Monday, May 10, 2010

Recovery Proving Elusive For Commercial Real Estate Market

5/7/2010 8:7 PM ET

The United States real estate market is one of the largest markets in the world, and world economic activity is to a large extent dependent on this significant market, as evidenced by the sub-prime crisis and the eventual global financial crisis of 2008/09. The market is broadly classified into two sectors, Residential and Commercial, and was one of the worst hit industries in the recession. What's new? A more serious debt maturity crisis is looming large for the commercial real estate sector, looked upon as a second phase of the real estate collapse.

The weakness in the real estate industry can be largely attributed to the housing bubble, although one cannot deny that certain policy decisions also played a major role. It was only in late 2007 that Alan Greenspan, the former Chairman of the Federal Reserve, admitted that there was a bubble in the U.S. housing market and said that housing prices were likely to fall significantly. As he predicted, during 2008/09, housing prices nosedived and foreclosures soared.

Reflecting back, when Greenspan was still the chairman, the Fed, fearing deflation, started slashing the federal funds rate (the interest rate that banks charge each other for the use of Fed funds) to a half-century low of 1% by mid-2003, and it stayed there for a year. The underlying idea was to have more funds float in the system and improve the activity levels, as deflation could lead to falling profits, shrinking employment, increasing loan defaults, etc.

This effort to beef up the economy eventually turned counterproductive, as the easy availability of funds encouraged lenders to indulge in subprime lending - i.e. lending to borrowers with low credit profiles at higher interest rates. Lenders thought they could easily manage the risk through mortgage backed securities. Eventually, large sums poured into the real estate market and prices skyrocketed, leaving the housing bubble inflated.

Later, when the Fed started hiking interest rates again, the cost of borrowing increased and mortgages to subprime borrowers were reset at much higher monthly payments. As a result, subprime borrowers started defaulting, leaving mortgage lenders with property that was worth much less than the loan value. This, together with unaffordable home prices, led to the collapse of the subprime mortgage industry in 2007. Many of the largest lenders filed for bankruptcy protection in light of soaring foreclosure rates, while the economy slipped into recession. New housing deals struggled to close due to lack of funding and very conservative lending practices.

Of late, the residential real estate market has seen some positive signs, such as stabilizing home prices and increased sales, but foreclosures continue to haunt the market. Finally, there are some signs that pending deals are closing. According to National Association of Realtors (NAR), pending home sales rose in February and March. A pending sale is one in which a contract is signed but not yet closed. Normally, it takes four to six weeks to close a contracted sale.

At least there is some visibility for the residential market, as NAR chief economist Lawrence Yun said, "Later in the second half of the year, and into 2011, home sales will likely become self-sustaining if the economy can add jobs at a respectable pace, and from a return of buyer demand as they see home values stabilizing."

On the other hand, commercial real estate, an often forgotten sector of the industry, is still witnessing weak demand. Dropping real estate values, job losses and declining consumer spending left vacancies on a rise, which in turn has driven down rental rates and valuation.

According to commercial real estate research firm Reis, Inc., vacancy rates in the first quarter rose to a little over 17%, the highest level since 2000, and climbed to a 16-year peak at office buildings. The Moody's/REAL Commercial Property Price Index shows that U.S. commercial real estate values in February 2010 fell 42% from the market top in October 2007.

Ever since the beginning of the recession, consumer confidence has been low and consumers have increasingly preferred shopping at discount stores and big box retail outlets that offer low-end merchandise rather than malls that typically sell high-end items. This has significantly affected mall traffic, leading to an increasing number of tenants closing shops. The low confidence levels are reflected in the Conference Board's Consumer Confidence Index, which fell to 25 in February 2009 from over 100 in early 2007.

Further, new occupation and new construction has essentially stalled due to a lack of funding and very conservative lending practices. Although interest rates are low, banks are cautious about lending. The commercial mortgage backed securities (CMBS) market has virtually disappeared. Reis says that commercial-mortgage-backed financing dropped 95% last year from its record level in 2007.

The rate at which banks are failing, one could say, is "the" main reason for the lack of credit. Higher defaults on loans has led to huge write-offs by banks, causing many to fail. Of the approximately 256 banks closed or taken over to date by the Federal Deposit Insurance Corporation (FDIC), 229 were since 2008. Closures in the year 2009 were about 140, far surpassing the 25 that were closed in the whole of 2008. So far this year, already 64 institutions have closed, quite a troubling number.

Adding to the woes are low employment levels, which have reduced the demand for office space, especially in leading financial districts, resulting in falling office rentals. The unemployment rate is still hovering around the 10% level and will likely remain at these levels.

Apart from this, as mentioned earlier, the commercial realty market is facing a more serious debt crisis. The Congressional Oversight Panel has warned that $1.4 trillion worth of commercial real estate loans will reach maturity between 2011 and 2014. With the plunge in property prices, nearly half of these loans are at present "underwater," meaning that the borrower owes more than the underlying property is currently worth. According to Deutsche Bank, as many as 65% of these loans will have difficulty refinancing.

These problems will only exacerbate rising unemployment rates and declining consumer spending, as the suffering banks will become even more reluctant to lend, which could in turn reduce access to credit, hindering economic activity.

An analysis by the panel has found that nearly 3,000 of the nation's more than 8,000 banks have potentially dangerous exposure to commercial property loans. The damage from this could affect the lives of nearly every American. How? Job losses will only increase with empty office complexes, retail outlets, and hotels, while foreclosures on multifamily and apartment complexes could also push families out of their residences, even if they pay rents promptly.

So, it is evident that a commercial real estate market recovery depends largely on the health of the overall economy. A year-long contraction in gross domestic product (GDP) was snapped in the third quarter of 2009, when the Bureau of Economic Analysis released the data showing 2.2% GDP growth, driven largely by government stimulus. The expansion was maintained in the subsequent two quarters with a six-year high of 5.6% growth seen in the fourth quarter and better- than-estimated 3.2% growth seen in the first quarter. The Consumer Confidence Index has also risen from its low of 25 in February '09 to 57.9 in April 2010.

However, looking at the problems the commercial real estate industry is faced with, it looks like it will suffer substantial difficulties for a number of years. Typically, commercial real estate lags residential market trends by 12-18 months. While the S&P Case Shiller 20 City Composite Index indicates that housing values peaked in mid-2006, the Moody's/REAL Commercial Property Price Index shows that commercial property values peaked nationally 16 months later in October 2007. The same trend could be expected in the recovery.

Lending activity is likely to remain sluggish for some time. Meanwhile, the continuation of the downward pressure in commercial property prices could create an attractive investment opportunity to some cash rich investors in 2010.

A true recovery will only be possible if liquidity returns, sustainable job growth resumes, and commercial mortgage-backed securities re-emerge. However, at this point, the prospects for commercial real estate are much less optimistic.