Illustration by S. Kambayashi

FROM a distance Potsdamer Platz looks a bit like its old self. Once the central hub of Berlin, before it was turned into a rubble-strewn no-man's-land divided by the Wall, it is now surrounded by shiny new towers. Get a little closer, however, and it becomes clear that many buildings are just façades painted onto giant hoardings that rise ten stories high between actual office blocks.

This subterfuge makes for a far more pleasant view than that provided by vacant lots. It also points to an unusual degree of restraint among developers in Europe's second-largest property market (by transactions). The commercial-property market in most other parts of the developed world is in deep trouble.

Unlike other property busts, this downturn has not been driven by speculative overbuilding but by investors' overenthusiasm. Commercial property was a popular asset class for much of this decade. Institutional investors who lost a lot of money when the dotcom bubble burst were persuaded that switching from the stockmarket into property would diversify their portfolios and reduce their risk. Cheap finance was plentiful. Investors could indulge in a version of the “carry trade”—borrowing at a low interest rate 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, an estate agent, 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, a rating agency, estimates that American commercial-property prices dropped by 7.6% in May alone, leaving them almost 35% below their peak in October 2007. Prices would have gone down even further had not transactions dried to a trickle (see chart). Owners are loth to sell into a falling market, although some distressed sales are occurring.

All this sounds like a replay of the downturn in the residential-property 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 of these, mainly those issued between 2005 and 2007, are now running into trouble.

Realpoint, a credit-rating agency, says that nearly $29 billion of CMBSs, around 3.5% of the total, have become delinquent (ie, borrowers have not kept up interest payments) in the past 12 months. It thinks the delinquency rate could reach 6% by the end of the year. Richard Parkus of Deutsche Bank reckons the default rate could eventually reach 12%. Together with bad construction loans, that could push the losses of American banks on commercial property to $200 billion-230 billion. Many small banks will go under as a result.

European banks are exposed to property, too. The good news is that the two biggest euro-zone economies, France and Germany, have seen only modest declines in rents and prices. But one of Italy's biggest property companies, Risanamento, is fighting to stave off its creditors. And pain is being felt all around the periphery of the euro area. In Spain (see article) and Ireland vacancies are surging, property prices are plummeting and cranes are standing idle.

Prices are plunging across central and eastern Europe, too, although the volume of transactions remains slim. Yields in many of these markets were driven down by hopes that they would, in time, converge with those in mature European markets. Vacancy rates in cities such as Budapest have surged to about 15% while those in Prague have almost doubled (to roughly 10%) over the past year. Some of the biggest falls in rents are taking place in Russia. Rents in Moscow have fallen by 63% in the 12 months to the end of June although they are still the third-highest in Europe (after the West End in London, and Paris). With almost one-fifth of office space empty, further falls in rents and prices seem likely.

Asia has not been spared either. The worst-affected property markets in the region have been financial centres such as Singapore and Hong Kong. Shrivelling bank balance-sheets have meant shrinking demand for office space, as armies of bankers have lost their jobs. Singapore's swankiest business district led the retreat in office rents across the region, shedding more than half between June 2008 and June 2009, according to Cushman & Wakefield, a consultancy. Hong Kong was not far behind with a 43% drop in the same period. Mumbai (down by 40%) and Shanghai (32%) were the next hardest hit.

There are some signs that the speed of the downward adjustment is slowing. In Hong Kong, office rents in the prime central district declined by 20.1% in the first quarter. The fall was much more moderate, but still 10.4%, in the second. Looking ahead, Singapore seems particularly dicey, because 8.3m square feet (770,000 square metres) of new office space will be coming into the market by 2013. According to CLSA, a broking firm, oversupply will also weigh heavily on office property in China. Vacancy rates in Shanghai and Beijing could rise to 35% in 2010 from around 17% and 22% respectively today.

A year ago everyone was worried about losses on residential-property loans. If the latest data are any guide, both American and British house prices may be finding a bottom. Concerns are now switching to the commercial sector. History suggests downturns in that market last for years, rather than months. Almost 20 years have passed since the Japanese property market peaked. Prices still fell by 4.7% last year.