RISKY OFFICE AFFAIRS

Banking crises and property crashes often go hand in hand. That is one reason why America's housing bust has so troubled investors and policymakers recently. Commercial property, too, has a history of boom and bust that has brought havoc to the financial markets: think of the Japanese property slump during the 1990s, or Britain's secondary-banking crisis of 1973-74, when too much lending to property developers helped cause the London stock market's worst year of the 20th century.

Even though commercial and residential property do not necessarily move together, the same factors associated with the American housing market—tighter lending standards and slower economic growth—should on the face of it hurt business demand for office and retail space as well. Like residential mortgages, loans for offices and shops have been bundled up and sold to investors. So could some swanky offices and shopping centers eventually suffer the sub-prime fate? Until early last year there was plenty of evidence of hubris. In February of 2007 the $39 billion paid by Blackstone, a private-equity firm, for Equity Office Properties, a big landlord, was a record price for a buy-out—and the seller, Sam Zell, has a reputation for shrewdly judging the top of the market.

Commercial property has been the asset to own this decade. Figures from the National Association of Real Estate Investment Trusts, an industry body, show that an investment in American property at the start of 2000 would have more than quadrupled in value by the end of 2006. By comparison, the S&P 500 returned just 8% over the same period.

Tighter lending standards have not had the dramatic consequences that they have had in the residential sector. There has not, as yet, been the sharp rise in loan delinquencies that was seen in sub-prime mortgages. The credit crunch has undoubtedly had an effect on confidence but so far it has not been catastrophic. Debt is still available but the cost has gone up a bit and the loan-to-value ratio has fallen. That means property is likely to behave in a patchy fashion. Investors may start to shun properties in poor locations or with low-quality tenants. But they will still be attracted by city-center buildings that have been pre-let or by markets that are soaring, such as Asia's. A lot may depend on whether the debt markets recover their confidence. In America, in particular, a healthy property market requires a revival in the issuance of commercial mortgage-backed securities. So, while commercial property is no longer the bargain it seemed a few years ago, when rental yields were well above those on government bonds, it will probably take a recession, in America and elsewhere, for the recent wobbles to turn into an outright crash.

To be sure, retail landlords started chewing their fingernails in 2007, as concerns mounted that key tenants might become bankrupt. But since the beginning of 2008, as bankruptcies have started to pile up, the shares of retail investment trusts (REITS) are actually up some 9%. Indeed, after Linens ‘n’ Things filed for bankruptcy last week, the share prices of Kimco Realty and Developers Diversified Realty, both of which have exposure to the home goods retailer, barely blinked. Any reaction, however, would have been largely symbolic – the stores Linens plans to close account for less than 1% of their portfolios’ revenues, according to Green Street Advisors.

Has the market already priced in the worst, or are investors underestimating the extent to which bankruptcies could boost vacancy rates? Of the large public REITS, those whose shopping centers are anchored by “big box” tenants that sell home furnishings, apparel or electronics are likely to be most badly affected. They can try to recoup lost rent by recruiting new tenants and in some cases those tenants may pay more. But distinctive big box stores can be expensive to remodel and “un-brand.” And if the economy continues to sputter, making survival difficult for stragglers such as Circuit City and Office Depot, emptied stores could stay vacant longer – especially in housing bubble markets. On the other hand, most of the supermarkets that anchor smaller shopping centers are better protected from the downturn.

The biggest retail REITS have a broad range of tenants, which should insulate them against selected bankruptcies. Privately held regional developers – and their regional bank lenders – will get hit harder first. But investors should not assume that this year’s run of bankruptcies marks the turning point.