Real Estate Forum - September 2011

software grew at 5.7% in the second quarter, down somewhat from the 8.7% growth during the first quarter but still healthy. Businesses, particularly large companies, are well positioned to continue to invest, if they can get comfortable with the sustainability and strength of the recovery. Nonfinancial S&P 500 companies have more than $1.1 trillion in cash and liquid assets on the balance sheets and are enjoying strong year-over-year profit growth, estimated to be around 17–18% this year. Despite the economic slowdown in the first half of 2011, businesses are expected to continue to invest in new technologies, for both cost reduction and selectively to expand capacity. Business investment is forecasted to continue to grow around 7–8% during the second half of the year.

While this growth should help sustain the current recovery, this figure is well below what would be expected at this point in the recovery, due to lack of business confidence in U.S. demand growth and a fundamental shift in business psychology from “risk taking” to “risk aversion.” Additionally, multinational companies are choosing to invest abroad rather than in the United States to have plants closer to their customers, particularly in emerging markets, and/or to reduce labor costs. With close to 50% of multinational company sales coming from abroad, this trend is expected to continue.

The other drag on business investment is small companies’ struggle to obtain financing to expand. A recent survey by Pepperdine University found that small businesses ranked access capital as their primary challenge. Despite easing of lending standards, the FDIC reported that loans of less than $1 million were down 10% from one year ago. Only 17% of small businesses (businesses with revenues less than $5 million) were able to obtain bank financings for which they applied during the last year, while 37% of mid-sized companies with revenues greater than $25 million received financing.

Until business confidence is restored and banks— particularly regional and community banks— resume lending to small businesses at pre-recession levels, business investment is likely to languish in the 6–10% range, which will support modest economic growth but not drive GDP growth into the 3.0– 3.5% range necessary to put a dent in unemployment.

COMMERCIAL REAL ESTATE (CRE) RECOVERY STRENGTHENS IN SECOND QUARTER CRE markets continued to recover in the second quarter, even as economic growth slowed. CRE sales volume, including apartments and hotels, surged to more than $55 billion during the second quarter, up 117% from one year prior, according to Real Capital Analytics. While office, industrial, and retail property sales were all up, retail property sales were the strongest at $15.2 billion, followed by office at $14.0 billion and industrial at $6.6 billion. For the first half of the year, property sales, including apartments and hotels, were close to $91 billion— double the first-half 2010 volume.

Another indicator that the CRE markets are on the road to recovery is the number of new properties listed for sale in the second quarter as pricing improved. New property listings increased 79% in the second quarter from one year prior the largest gain since 2005, according to Real Capital Analytics. Further, new property transfers into special serving slowed to $12.0 billion during the second quarter and were more than offset by $15.9 billion of workouts during the same period. Total outstanding distressed CRE is estimated to be $180 billion at the end of the second quarter.

CRE OUTLOOK MUDDIED FOR THE SECOND HALF Unfortunately, the recent economic slowdown and the S&P commercial mortgage-backed securities (CMBS) fiasco in July have muddied the outlook for CRE in the second half. Prior to S&P spooking investors by withdrawing its rating on a $1.5 billion Goldman Sachs/Citi CMBS securitization hours before the deal was to settle, the CMBS market was on track to hit $40–45 billion in volume, up from $10 billion in 2010. This S&P action, on top of growing investor concern about deteriorating loan underwriting standards, effectively shut down the conduit loan origination market this summer.

Adding to the CMBS market woes, the recent turmoil in the equity and fixed income markets has spurred investors to avoid risk and flee to Treasuries. Spreads for recently issued 10-year AAA CMBS bonds gapped out to 220 bps over swaps, up from fewer than 100 bps in June. The chaos in the CMBS market is likely to force a number of new and small conduit organizations out of the market. When the market does reopen, perhaps in September, borrowers will likely find underwriting standards