Hurricanes Take a Toll on Investors

Hurricanes Katrina and Rita created significant short- and long-term disruptions in the US economy that will impact the commercial real estate market in a number of ways. In the short term, the 2005 hurricane season disrupted oil and natural-gas production, destroyed or severely damaged millions of square feet of commercial property and added hundreds of thousands of workers to the ranks of the unemployed. Longer term, the hurricanes will create a spike in construction costs and raise the price of operating investment properties.

The vulnerability of the nation's energy-production system was clearly laid bare when Katrina and Rita damaged oil production facilities in the Gulf of Mexico. Oil-refinery capacity in the region accounts for nearly half of the US total. Lost oil production since late August is at nearly 14% of the region's annual total, while natural-gas production is down almost 11% over the same period. The nation has already experienced the short-term effects of these disruptions: Gasoline prices spiked to more than $3 per gallon in most areas but have since declined to an average of approximately $2.50 per gallon and natural gas prices are running 35% above year-ago levels.

Commercial real estate in the path of the hurricanes has been virtually destroyed. A number of assets that suffered direct hits will not be salvaged, while extensive flood damage was incurred by properties out of the direct line of the storms. The warm, moist conditions that prevailed in the wake of both catastrophes have created an ideal breeding ground for mold, further exacerbating losses to investors. In addition to direct wind and flood losses, investors are grappling with lost income as tenants invoke force-majeure clauses in leases on uninhabitable buildings.

Local and state economies along the Gulf Coast will be under stress as they cope with the large number of unemployed. An estimated 500,000 jobs were lost due to the storms. In September, unemployment rates in Louisiana and Mississippi increased 5.8 percentage points to 11.5% and 2.9 percentage points to 9.6% respectively.

The storms will have a lasting impact on the economy and commercial real estate markets. Construction costs have already risen and are expected to remain high for the foreseeable future. Developers had been struggling to acquire cement, steel and, in certain areas, lumber products for the past year. Katrina's damage to New Orleans' port facilities has put further upward pressure on cement prices, since nearly 10 percent of US cement imports are normally routed through the area's terminals. Prices for lumber and other building materials are also expected to remain at elevated levels as the rebuilding efforts move into full swing. Besides cement and lumber, steel, rubber, diesel and copper prices were all rising prior to Katrina. Rebuilding efforts should keep prices elevated for these and other construction-related commodities for at least the next year.

Rising labor costs could present an even larger problem for developers than rising materials costs. Commercial builders have been dealing with construction labor shortages in many regions of the country for the past two to three years due to the home-construction boom. The problem has been especially acute in the fast-growing southern states. As workers migrate to the Gulf area to help with the rebuilding, the labor shortages in the areas they leave will intensify.

Property investors will likely face higher costs as a result of the hurricanes. Insurance and energy expenses will increase and may remain elevated for some time. Estimates of Katrina's insured losses range between $35 billion and $60 billion, while combined losses for Rita and Wilma are expected to cost another $10 billion. Eventually these losses will work their way into higher premiums for all property owners as insurers gradually rebuild reserves. Energy costs for property owners have already risen considerably over the past two years, and the storms' disruption of natural-gas production is expected to lead to considerably higher heating bills this winter.

The Federal Reserve has continued on its course of raising overnight interest rates, lifting the Fed Funds Rate by 25 basis points in both late September and early November. The Fed has signaled that its primary concern is inflation, not a slowing economy. Despite the economic blows dealt by Katrina and Rita, third-quarter GDP growth came in above expectations at 3.8%. Positive news on the economic front in recent days has pushed bond yields higher. As of early November, the yield on the 10-year Treasury was up more than 20 basis points from the beginning of October and more than 60 basis points from early September. Signs of slowing in the housing market have begun to emerge, and additional increases in mortgage rates are expected to lead to further cooling.

With energy and construction costs forecast to remain elevated, there is a real chance that consumer spending will be negatively affected, which could lead to a disappointing holiday season for retailers. Higher construction costs and mortgage rates could also cause a greater-than-expected slowdown in the housing market, which would in turn reduce GDP growth. On the positive side, higher construction costs will lead to a reduction in new commercial real estate supply, and although interest rates have risen over the past several weeks, they remain low by historical standards, both factors that will keep values on solid ground.

Based in Walnut Creek, CA, Hessam Nadji is a managing director of Marcus & Millichap Real Estate Investment Brokerage Co. and oversees the firm's research-services division. Views expressed here are the author's solely.