The list of unintended consequences and political missteps over the past few months seems like a cookbook approach on how to derail a recovery. The over-speculation that exacerbated the spike in commodity prices, partly due to super-charged liquidity spurred by Quantitative Easing 2 (QE2), the tactical Band-Aiding of sovereign debt issues in Europe, Japan’s supply-chain disruption and a double-dip in U.S. for-sale housing were some of the ingredients thrown into the mix. The economy showed resilience against these “paper cuts” over the past 18 months; however, the down-to-the-wire squabbling over the U.S. debt ceiling and budget planning, and subsequent downgrade of U.S. debt have spawned the two most powerful negative forces a recovery could face: fear and uncertainty.
In past blogs, I cited that the biggest risk to the recovery would be a self-fulfilling prophecy stemming from another round of fear or uncertainty, pushing consumers and companies to the sidelines again. Unfortunately, the economy’s resilience against many of the ‘paper cuts’ throughout the recovery is now seriously challenged by uncertainty related to the U.S. downgrade and the outlook in Europe. A double-dip recession is not a foregone conclusion, but the likeliness of a stall or a “wait and see”-driven contraction is now much higher than it was a couple of months ago.
While we are navigating yet another body of uncharted waters, a few hard facts offer at least some balance against the Doomsday scenarios suggested by some analysts, especially compared to the circumstances of 2008. For starters, the degree of the unknown is less severe in the current environment compared to the guess work that prevailed throughout much of 2008 and 2009 as to how many financial institutions could collapse. It was also unclear then as to how distressed assets would be handled and a fire sale surely would have stressed the system even further. U.S. banks are far better capitalized today thanks to QE1 and tight-lending standards, and their stance on asset sales has been to avoid fire sales on quality assets This is in contrast to 2008 when the very survival of virtually all major U.S. banks was in question. The downgrade will certainly hurt some banks and institutions with the systemic or implied backing of the U.S. government but the prospects of a broad collapse are far less of a threat. Corporate profits have exceeded their previous peak thanks mostly to expense reductions. This means companies are lean and highly productive, reducing the need for the mass layoffs witnessed in 2008 and 2009. As important, there are no bloated sectors or employment bubbles about to burst as was the case with construction and financial services in 2007 and 2008. We are more likely to see hiring stagnation when the dust settles than massive job cuts.
There are other factors real estate investors have to keep in mind. While the stock market is in a panic, it is ironic that capital flows into U.S. Treasuries have remained strong, pushing interest rates down to historic lows and reaffirming demand for U.S. debt despite the downgrade We should not underestimate the damage, in the form of higher costs of borrowing and loss of confidence, that the downgrade could eventually cause but in the heat of moment, investors are still flocking to U.S. Treasuries, which means interest rates are likely to remain low at least in the short to mid term. For real estate investors, the combination of extremely low interest rates, stabilized fundamentals and volatility elsewhere point to rising capital flows, but still on a selective basis. As disappointing as the job growth numbers have been during this recovery, the 1.7 million private sectors jobs added in the past year were enough to bring an end to occupancy and rent declines across all property types. Unless we enter a massively downward spiral that leads to fear-based, not fundamentals-based job cuts, property operations should remain relatively stable in most sectors. Apartments, in a league of their own, should continue the march down the recovery path, albeit at a much slower pace.
The flight to safety observed throughout the recovery in CRE sales over the past 18 months will intensify after waning a bit as yields compressed to extreme lows in the past few months. More Class A, primary-market buyers will be back now that the cap-rate to interest-rate spread has widened. Class B assets in strong metros and top-tier assets in healthy secondary markets stand to win as well. Buyers that walked away from otherwise well-priced, strategic acquisitions during the last market panic are well served not to overreact this time around. Lenders’ spreads have already pushed out by 30 basis points to 50 basis points in reaction to the events of the past few days and there is likely to be more caution, tighter underwriting and more emphasis on buyer qualification but credit is generally available for commercial real estate deals. The CMBS recovery may take a step back until there is more visibility. Lower-quality assets and tertiary markets will see their prospects dim even further for the foreseeable future as risk aversion is re-emphasized. The expectations for meaningful rent growth may have been pushed out as a consequence of the current flare up in uncertainty but locking in current interest rates and buying the right commercial real estate asset in the right market is even more of a competitive investment alternative than it was a few months ago.
A more concrete outlook depends on how the message of the markets will be interpreted by the political system here at home and in Europe now that additional downgrades are feared. While some of the usual tools may not be available now or are simply ineffective, there could be a silver lining in the form of future government actions, which I will address in the next blog.
Hessam Nadji is managing director, research and advisory services at Marcus & Millichap Real Estate Investment Services. He is also interim director of the firm’s Institutional Property Advisors (IPA) division. Contact him at [email protected].