An Update on Emerging Issues in Banking 

Weak Fundamentals for U.S. Office Markets

March 21, 2002 

The U.S. commercial office sector eclipsed a variety of records for speed of 

decline in 2001. The amount of occupied U.S. office space declined for the first 

time in the 20 years such data have been collected. This 89 million square foot 

reduction in occupied office space--an amount roughly equivalent to all of the 

office space in Denver, Colorado--contributed to record increases in U.S. office 

vacancy rates.1 Commercial real estate lenders may experience rising 

delinquencies in 2002, as office vacancy rates appear likely to increase further. 

As commercial real estate construction gradually picked up steam over the past 

five years, the FDIC has closely monitored market conditions and has published a 

number of analyses covering the various commercial property types.2 Through the 

end of 2000, a strong U.S. economy supported large annual increases in demand 

for U.S. office space and kept vacancy rates low. During this period, however, 

many high-tech firms engaged in "speculative leasing," signing agreements to 

lease office space in excess of their current needs in anticipation of tight market 

conditions in the years to come. 

During 2001, as the U.S. economy slowed and the high-tech equity bubble 

deflated, many of these same firms attempted to unload excess space by offering 

it for sublease. The result has been a glut of available office space in many 

markets. Torto Wheaton Research reports that 36 of 53 major metropolitan areas 

experienced negative net absorption of office space in 2001.3

The flood of sublease space put upward pressure on office vacancy rates, which 

increased in 51 of 53 major markets during 2001.4 In three markets--Austin, San 

Francisco, and San Jose--the office vacancy rate increased by more than 10 

percentage points. Taken as a whole, the nation's office vacancy rate increased 

by 5.3 percentage points during the year, from 8.4 percent to 13.7 percent. Rents 

also declined, on average, by nearly 10 percent during the year. Currently, leasing 

activity for office buildings is slow or nonexistent in many markets as potential 

tenants reassess their future needs. 

Similarly, demand for other commercial property types has also retrenched. 

Industrial properties, for example, also experienced negative net absorption for the 

first time in 2001. Declining conditions in retail, single- and multi-family properties 

are further documented in the FDIC's Survey of Real Estate Trends. 

Because of the time lag inherent in commercial real estate construction, many 

projects that were started in response to high demand in 2000 will be completed 

sometime later this year, and will place further pressure on office market 

fundamentals. Chart 1 identifies ten U.S. office markets that had both rapidly rising 

vacancy rates in 2001 (horizontal axis) and a large amount of new construction in 

progress (vertical axis). Completions of these projects in 2002 will put continuing 

upward pressure on vacancy rates in these markets. 
D

Despite the sharp decline in office demand, analysts cite a number of factors in 

support of the belief that the magnitude of this office market downturn will be less 

severe than in the cycle of the 1980s. These factors include heightened market 

transparency resulting in better and more timely market information, better loan 

underwriting and greater liquidity. Still, many analysts do not anticipate office 

market recovery to commence until later this year at the earliest. 5 

A large number of FDIC-insured institutions extend credit for office construction 

through construction and development (C&D) loans and commercial real estate 

(CRE) loans. 6 Chart 2 shows the percentage of insured institutions over time with 

moderate to high exposures to these combined loan types as a percent of equity 

capital. The chart shows that while the percentage of the industry with the highest 

exposures (more than 500 percent of capital) is lower now than during the late 

1980s, the percentage of institutions with moderate to high exposures (200 to 500 

percent of equity capital) is higher now than at any point in at least the last 17 

years. 

D

Despite this increase in exposures, commercial real estate loan performance 

remains solid at present. At the end of 2001, noncurrent C&D loans (or loans 90 

days or more past due and those in non accrual status) for the industry totaled 

$2.4 billion (or 1.1 percent of all C&D loans), compared to $1.6 billion a year 

earlier. By comparison, at the end of 1991, the worst year of the last cycle, 

noncurrent C&D loans reached $17.5 billion or 13.6 percent of all C&D loans. 

Performance has deteriorated more noticeably among commercial real estate 

loans held by issuers of Commercial Mortgage Backed Securities (CMBS). 

Standard & Poor's recently noted that a dramatic increase in overall CMBS 

delinquencies has occurred since the third quarter of 2001. Although these 

delinquencies are primarily centered in lodging property loans, concerns are noted 

for the high vacancy rates in office properties and the risk that these may lead to a 

"substantial increase in the mortgage delinquency rate" if the economic downturn 

does not reverse shortly. 7 

The outlook for commercial real estate credit quality depends both on the depth 

and duration of the current economic slowdown. In spite of signs of a recovery in 

the U.S. economy, many analysts do not predict an uptick in office absorption to 

occur until early 2003. In the interim, further office vacancy increases and rental 

declines can be anticipated before a return to equilibrium occurs. 

1 Office space as tracked by Torto Wheaton Research covers competitively leased office properties that are 

10,000 square feet or 

more.

2 See previous Regional Outlook articles: "Ranking Metropolitan Areas at Risk for Commercial Real Estate 

Overbuilding," Third 

Quarter 2000 and "Slowing Economy Reduces Demand for U.S. Office Space," Third Quarter 

2001, http://www.fdic.gov/bank/analytical/regional/index.html.
3 Torto Wheaton Research. Spring 2002. Office Outlook. Absorption represents the measure of demand for 

commercial real 

 estate space. Negative absorption occurs when previously occupied space is returned to the market as 

vacant space available for 

lease or sublease.

4 The only two markets with office vacancy declines were Riverside, California and Honolulu.

5 Gordon, Sally. "CMBS: The Commercial Real Estate Cycle Is Past the Peak But Poised for a Pick-Up," 

Moody's Investors Service. March 11, 2002.

6 C&D loans include both residential and commercial construction loans. A breakout by category type is not 

available.

7 Chun, Roy and Peter P. Kozel, Ph.D. February 15, 2002. "CMBS Delinquency Rates Rise; Moderation in 

Future Rise Depends 

on Mid-Year Economic Recovery." Standard & Poor's Structured Finance.

Last Updated 03/21/2002 
Chart 1: High construction activity and rising vacancy rates could stress some office markets.

Metropolitan 

Market Name

Vacancy Rate 

Increase: Change in 

Vacancy Rate During 

2001, in Percentage 

Points

Construction Activity: Square 

Feet of Office Space Under 

Construction at Year-End 2001 

as a Percentage of Total 

Rentable Space

Austin 14.90 7.5%

San Jose 13.10 3.4%

San Francisco 12.30 4.4%

Boston 9.60 3.0%

Seattle 9.00 7.2%

Oakland 8.00 4.4%

Denver 7.40 1.6%

Northern New 

Jersey 7.40 6.4%

Wilmington 7.40 4.5%

Washington, 

DC 6.80 3.4%

Fort 

Lauderdale 6.70 4.3%

West Palm 

Beach 6.70 0.6%

Phoenix 6.50 2.8%

Columbus 6.20 0.7%

San Diego 6.20 2.5%

Portland 5.90 5.0%

Chicago 5.80 2.8%

Orange County 5.50 0.7%

Ventura 5.40 4.0%

Kansas City 5.30 1.4%

Sum of Markets 5.30 2.7%

Fresno 5.20 0.0%

Salt Lake City 5.10 2.2%

Stamford 5.00 0.8%

Atlanta 4.90 2.6%

Dallas 4.80 2.1%

Detroit 4.80 1.7%

Indianapolis 4.40 0.0%

Orlando 4.40 1.6%

New York 4.30 1.8%

Las Vegas 4.20 5.2%

Nashville 4.10 1.5%

Westchester 4.10 1.3%

Cincinnati 4.00 1.4%
Miami 4.00 5.1%

Jacksonville 3.60 2.2%

Philadelphia 3.50 3.0%

Charlotte 3.40 4.0%

Tucson 3.30 1.4%

Hartford 2.40 0.0%

Long Island 2.40 1.6%

Baltimore 2.30 3.5%

St. Louis 2.30 1.3%

Sacramento 2.20 3.8%

Tampa 2.10 0.9%

Houston 2.00 2.1%

Los Angeles 2.00 2.0%

Fort Worth 1.60 2.0%

Minneapolis 1.60 1.3%

Cleveland 0.80 2.9%

Oklahoma City 0.70 0.0%

Albuquerque 0.50 2.4%

Riverside (0.40) 0.0%

Honolulu (0.50) 0.0%

Source: Torto Wheaton Research
Concentrations of commercial real estate loans to capital have risen sharply since 1998. 

Percent of FDIC-Insured Institutions with construction and commercial real estate loans-to-equity 

capital greater than: 

Year 200 percent 300 percent 400 percent 500 percent

1984 15.13 8.15 5.17 3.83

1985 16.63 9.06 5.61 3.96

1986 19.91 11.17 6.94 4.89

1987 20.92 11.44 7.15 5.04

1988 21.74 11.42 6.86 4.68

1989 21.38 11.07 6.42 4.12

1990 21.00 10.64 5.91 3.66

1991 19.94 9.17 4.65 2.74

1992 18.24 7.47 3.47 2.00

1993 17.47 6.93 2.85 1.44

1994 19.67 7.89 3.14 1.44

1995 18.16 7.02 2.46 1.04

1996 19.98 8.29 3.19 1.25

1997 20.76 8.49 3.24 1.26

1998 21.54 9.67 3.90 1.43

1999 26.92 13.72 6.44 2.54

2000 28.61 14.49 6.70 2.77

2001 31.55 17.83 8.72 3.67

Source: Bank Call Reports; Thrift Financial Reports (FDIC)