Recent events in the market, including the drawn out debate over the budget ceiling, Friday’s downgrade of the US credit rating and today’s downgrade of Freddie & Fannie by Standard & Poor’s, coincide with new data that show the broader economic recovery has slowed in recent months. Bet I’m not telling you anything that you didn’t already know.
These developments, alongside heightened volatility in stock markets, have obviously prompted concerns about the resilience of the commercial real estate recovery. In assessing what all of this means for the investment outlook, our clients are looking to us for leadership and a more balanced, long-term assessment of the future. Along those lines, and while I could certainly fill this post with a summary of the downside risks stemming from recent events which have recently imbued the blogosphere, the following is a different but pragmatic take on the road ahead – the market is currently sensitive to the downside risks, but it is also prone at this juncture to discount positive information. There is some good news, which stands apart from the cacophony of recently sounded panic alarms.
On the economic front, there are indications of continuing resilience. Among them, the details of last Friday’s employment report have been lost in the discussion of the downgrade. That report shows the private sector adding over 150,000 jobs during July, easily beating economists’ projections. And while job growth needs to improve further, it is significant that businesses added a meaningful number of jobs even in the midst of the budget crisis. Corporate profits have rebounded, more than doubling from their recession levels and even surpassing their pre-recession peaks. Those profits will feed hiring once a sense of long-term normalcy returns to the market.
Closer to my world, trends in commercial real estate investment markets suggest a degree of resilience in the face of market disruptions. Some of the key trends to consider are as follows:
Investment Activity Continues to Increase
CRE property sales continued to increase in the second quarter, hitting levels comparable with sales during 2008. Even as the economic news has become more tentative, activity in July remained strong. The large coastal markets remain the most active, but rapid declines in cap rates in these locations are supporting a stronger value proposition in secondary and tertiary markets and for relatively smaller properties. Spillovers into the middle market have been slower in coming, in part because sales depend on the availability of financing, but that piece of the puzzle is also falling into place.
Credit Availability is Improving
The latest data show that delinquency and default rates at the regional and community banks that account for a large share of mid-size and small property lending have come off their peaks. As the stress from legacy loans has become more manageable for many institutions, a large number have actively returned to the market in making new loans. These banks are less active in the major metros, where lending by foreign banks and other lenders is driving outcomes. Instead, they are relatively more active in the markets where large institutional lenders and investors are not. CMBS lending is also contributing to credit availability for mid- and small-tier borrowers. We expect CMBS to be an important contributor to overall credit availability, in spite of recent bumps in the road for issuers.
As for today’s downgrade of Fannie Mae and Freddie Mac, this probably means higher costs of capital for these institutions, in spite of their unique relationship to the government under their conservatorship arrangement. Not receiving much attention over the last 3 days, however, is that strong fundamentals in the apartment sector mean that other sources of credit are eager to finance investment activity. This is clearly in evidence with banks, which Chandan Economics find have increased their net apartment lending in 2011. Keep in mind that residential mortgage rates will generally rise if Fannie and Freddie’s costs go up. That supports apartment fundamentals, supporting non-GSE lenders’ favorable assessments of the sector’s risk profile.
S&P Downgrade a Wake Up Call in Washington
I’m oversimplifying, but the U.S. debt downgrade, in my opinion, wasn’t much about the ratio of public debt to GDP or any other metric for that matter – the downgrade wasn’t rooted in math, or with respect to the U.S.’s ABILITY to service its debt. Rather, the downgrade was about our government’s WILLINGNESS to do so. The chaotic two month’s in Washington and the partisan rancor which transpired was significant, and spoke as much to the likelihood of default as anything.
Perhaps most important, when issued, the S&P downgrade offered very little in the way of new information about the quality of US debt. More than anything, it spoke to the character of the U.S. government. Dare I say that this may trigger a new, more levelheaded approach to governance and policymaking? With many of the pieces of a resilient recovery in place, stronger signals from our elected officials that the rules of business will normalize and that our countries’ challenges will be addressed in a timely and meaningful way, this could be the best legacy of the ratings rebuke. Until then, be on the lookout for continued improvements in credit availability, the debt capital markets, and other positive economic indicators which fuel the resilient commercial real estate marketplace.
I’m not being Pollyanna, but there is some good news to consider of as of late.
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