GDP: 4.5% in Q1; 4.3% in Q2; 4% in the second half. Unemployment Rate: 5.5% by 11/04. Job Growth: +1.2, or 1.4 million jobs. 10-Year Treasury Yield: 4.49% to 4.71% by 12/31, with a low forecast of 4% and a high of 6.4%. Federal Funds Rate: 1.63% by year end, with a low of 1.0% and a high of 2.5%. Federal Deficit: $500 billion. Dow: 10,980 avg. by year end, with a low of 9,750 and a high of 11,800. S&P 500: 1139 avg. by 12/31, with a low of 890 and a high of 1300. S&P Profits FYE: +11.58% by year end.
If these forecasts are half correct we should have a good, if not great, year in commercial real estate. This is especially true if the big message continues to be low interest rates and something new is added: job growth, the engine of real estate demand. This past year was a good one, in spite of deteriorating fundamentals, due to: low interest and cap rates; the explosion of private capital into commercial real estate; and the increase in sales transactions (+ 24.05% for the 12 months ended 6/30/03). Job growth is the missing ingredient that should start to improve the supply/demand imbalance and hopefully begin a market correction.
Commercial real estate as an asset class is coming out the downturn far better than in past cycles. The NCREIF All-Property Index is +7.8% for the 12-month period that ended 9/30/03, and the Morgan Stanley REIT Index was up +36.9% for 2003. CMBS delinquencies were 1.6% in November, a slight increase over January’s 1.4% but still very low. Fitch Ratings recently reported that, in spite of two years of deteriorating fundamentals and increasing delinquency rates, it will not alter its Stable Outlook Ratings for commercial mortgage-backed securities in 2004. Fitch predicts that default rates will taper off as the US economy stabilizes and losses occurring in the resolution of defaulted CMBS loans will continue to affect only a small fraction of collateral. Life-company delinquencies are all but non existent at .4%.
Many forecasters are predicting more rapid growth in the first half of '04 because they see rising interest rates in the second half of the year dampening housing and auto sales. With an election on the horizon, I predict that the Fed will be very accommodating and any tightening will probably not occur until the end of the year. If we get the kind of economic and job growth forecasted, we will face higher rates in 2005. Thus 2004 will be an especially good year to leverage with rates at 40-year lows.
The supply of capital in 2004 should be no problem since 2003 CMBS lending in the US should surpass 1998's record levels, and all CMBS lenders are forecasting increased appetites in 2004. Life companies had increased allocations in 2003 and are targeting more for '04, and banks remain hungry for good loans. Fannie and Freddie weathered accounting problems and are aggressively pursuing multifamily loans. The structured-finance market has ample sources of equity, participating debt and mezzanine debt from a wide array of institutional and private sources. Once again, the problem is finding good deals, not capital.
What could go with this rosy picture? The terrorism threat is always out there, as we were reminded over the holidays with heightened alert levels; the cancellation of flights from France, England and Mexico; and increased security at public gatherings such as the New Year's Eve event in Times Square. The twin deficits (foreign and domestic trade) fueled by negative trade balances and the occupation of Iraq will ultimately need to be dealt with, and an interest-rate spike created by China or Japan dumping Treasuries could occur.
Most of the positive forecasts are predicated on business spending increases in 2004 by investing in new equipment, slowing their inventory reductions and hiring more. The consumer, armed with record-low credit and tax cuts, carried the ball in '02 and '03 but may be tapped out. How many more SUVs and new condos can we buy? If businesses don’t pick up the ball, we could have problems. Other potential pitfalls include continued financial scandals, high energy prices and mad-cow disease.
All things being equal, it looks like the beginning of a very good year. As in any year, it’s always best to get the hay in the barn early. You never know when the bad weather will come. It’s also good for performance bonuses. Happy New Year!
John T. Fenoglio is a partner in Houston-based investment-banking firm Live Oak Capital Ltd.
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