Pessimism About the CRE market

I’m pessimistic about the CRE market.  It seems that despite the efforts to bring the securitization market back to life, which I hope works, the economic indicators are not positive.  Here are a few indicators I think are germane to the commercial real estate market in California and nationwide.  They appear to indicate that we have a lot more distress ahead of us before the CRE market recovers:

Unemployment:  The LA Times reported on July 2 that the unemployment rate edged down to 9.5% as many workers dropped out of a labor market that remains very sluggish, with private employers adding fewer jobs in June than anticipated. 

Consumer Confidence Down:  The Conference Board said that its Consumer Confidence Index which had been on the rise for three consecutive months, declined sharply in June. The Index dropped to 52.9 in June from 62.7 in May. It was the lowest level since March, when the index stood at 52.3.

The well regarded Calculated Risk blog forecasts a 2nd half slowdown but not a double dip in GDP growth based on the following:

1)      less Federal stimulus spending in the 2nd half of 2010. The decline in stimulus will probably be a drag of about 0.5% on GDP growth by Q4.

2)      the end of the inventory correction. The inventory adjustment contributed 3.79 percentage points in Q4 2009 of the 5.6% annualized growth rate, and 1.88 percentage points of the 2.7% GDP growth (annualized) in Q1 2010. This will probably fall close to zero in the 2nd half (maybe even slightly negative).

3)      more household saving leading to slower growth in personal consumption expenditures. The personal saving rate increased to 4.0% in May, and will probably rise further in the 2nd half.

4)      another downturn in housing (lower prices, less residential investment). This might subtract 0.25 to 0.5 percentage points from growth in the 2nd half.

5)      slowdown and financial issues in Europe and a slowdown in China, and

6)      the cutbacks at the state and local level. According the Mark Zandi, this will subtract about 0.25% from GDP growth.

Paul Krugman in his NY Times Blog wrote recently:   “We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense. And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.”

Note:  I don’t agree with Professor Krugman that the cure for too much debt is more debt.  It never seems to work when someone uses Mastercard to pay off Visa or vice versa; and I suspect that doesn’t work for countries either, even rich ones like the US.  Eventually we have to pay the bill, or the interest expense gets out of hand.

Fed Governor Kevin Warsh, speaking at the Atlanta Rotary Club on June 28:  “Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made in the USA, but first manifested itself here. . . The volatility in financial markets is not the source of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy.  Excessive growth in government spending is not the economy's salvation, but a principal foe.  .  . The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.

Reuters reported on June 22 that the American Institute of Architects’ Architecture Billings Index declined to 45.8 in May from 48.5 in April. Any reading below 50 indicates contraction.

Retail and office are hurting.  Bloomberg reported that the office vacancy rate climbed to 17.4 percent in the second quarter, up from 16 percent a year earlier and 17.3 percent in the first quarter, according to Reis.  This is the highest level since 1993.  Further Reis reported on July 7 that U.S. strip centers, the vacancy rate in the second quarter rose 0.10 percentage point from the first quarter to 10.9 percent, slightly below the 11 percent in 1991, per Reuters.  At large U.S. malls, the vacancy rate rose 0.10 percentage point from the first quarter to 9 percent, the highest since the first quarter 2000, when Reis began tracking regional malls. Asking rent fell 0.2 percent to $38.72 per square foot, marking the seventh straight quarter of decline. Asking rent was the lowest in more than four years. (Reis does not track effective rent at regional malls.)

In June, John Murray, Pimco’s Commercial Real Estate Portfolio Manager and the PIMCO CRE/CMBS Team, released Pimco’s U.S. Commercial Real Estate Project Report.  Pimco’s bottom line conclusions included the following (edited slightly for brevity): 

• Although capital is clearly returning to commercial real estate, helping to stem the value decline in the sector, optimism should be tempered, because national price indices are misleading when transactions are limited and fail to reflect the significant uncertainty around property valuations.
• Changes in the structure of capital markets – notably the proliferation of complex securitizations since the last CRE crisis in the early 1990s – will lengthen the deleveraging process and suppress a recovery.   The impaired ability to transfer CRE risk out of the banking system relative to previous cycles makes a stable, let alone a V-shaped, recovery unlikely. Instead, many CRE assets likely will not return to 2007 prices until the end of this decade.
• Macroeconomic headwinds such as limited GDP growth in the U.S., elevated unemployment, potential re-regulation and a secular increase in the savings rate will force the market to re-evaluate the assumptions it has used to price CRE. These trends severely affect the outlook for rents, vacancies and capitalization rates, highlighting the downside risks that remain in CRE.