Risks are Manageable in GSA-Heavy Markets

SAN DIEGO-Next Tuesday, June 18, attendees at RealShare Investment & Finance (part of the RealShare Conference Series produced by ALM Real Estate Media Group, which publishes GlobeSt.com and Real Estate Forum) will have the opportunity to attend several noteworthy panel sessions, including “What's Up Ahead? A Look at 2013's Economic Climate.” Dr. Sam Chandan, president and chief economist at Chandan Economics, will be speaking on the panel, which deals with how fiscal activities in Washington, DC, will impact the commercial real estate industry. GlobeSt.com caught up with Chandan recently to discuss some of these issues in the following exclusive interview.

GlobeSt.com: How separated is the commercial real estate industry from what's happening in Washington, DC, now? Are we really able to look away?

Sam Chandan: For better and worse, commercial real estate is tightly linked to developments in Washington. For buyers and lenders, monetary policy and the low cost of capital have defined the recovery and remain the dominant drivers of investment outcomes.

The lion's share of investors posits that the price recovery is simply a leading measure of fundamentals. That's a flawed assessment with the same conceptual grounding that allowed underwriting on prospective cash flow. Instead of strong fundamentals as the primary engine of value, we have a scenario where real returns on risk-free assets are negative.

The Fed isn't just interested in keeping borrowing costs low. They want capital to flow across the risk spectrum. The important thing to realize is that different asset classes—commodities, real estate and others—have responded to those monetary policy interventions in different ways. For example, we've had historically low mortgage rates in the single-family residential market; prices are rising sharply now, but that wasn't the case two or three years ago. Confounding factors, including difficulties in qualifying for credit, limited the price response.

At the other end of the spectrum, commercial real estate markets are internalizing low rates very well and sometimes too well. That's especially the case in the apartment market, where the agencies have acted as an efficient transmission channel for monetary policy by virtue of their inherent subsidy, to an extent that banks and other would-be apartment lenders are crowded out.

There's a strong case that artificially low rates have done more than stabilize asset prices; in the most actively contested commercial real estate markets, they are distorting prices to a degree that will become apparent as rates rise. The spreads comparison of cap rates to Treasuries is naïve; it ignores that we don't have a free-functioning market for government bonds. There is an abundance of places where property income-growth will not fully offset rising rates and where we'll see a larger minority of today's loans default when they reach maturity in five years' time.

GlobeSt.com: What impact will cuts affecting federal office buildings have on the market as a whole, and what can be done about it?

S.C.: The potential for negative net absorption related to GSA leases is a definite concern, but a manageable one if supply remains in check. Some office developers see things improving after the federal government adopts a long-term plan for reducing the structural deficit and allows a modest reopening of the spigot. It's possible and maybe even likely. But if you're a construction lender putting money out for office development in a GSA-dependent market or submarket, you're encumbering yourself with palpable tail risk.

In Washington, DC, specifically, my team's overriding concern is the quality of recently originated apartment loans. DC is one of the most aggressively underwritten apartment markets in the country. The possibility that weaker demand or sustained development activity could impinge on apartment rent trends is not well reflected in lending standards.

GlobeSt.com: What should the industry watch out for in terms of the national economy?

S.C.: Though it will take some time, we're moving out of the economic goldilocks zone that is a key reason for current investment behaviors. The last jobs report is a case in point: not so hot it will drive immediate rate fears and force money into higher-yielding asset classes; not so cold it will signal a slowdown in the economy that undercuts the narrative behind rock-bottom cap rates and debt yields. The status quo is ideal for many investors in our industry. It won't last.

As the economy picks up, we'll see the wheat from the chaff in areas like inflation hedging. Not every property is an effective hedge, but not every buyer has stopped to differentiate which one is which.

GlobeSt.com: What else lies ahead for CRE as we move further into recovery?

S.C.: More lending. That road will be bumpy, principally on account of higher financing costs, risk-taking by conduit lenders and a pull-back by the GSEs. The widely deployed tools for measuring and mitigating credit risk are just not that different than they were in 2006 and 2007. The market has mistaken a cyclical attention to risk as a substitute for corrections to incentive conflicts. That's disappointing, but low rates have made it an easy assumption.

There are positives. We'll see a further broadening of investment to secondary and tertiary markets. As demand improves, more markets will reach an inflexion where lease rollovers become accretive rather than dilutive to cash flow. All of this is happening against the backdrop of an evolving economy where the ways we use space—to work, shop, live, move goods—is changing at an ever-faster pace.