Commercial real estate not immune but well positioned to withstand economic slowdown and capital markets volatility

Real Estate Weekly, July 23, 2008

Financial markets and the commercial real estate sector are in the midst of a somewhat unique shift. Similar to past turning points, excesses during the run-up are causing a traditional investor pullback as risk is repriced. During the first quarter of 2008, however, a full-blown credit crunch emerged, with much different characteristics than in past cycles, due to the very nature of the financial engineering that fueled the boom. The pooling of a broad range of home loans, including high-risk subprime mortgages, into Mortgage-Backed Securities (MBS) made it easy and temporarily profitable for lenders to increase originations and relax underwriting standards. Home sales soared well above real demand drivers, leading to overbuilding and significant speculation. Poor risk assessment by ratings agencies and investors in these pools resulted in an underestimation of potential defaults, particularly for adjustable-rate subprime loans that reset at dramatically higher interest rates. The wide use of related complex financial instruments and derivatives tied to MBS further exacerbated the risk and has made it difficult to quantify and reprice the now-troubled portions of these investments. The resulting liquidity crunch emerged as uncertainty regarding the magnitude and true "market" value of these securities pushed investors to the sidelines and led banks to tighten lending standards across the board.

Better Late Than Never: Federal Reserve Actions Wide-Ranging, Aggressive. Fed action, which finally turned aggressive in March, has stabilized financial markets--at least for now. Its measure to prevent Bear Stearns from collapse, in particular, helped stave off a domino effect that clearly could have threatened other major institutions. The reassessment of risk and securities' valuations is well under way, as reflected in massive writedowns. The Fed's steps to restore liquidity, along with interest rate cuts, are also playing a critical role in stabilizing financial markets. Signs of gradual improvement are emerging, including private equity injections into key financial institutions and rising U.S. Treasury yields, indicating investors are slowly taking on more risk. It will take a few more months before the benefits of recent Fed actions are passed along to consumers and businesses, as financial institutions first focus on stabilizing their own positions. The successful refinancing of the majority of maturing fixed-rate U.S. Commercial Mortgage-Backed Securities (CMBS) loans since the start of this year, along with a modest rise in conduit lending in recent weeks reflect some "thawing out" of the previously frozen CMBS sector.

Negative Psychology a Drag on Otherwise Sound Fundamentals. Until late last year, U.S. economic drivers outside of manufacturing and housing had been on relatively solid ground. In the second half of 2007, health care, education, professional services, trade and tourism added 733,000 jobs, while construction, manufacturing and financial services shed 283,000 positions. Negative psychology and tighter credit markets have since eroded consumer and business confidence, triggering a downturn. In the first four months of 2008, companies scaled back capital investments and cut 260,000 jobs, weighing heavily on U.S. consumers already burdened by the housing downturn and high energy prices. The economy has stalled, creating a challenging environment for commercial real estate owners, regardless of whether a technical recession (two or more consecutive quarters of contracting GDP) takes place. The government's stimulus package, liquidity injections and lower interest rates make a technical recession unlikely in 2008 and should foster some growth later this year. In addition, companies avoided excessive hiring and capital investments during the most recent expansion period, supporting expectations for a moderate downturn.

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Commercial Loan Delinquency Still Near Historic Lows. Commercial real estate loan delinquency rates have increased modestly, but at less than 0.5 percent, they remain near historical lows. This is reflective of generally healthy occupancies and income growth during the past few years. Spillover concerns from the troubled residential sector and fears of future problems with late-vintage commercial loans, however, are keeping many CMBS investors on the sidelines. In the first quarter of 2008, commercial banks and life insurance companies tightened underwriting standards further, and some reached capacity limitations. This group of lenders initially helped offset the void created by the CMBS market, and their recent pullback is causing additional constraints on commercial real estate financing. Apartment investors have been impacted the least by the capital markets shift due to increased lending by Fannie Mae and Freddie Mac.

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COMMERCIAL REAL ESTATE OUTLOOK

Fundamentals Rule, Again

The current environment is best defined as a transition from unsustainable, frothy conditions to a "normalized" market, not a systemic crash. Unlike past cycles, generally healthy commercial real estate fundamentals and a lack of significant overbuilding will limit the correction. Furthermore, the last period of economic expansion was relatively brief, and companies remained cautious when hiring and leasing space. That is not to say that occupancies and rents will not suffer from the economic slowdown. Vacancy will rise this year as job losses hinder household formation and companies delay leasing commitments. Unless the downturn deepens unexpectedly, however, the increase in vacancy should be moderate, keeping U.S. averages below previous cyclical highs. Retail is our primary concern, as tenants are directly affected by the housing slump and reduced consumer spending.