Looks like the commercial-property market is in deep trouble. Anybody surprised?

This downturn hasn’t been driven so much by speculative overbuilding but by investors’ overenthusiasm. Commercial property was a popular asset for much of this decade. Institutional investors who lost lot of dough when the dotcom bubble burst were persuaded that switching from the stockmarket into property would diversify their portfolios and reduce their risk. Investors indulged in borrowing at a low interest rate (with plenty of ready financing available) to buy buildings and counting on the rental yield and capital growth to more than cover their financing costs.

That strategy looked smart when rents and capital values were rising and vacancy rates were low. But as cheap financing has dried up and economies have tumbled into recession, investors have become badly exposed. According to Marcus & Millichap, the office-vacancy rate in Manhattan climbed by more than three percentage points in the first half of the year, to 11.2%. As tenants have disappeared, rents have fallen too—by 16% over the past year, Marcus & Millichap reckons.

Property prices have also been badly hit. Moody’s estimates that commercial-property prices dropped by 7.6% in May alone, leaving them almost 35% below their peak in October 2007. Owners don’t like selling into a falling market (although some distressed sales are occurring) otherwise we suspect prices would’ve gone down even further had transactions not dried to a trickle.

This sure sounds like a replay of the downturn in the residential market, where easy borrowing terms allowed homebuyers to push prices to extreme levels. To add to the sense of déjà vu, property loans have also been bundled into complex financial instruments, known as commercial mortgage-backed securities (CMBSs). The riskiest ones issued between 2005 and 2007 are now running into trouble.

Stay tuned.