The Next Shoe to Fall Before Recovery
By Lawrence Yun, PhD., CHIEF ECONOMIST NATIONAL ASSOCIATION OF REALTORS
The commercial real estate landscape is precipitously unraveling. The delinquency rates on commercial loans are still low by historical standards, but are rising steeply. The increased defaults, unlike homeowners who could not pay their higher resetting mortgage payments, are often occurring even though payments are being made on a timely basis. Lenders are labeling loans as ‘nonperforming’ because of a perceived decline in mark-to-market collateral value, and demanding that borrowers come up with cash to cover the short-fall.
The credit crisis has also essentially shut down the issuance of commercial mortgage-backed securities. With capital so scarce, property purchases have all but dried up. Investment in office properties was down 75% in 2008, retail investment fell by a similar amount, while industrial investment fared relatively better … if we can use the term … with a 58% downfall.
On top of the credit-crisis and market-to-market accounting-induced defaults, commercial market fundamentals are turning sharply for the worse. By 2010, the cumulative job cuts could reach 6 million, which would be roughly equivalent to a situation in which everyone who had a job in Illinois at the start of the recession now found themselves on the unemployment roll.
The national office vacancy rate will jump to 17% by year’s end from 13% in 2008. The industrial vacancy rate could rise to 13% from the under-10% rate of just two years ago. The retail sector will also feel the pain of a 14% vacancy rate, up from 9% at the start of the recession. As a result, rents will fall by 5% to 8% in these property sectors in most metro markets.
The sector that is holding up decently is the multifamily sector. With home sales at12-year lows and foreclosure rates rising, the demand for rental units has held its ground. The apartment vacancy rate is expected to stay close to 6% with rent growth to rise by 2% in 2009.
How do we get out of this jam? First, a massive government stimulus package was already passed in late February. The $787 billion package, a mix of tax cuts and government spending, is by any measure HUGE. The efficiency and efficacy of the components are questionable and debatable, but the vast scope of the stimulus package assures that there will be economic turnaround before year’s end. The economy may even be able to squeak out a gain as early as the third quarter. That will steadily help on the mob front and on net absorption going into 2010. Low interest rates and the Federal Reserve pumping liquidity into frozen markets, such as directly buying commercial mortgage-backed securities and small business loans, will also help unclog the credit market.
The baseline forecast, however, is:
· The economy will pop positive from the fourth quarter;
· The GDP to expand 1.7 percent in 2010;
· The unemployment rate, after peaking near 10 percent, will steadily slide down next year;
· After no rise in consumer price inflation this year, inflation will only rise by 1.2 percent next year;
· There is little inflation threat – both despite the massive liquidity pump and government spending, and because of continuing excess slack in the economy – which will permit the Fed to keep the rates low through the end of 2010;
· The 10-year Treasury yield rising to a possible 4 percent by then will not hamper recovery;
· Cap rates, which had been widening in recent quarters to Treasury, can remain at a comfortable 6-7 percent, thereby preventing property values from collapsing.
A pessimistic turn of events is the debt market’s inability to handle the federal deficit of nearly $2 trillion. What is China does not buy U.S. debt? What if inflation pops once the velocity of money picks up? What if the credit crunch continues despite all government efforts? The economy, after a short term boost, could easily sag again. Once that happens, there may not be a public appetite for more government stimulus. There may not be financial market appetite to take on excessive government debt. A sagging economy with no further feasible stimulus is a receipt for disaster. Because of this possibility, in my view, the massive government stimulus package of 2009 is a one-time shot at getting the economy right.
In the optimistic scenario, a strong resurgence of consumer confidence will push the economy to grow at a faster than normal pace, while strong job gains and fewer on the unemployment dole will quickly trim the federal budget deficit. The stock market could turn markedly higher from a relaxation in mark-to-market accounting, which NAR has been advocating. Another source of rising consumer confidence will be the end of home price declines. The home buyer tax credit is an added incentive to jump into the market. As buyers enter, housing inventory will get trimmed and home prices could stabilize in many parts of the country by the year’s end. Home price stabilization will mean no further bleeding of bank balance sheets and no further destruction of housing equity. Banks will lend more and consumers will hit the malls.
On a hopeful note, we are already seeing a rather strong recovery in home sales in the hard hit markets of California, Arizona, Nevada, and Florida. Buyers are fighting over knocked-down home prices. It appears that once a few buyers get in on the game, other are following. Sales are doubling in California with frequent occurrences of multiple biddings. A tipping point has evidently been achieved, Will other states follow a similar recovery path?
