Commercial property market in Utah County faces headwinds

Commercial property market in Utah County faces headwinds

Sunday, June 14, 2009 12:10 am

The ongoing recession, which had its roots in the collapse of the subprime mortgage market two years ago and then spread like a mutating virus to banks, retailers, manufacturers and automakers, now has the commercial real estate market in its grip.

Just as the local and national economies are struggling to regain their footing, commercial mortgage defaults are mounting because of tight credit conditions, along with reduced property cash flows and declining values. And with unemployment still on the rise, fewer employees mean businesses would need less space, and less rents for property owners could in turn hamper their ability to make their mortgage payments.

Case in point, the Shops at Riverwoods in Provo, which has been struggling with weak retail sales and the bankruptcies of two of its largest retail tenants in recent years, was foreclosed on in March after it defaulted on mortgage payments on a $26.5 million loan.

Not surprisingly, widely publicized commercial projects like The Boyer Co.'s Southgate Center in Provo, John Q. Hammon's Embassy Suites hotel and convention center in Pleasant Grove, and the Fashion Outlets at Traverse Mountain, are delayed nearly two years after they were announced. That's due in large part to the tight credit environment, which continues to thwart many developers' efforts to obtain construction financing especially for large commercial projects, as well as weak consumer spending, which made many national retailers scale back their development plans.

But Jon Anderson, partner and principal broker with Commerce CRG's Provo-Orem office, believes the office and industrial market in Utah County are showing signs of bottoming out, although retail vacancies will likely continue to rise through the end of the year.

Interviewed by Grace Leong

• Question: With Utah's unemployment rate currently at 5.2 percent and poised to continue rising this year, what impact will this have on the local commercial real estate market?

Answer: The health of the retail sector is largely dependent on job growth. When people are employed, they have money to spend, retail businesses stay viable and owners are able to pay rent. But when you have fewer employees, you need less space, and some tenants are renewing their leases for smaller spaces. That means, less rent for the property owner to make their mortgage payments, and that contributes to rising vacancy rates.

• What's happening to the so-called hot spots of retail development in Utah County?

Some of them have slowed or come to a standstill temporarily because the financial markets have undergone more substantial changes in the last 12 months than they've ever had in past years in the way properties are financed and the qualifications for getting financing. Our economy is based on confidence. When people are confident, they spend. But when the economy changes and people start to lose confidence, they stop spending, and in turn, business investment dries up and the economy slows. Most of these developers are waiting until credit conditions free up and the economy is back up again.

• Very little or no construction activity has been seen so far on highly-touted commercial projects such as John Q. Hammon's Embassy Suites hotel and convention center in Pleasant Grove, the Fashion Outlets at Traverse Mountain, The Boyer Co.'s Southgate Center in Provo, and University Tower in Provo. In fact, all of these projects were announced in 2007 right before the housing and financial meltdown intensified. Can you give us an update on what's happening with these projects?

It's an economy issue. John Q. Hammons won't go full speed ahead with the convention center until he's confident the economy is at a place where he can fill the hotel up and meet his pro forma earnings for the property. But the broker handling the project said recently that they plan to start construction around this August or September.

In University Tower's case, they made a big announcement to see what kind of support they'd get. If they don't get enough tenants, they may perpetually stall the project until they disband it later. Or if they find tenants, they'll do it a few years later. Once Zions announced they were going to build their building, that stole all their thunder and potential tenants. So you won't see University Tower happen for a couple of years, if at all.

For Southgate, my guess is their potential anchors, Target and PetSmart, are most likely saying they're not going in until they see how retail sales fare. When those two anchors are ready to go in, that's probably when the project will start up. Similarly, with Fashion Outlets at Traverse Mountain, in this kind of market, you don't get national retailers signing for more stores. Most of them are trying to save and prop up their existing stores and save financial resources for a rainy day.

• Is new Zions Financial Center in Provo the only commercial project still on track?

In Utah County, Zions is the largest commercial project still moving ahead. The second largest project is Northgate Village on 800 North in Orem. They're building about 30,000 square feet of Class A office and some retail including a WinCo Foods store. There's pent-up demand in that area. It's been about five years and this project is just now coming to fruition.

• Has University Mall found a tenant for the former Mervyns space yet?

They've not found a retail tenant yet for that 94,000-square-foot space. But the owners are now looking at the possibility of filling the first floor with retail and the second floor with office. There are only about 20 to 25 retail tenants nationally that can fill that big a space, but there are about 300 to 400 retail tenants that can fill half of it, especially in this market. But I'm very impressed with the way they've remerchandized the mall. They've created outdoor entrances and drive-up capability to the mall instead of offering just two or three entrances into the mall. They've brought restaurants that generated traffic for them and take advantage of hard corners at the entrance space, with Carrabba's Italian Grill and Starbucks at one corner, Goodwood Barbecue in another corner. The new Cinemark theater is also driving in a lot more traffic for them, and in July, a new pirate-themed family restaurant will take over the 18,000-square-foot building where the old dollar theater used to be.

• Who would be a likely buyer of the Shops at Riverwoods, which is now under receivership? Is the mall in danger of being closed if the recession worsens? How many more commercial property foreclosures can we expect to see in Utah County?

The potential buyer will most likely be a local regional mall owner. It has to do with population and demand. National chains aren't as likely to come to tertiary markets or third-tiered market like Provo. I can't fathom the Shops would ever be closed. Somebody will try to make it viable one way or another. Some of the stores could be converted into a partial office property. But there's so much office space now and lease rates are down, so it's not likely to be converted to offices any time soon. There may be more commercial property foreclosures in the county, because there are companies that are struggling out there. But I doubt the foreclosure rate will accelerate. Like in the Shops case, when you get down to 65 percent vacancy and your expenses exceed your revenue, that's not a good place to be at.

• What's your outlook on retail, office, industrial vacancies and lease rates in Utah county?

Office vacancies could hit 12 percent by mid 2009, up from 10.5 percent in the same period last year. A healthy office market is typically between 5 percent and 7 percent vacancy. If it gets to 15 percent vacancy, then it gets alarming. The last time we had office vacancy of between 15 percent and 20 percent was after the dot-com bust. But I think we've seen the bottom for office vacancies in Utah County. Things are starting to pick up slowly in all sectors of the market. In the investment market, we see things being sold now because local and regional investors believe commercial property prices aren't going any lower. Leasing rates are now averaging $13.50 per square foot for Class A office space, compared with $20 per square foot on average a year ago.

Industrial vacancies could jump to 14 percent by the middle of 2009, compared with 3.3 percent a year ago. Ten percent or under is considered healthy for industrial vacancies. Industrial lease rates now average around $5 per square foot compared with $6 a square foot a year ago.

The retail market started to stumble in the past six months as the recession worsened, as fewer stores are expanding or renewing leases on their stores as sales dropped. Case in point, Ernie's Deli closed their University Parkway store in Provo and consolidated back to their Orem store because sales have been tough. Circuit City and Mervyns' closures are some of the most recent retail losses we've had. Retail vacancies may rise to 7 percent by the middle of the year, which is the highest it has been in a few years, compared with 4.3 percent last year. If national retailers like PetSmart, OfficeMax or Office Depot pull out of the market, that could push vacancies over 10 percent. But we don't think retail vacancies will go above 10 percent in the foreseeable future, because we have a lot of local and regional tenants that are still doing OK, compared with the national retailers. Leasing rates at strip centers may drop to $14 and $15 per square foot on average by mid 2009, compared with $17 to $19 a year ago.

• What concessions are commercial landlords offering to retain existing tenants and attract new ones?

Generally, concessions become a factor in negotiations of lease rates. Some landlords are giving discounts on rents or opting to give four or five months of free rent to keep or attract tenants. On average, concessions on lease rates for industrial, retail and office space are in the 20 percent range.

And these rent concessions seem to be working. The former Tony Roma's space in front of the 24-Hour Fitness center in Provo has been empty for about two years. But we're now finalizing a lease with a new restaurant tenant that a year ago wouldn't have been able to afford rents charged on that building. Leasing rates for that retail space have dropped about 20 percent. We're also bringing in several new tenants including the U.S. Census Bureau, which will take 7,000 square feet at a 13,500-square-foot building behind 24-Hour Fitness. Once the new tenants come in, that will bring our retail vacancy rate at that strip mall to just 8 percent over the next month from the current 26 percent.

• According to Foresight Analytics, which tracks delinquent property loans, the delinquency rate in Provo for commercial mortgages, or loan payments that are 30 to 89 days late, jumped to 4.8 percent for the first quarter of 2009, up from 2.2 percent a year ago. That's well above the delinquency rate of 3.6 percent nationally and 4.5 percent statewide. Default rates on commercial mortgages, where loans are 90 days or more past due, are also rising in Provo. Why are delinquency and default rates on commercial mortgages rising?

It's to be expected in this kind of economy. With the amount of changes going on in the financial world, you can't expect delinquencies to not increase. Debt for refinancing remains scarce and the recession has dragged down rents. Banks are far less flexible in terms of extending or refinancing loans. If a strip center's loan is due to be paid off next month, and they can't refinance it because of tight credit conditions and the bank refuses to renew the loan unless they pay down part of the principal. But the owner doesn't have the money to pay it, then it's counted in a group of delinquencies. Right now, the question on most commercial property owners' minds is whether they can refinance their properties over the next few years. If you own a commercial property and you have a loan coming due in the next year or two, you're probably sweating a little, wondering if you can refinance or not.

• Is getting credit still a problem for commercial builders?

It's still a big problem. That's why new projects aren't going up. As a developer, I might say I believe in the property and would likely be able to get the property leased up in six months, but the bank may disagree and not give the loan. It could reflect tight conditions in the credit market and difficulty in getting fresh financing. The biggest problems we've seen so far relate to problems with making mortgage payments. If there's less cash flow from the property, that hampers borrowers' ability to keep current on mortgages.

• But some commercial real estate mortgage servicers nationally are seeking to extend maturing loans for up to five years, from the current six- to 12-month extensions, to prevent borrowers from defaulting or giving up office, retail and apartment buildings at distressed levels. Will this help reduce more impending commercial loan defaults in Utah County?

Most likely it will. If you have fewer lenders demanding borrowers pay up loans now, then they won't likely be on the delinquency list. Banks are starting to loosen up, because they realize it's not in their best interest to call the loans due. If the owner defaults, then it's not good for the owner or lender.