Real Estate Forum - February/March 2009

Insight
By William R. Pollert
Industry May Be Under the Gun,
But It Will Not Last Too Long

THIS YEAR WILL BE TOUGH FOR COMMERCIAL real estate. The shutdown of the debt markets squeezed most of the life out of the business last year as transaction volume fell by 75% and cap rates jumped 50 to 300 basis points. The industry now faces the added burden of an economy that has been in a freefall since at least the third quarter of 2008. As a result, vacancies are growing, rents are under pressure and tenant bankruptcies and defaults are on the rise across all sectors.

The federal government is focused on passing an $850-billion to $950-billion stimulus package. Its ultimate success will depend on reviving the capital markets.

Stimulating the capital markets, however, has been difficult. Last year, the Fed cut the Federal Funds rate to nearly zero and injected over $2 trillion into the finan-

Since most of the sales activity is expected
to come from distressed assets, it may give
the impression that things are a lot worse.

cial system. The Treasury spent half of the $700-billion Troubled Asset Relief Program money to bail out banks and financial institutions. While this unprecedented action did restore short-term inter-bank lending, it did little to help the capital markets.

Bank balance sheets remain stressed by mark-to-market write-downs of toxic structured debt securities and rising residential mortgage defaults. But even if the Treasury’s efforts to encourage lending were successful, banks do not have the capacity to fill the enormous void left by the shutdown of the structured debt market.

Three decades ago, banks supplied 75% of loans worldwide. Before the credit meltdown, that share dropped to about 33%, largely due to securitization. Given the size and complexity of the global economies, any meaningful recovery will require the resurgence of the capital markets. The key is restoring investor confidence. This is particularly important to the commercial industry, where CMBS accounted for 27%, or $230 billion, of financing in 2007.

Given investor paranoia about any structured asset-backed security including CMBS, it is unlikely that the capital markets will restart without aggressive govern-

ment involvement, whether in the form of direct securities purchases and/or guarantees. Under the best of circumstances, the capital markets—particularly for CMBS—will not be functional until the second half of the year and a return to normalcy is not in the cards until sometime in the second half of 2010, for several reasons.

For one, the government still does not have a clear strategy on how to deal with the turmoil. Whatever program is decided on, it will take months to implement and have an impact. Investor confidence continues to be eroded by the constant stream of worsening economic data and “bad surprises” in the financial markets.

Rating agency downgrades of CDO and ABS securities are forecasted to rise in the months ahead because of new rating methodologies for structured asset-backed securities. These changes have already caused hundreds of tranches of CDO and ABS securities to be downgraded. CMBS defaults are also expected to soar in 2009, as close to $20 billion of securitized conduit loans will need to be refinanced and tenant bankruptcies jump.

Since most of the sales activity is expected to come from distressed assets, where prices are most depressed, it may give the impression that things are a lot worse than they are. This could hamper a recovery since it may initially accentuate the price gap between non-distressed sellers and buyers as markets recover. Once the structured debt markets return to a more normal $100-billion to $150-billion level, borrowers will face a new world of tough underwriting and lower leverage loans (50% to 60%), but deals will get done.

The bottom line is that 2009 will be a very tough year, especially for those who own lesser-quality properties or have to sell. But as with all cycles, this too will pass. When the capital markets reopen and the economy begins to grow in 2010, investors should be well positioned to benefit. In the interim, the strategy for success in 2009 will be de-leveraging and balance sheet strengthening. ◆