the end of May, Tishman Speyer Properties, along with Lehman Brothers Holdings Inc., announced they would buy Archstone-Smith Trust, one of the largest apartment-building companies in terms of market capitalization, for $15.2 billion. Before the deal was announced, Tishman Speyer and Lehman had lowered their bidding price, citing credit markets and unforeseen tax issues.

Rents and occupancy rates -- the fundamentals of real-estate values -- are expected to stay relatively firm in 2008. Mr. Chandan predicts landlords will be able to charge 6.2% more for office space this year. In 2007, rents increased 10.4%.

Any downturn in commercial real estate will be different from the past, said Harvey Green, chief executive of Marcus & Millichap, because unlike the residential market, there has been relatively moderate production of new supply.

"We haven't been in a long cycle of rent growth to justify that much new construction," said Mr. Green.

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