Last November, San Francisco Federal Reserve Bank President Janet Yellen gave a speech on the national economy and put the prospects for the commercial real estate market in stark perspective.

“The outlook for the residential market is uncertain, and uncertain is much better than the prospects for commercial real estate, which clearly are weak,” she said. “All indications are that commercial real estate will continue weighing down the recovery going forward.”

Her main concern was the plunging value of commercial property — upward of 35 to 40 percent — brought on as high unemployment, the housing slowdown and recession have led to higher vacancy rates and a forcible correction of price gains seen between 2001 and 2007.

The obvious and immediate effect of higher vacancies is the property generates less income, but the long-term effect is downward pressure on rents, which further reduces income and devalues the property. As these values decline, banks are seeing ugly loan-to-value ratios and getting concerned about bad loans.

“These loans have covenants in place requiring a certain level of occupancy or income from the property or the lender can call the note due, or demand the owner pay some amount to increase their equity, thereby lowering the loan-to-value ratio,” says Bob Dean, executive vice president of the western region for Grubb & Ellis Co. “Few owners can write that kind of check, so there’s the specter of more foreclosures on commercial property.”

Much like in residential areas, a foreclosed commercial property tends to have a negative effect on the values of neighboring properties, and the cycle continues. Locally, CB Richard Ellis’ 2010 Market Outlook is predicting an increase in foreclosures, but not a wave of the sort Yellen and others fear on the national level.

The good news is most banks recognize they aren’t equipped to manage a commercial property, and in recent months regulators have shown greater flexibility in what they expect from lenders. This provides vital breathing room needed for lenders and borrowers to work out new agreements and, hopefully, stave off disaster.

Here in the Sacramento region, we are a perfect microcosm of what’s happening nationally.

“We’ve got values that have dropped around 40 percent and may continue dropping,” says Dave Brennan, senior managing director with CBRE in Sacramento. “At the same time, the local market will see lots of loans maturing in the coming months and years. Combine that with lack of demand and high unemployment, and it’s an upside down world.”

There are some bright spots. However, not one sector or area in the region is doing “well.” There are simply those, such as downtown Sacramento, that aren’t as weak as other areas, such as Elk Grove and Roseville. Others, such as the Highway 50 corridor, are showing some promise because of the incredible deals available. But across the board, there’s no denying the region’s commercial real estate market has seen better days.

That’s putting tremendous pressure on landlords, who are offering phenomenal deals on rent concessions, tenant improvements and even incentives like moving expenses just to attract tenants.

Vacancy rates in industrial properties showed an uptick in 2009 to 12.5 percent, according to CBRE’s 2010 Sacramento Market Outlook. The big news, however, is for the first time since the early 1990s the industrial sector showed negative net absorption to the tune of 4 million square feet.

But there is reason to believe it’s a blip on the graph. There has been a run of bad luck with big users pulling out. At McClellan Park, OptiSolar alone accounted for 1 million square feet in early 2009 when it shut down plans for a major manufacturing facility.

San Joaquin County is the regional exception. In 2009, brokers closed deals on 16 projects with companies such as O’Reilly Auto Parts, Whirlpool and General Mills. More than 2 million square feet of industrial space was absorbed, and nearly 1,200 new jobs came on line.

“We’ve got about 100 active prospect files at any given time, so we’re seeing a closure rate of 15 to 17 percent,” says Michael Locke, president and chief executive of the San Joaquin Partnership. “We expect to see 2010 being parallel or slightly better than 2009 if credit loosens up.”

The good news for the broader industrial sector is that the region’s “sweet spot” — light industrial buildings of 10,000 to 50,000 square feet — remain strong.

“These are your local medical supply, food, beverage and other necessity distributors and they are Sacramento’s bread and butter,” Brennan says. “Buildings in this range have continued to show the most activity and the lowest vacancy rates in the sector.”

Also, expectations are that absorption will creep back into the positive numbers for 2010, and vacancy rates will show a small decline before leveling off sometime around midyear.

At roughly 21 percent, the vacancy rate for office space in the Sacramento region is at the highest level anyone can remember.

“What we’re seeing is historic. Nothing in the recorded history of office leasing has ever approached the rates we’re seeing now,” says John Frisch, managing partner with Cornish & Carey in Sacramento. “Maybe vacancy was that high during the Great Depression, but nothing else has come close.”

The ripple effect of the housing collapse is felt again. One of the two main drivers of the Sacramento office market has been the real estate food chain of banks, title companies and all the services that rely on those businesses. Today, those businesses are all but extinct. The pain is especially severe in suburban communities that thrived on residential growth.

The other main driver, the state of California, is already shrinking instead of growing, and future budget cuts could mean more unemployed state workers and less need for government office space.

“One thing we learned in 2009 is that the long-held belief that state government could insulate us from a lot of problems doesn’t hold up when state government is the problem.”

Rex Hime, president and CEO, California Business Properties Association

Compounding the problem is the completion of 1.5 million square feet of projects that broke ground before the recession really hit, including major projects like 621 Capitol Mall in 2008 and 500 Capitol Mall in 2009. Even so, downtown Sacramento continues to be the darling of local industry observers. Taken in isolation, its vacancy rate is hovering just below 12 percent, well below that of cities like Detroit (30 percent), San Jose (26 percent) and Dallas (23 percent).

Considering that a balanced office market has vacancy rates around 10 percent, tenants are enjoying tremendous leverage. The state is already implementing a broad “blend and extend” program where firmer, long-term leases are being signed in exchange for reductions in lease rates. In the private sector, a similar approach lovingly referred to as “blend and pretend” is also gaining steam.

“This is where banks meet with borrowers and rewrite agreements in terms everyone can live with for a short time with everyone agreeing to pretend the building value will be back up in a couple years,” Dean says. “Just like blend and extend, this is a win-win for everyone involved; it stops the negative cycle in anticipation of the recovery everyone is expecting.”

Looking ahead, however, projections of continued high unemployment in the region make for a bleak forecast in the office sector.

“I think vacancy will go up in 2010; there are very few employers in Sacramento that are actually growing,” Frisch says.

That means while asking rental rates will be fairly flat in the coming year, actual rates will face continued downward pressure until the market gets closer to balance and there’s demand for new buildings. Don’t expect that new construction to start anytime soon, however.

“There won’t be any new supply added for several years,” Frisch says. “In a typical year, we absorb 1 to 2 million square feet of space. We’ve got seven to 10 years of inventory to lease before we need any new office buildings.”

The news might be worse for retail. It’s hard to pass a shopping center anywhere in the region and not see how tough a year it has been for landlords. In 2008 and 2009, the region lost Gottschalk’s, Mervyn’s, Linens & Things, Circuit City and Office Depot, among many. Not surprisingly, the vacancy rate for retail space increased again in 2009, up to 14.2 percent, according to CBRE’s 2010 outlook.

If there’s good news to be had in this sector, it may be that it can’t get any worse.

Already, anchored centers have seen rents start to firm up somewhere between $1.75 and $2.25 per square foot and predictions are that vacancy will start to decrease for larger box spaces (50,000 square feet and above) as retailers make shrewd bets on a California recovery.

“The whole region is on sale. This is a time of unparalleled opportunity to jump into an A plus location at historically low lease rates,” Brennan says. “You can get an old Mervyn’s space in a prime Northern California location for the same rate as a space in Des Moines. Retailers are going to want to come here now and expect that over time that location is going to do really well.”

Calculated and tempered as they are, expert predictions for a better 2010 may fall victim to challenges that are specific to California.

“One thing we learned in 2009 is that the long-held belief that state government could insulate us from a lot of problems doesn’t hold up when state government is the problem,” says Rex Hime, president and chief executive of the California Business Properties Association. “Beyond continuing problems from state budget cuts, furloughs and layoffs, the state is likely to keep implementing new challenges whether we’re having good or bad years.”

Hime points to legislation that creates mandates on commercial properties related to energy use and carbon footprints. There’s also the looming challenge of “split roll taxation” which could move commercial properties out of Proposition 13 protections.

“Part of the value we have on a property is the certainty of what the tax hit is going to be each year,” Hime says. “Under this new idea that certainty would go away.”

Even without state-imposed headwinds, no recovery of the commercial real estate market is going to be possible without a change in the unemployment trend.

“I’ve been in this business a long time, and if there’s one ultimate solution to the commercial real estate problem, it’s jobs,” Dean says. “When overall demand increases, companies will start looking for more employees, and more places for them to work.”