Broad Trends
The current outlook for commercial real estate markets is mixed, with some property types and certain geographic markets on the upswing for two or more quarters. However, even where markets have strengthened, substantial risks remain.
The economy continues to constrain the expected recovery. Here the primary factor is tepid job growth, with job gains of just 117,000 in July, 46,000 (r) in June and 53,000 (r) in May compared to an economy with 139 million workers. This is especially negative for the Retail and Office property sectors. By contrast, collapsing home prices and the foreclosure crisis have shunted households from homeownership to the rental markets, providing a medium term boost to the multifamily sector. The inventory of existing homes for sale is shown in Figure 1, The Case-Schiller Home price index in Figure2.
Delinquencies have begun to decline in legacy CMBS, but continuing worries about the remaining balloon maturities defaulting persist (a large percentage don’t qualify for refinancing). This same concern extends to bank held-to-maturity portfolios, where CRE problems are driving FDIC bank takeovers.
A shadow hangs over the new issue market since S&P suspended ratings on CMBS in late July to review its rating processes.
In MIAC’s view, the markets stand at another tipping point, where a double-dip recession remains a real risk. Serious causes for concern include continuing erosion in investor confidence following S&P’s evaluation of its procedures, possible similar moves by other raters, and ongoing problems with sovereign debt, which have the potential of causing first Euro and then UK and US banks to halt inter-bank lending, in the worst case leading to another financial markets meltdown. Re-establishment of investor and consumer confidence is key.
Macroeconomic Situation
The sustainability of the rebound of the commercial real estate markets remains largely dependent on a strengthening economy allowing increases in employment. It is clear that despite current low mortgage interest rates and reduced home prices, there is simply no way for the housing sector to help pull the economy out of the recession as it has in the past. As Figure 2 indicates, inventory of homes for sale remains at historical highs, and, as a result, new home construction is largely moribund. MIAC expects that in some markets, the inventory could take years to clear, while in others clearing will happen much sooner. Until clearing happens, construction cannot put money into local economies.
There are signs of recovery. The soft job gains have allowed personal income to grow again, as Figure 3 shows. Real gross domestic product (GDP) growth has slowed since first quarter 2010, but remains positive: increasing at an annual rate of 0.4 percent in the first quarter of 2011 and 1.3% in the second quarter. The Bureau of Economic Analysis (BEA) attributed the second quarter GDP increase primarily to positive contributions from exports, nonresidential fixed investment, private inventory investment, and federal government spending. Strength in those components was partly offset by a negative contribution from state and local government spending. Also, imports, which are a subtraction in the calculation of GDP, increased.
Commercial Property Markets
The commercial space rental markets continue to show all the aftereffects of a recession, although, some sectors have been improving in 2011. We have made this comment before: the cause of the 2008 downturn in commercial real estate values was credit driven and not driven by the typical oversupply found in the late stages of an economic boom. That pattern is clear in the brighter segments of the commercial real estate markets today.
Multifamily
The multifamily sector is performing well in absolute terms and relative to most other commercial property sectors. Current demand is supported by collapsing home prices and the loss of homes through foreclosure. More intriguing, according to Morningstar Credit Ratings Managing Director and analyst Peter Rubinstein, is how strong demographic drivers look long term. This is shown in Figure 4, which tracks the live birth rate in the United States over the last 100 years or so. The leading edge of the “echo boom” generation (people born after 1988) is just beginning to reach the age at which people start to enter the work force, marry, and form families, the source of future housing demand. In fact, echo boomers significantly outnumber the original baby boomers. Given that new households tend to rent first, then buy homes later in life, forward demand for apartments should be quite strong.
Still, second-quarter data indicate the recovery in apartment rentals slowed relative to the first quarter. This is significant, according to Reis, Inc. because apartment rentals normally strengthen in second quarter with the end of winter and the school term. In other words, broader economic developments caused some potential and current renters to change plans. National vacancies as tracked by Reis fell by 20 basis points, from 6.2% to 6.0%. Given the uncertainties facing the economy, the risk of additional slowing exists.
New supply is sparse. Reis noted there were relatively few projects with start dates in 2009, and that only about 8,700 units opened in the second quarter of 2011. This implies that existing properties continue to drive the net absorption of apartment units, leaving the multifamily market in a reasonably position for recovery, long and short term.
Retail
The retail sector is struggling by comparison, reflecting weak consumer spending and low demand for space. The one positive for the sector has been the very low level of construction since the end of 2008. This can be seen in Figure 5.
As tracked by Reis, vacancy rates in neighborhood and community shopping centers have been essentially level since mid-2010 and rent trends are negative, though less so in the last two quarters. At regional and super-regional malls, vacancy rates popped in the first two quarters of 2011, while rent trends have been mixed. Given the high level of vacancies currently, it could be some time before reviving demand could absorb existing space, encouraging landlords to raise rents and remove concession in most markets. Whether consumers will turn from superstores and warehouse clubs as unemployment declines and incomes rise is a longer term unknown. Moreover, the long term impact of internet shopping on demand for retail space is uncertain.
To conclude, MIAC expects the retail sector to remain weak well into 2012.
Office
On the positive side, according to Reis data, the vacancy rate in the Office sector declined for three straight quarters as of second quarter 2011. However, vacancies were absorbed at a slower rate nationally in the second quarter than the first, tracking events in the broader economy. Likewise, both asking and effective rents have been rising since fourth quarter 2010.
Demand for office space is, of course driven by employment in office-using segments of the economy such as corporate offices, banking, insurance, real estate, law, tax, accounting and other professional services. Analysis by Cassidy Turley indicates that office-using employment began to increase again at the start of 2010 for the first time since mid-2007.
Morningstar’s Rubinstein notes some markets - such as New York and Washington, D.C. are turning around, while others are stagnant or declining. (Cassidy Turley also spot San Jose-Silicon Valley among top markets by absorption in both first half 2010 and first half 2011.) To return to the kind of health the office market displayed in 1999 (8.7% vacancy rate) and the same number of office employees (27.5 million), Rubinstein estimates the economy would need about 7% to 9% job growth, providing another 2.0 to 2.5 million office works to absorb existing supply. That calculation suggests office markets could need four or more years to fully heal.
Industrial
The industrial/warehouse sector is another bright spot in property markets. As tracked by Cassidy Turley, net demand (space absorption) was a “healthy” 21.9 million square feet (“msf”) in second quarter 2011, following absorption of 24.9 msf first quarter. Vacancy rates in this sector have trended down steadily for the last twelve months, reaching 9.3% in Q2. Because the sector is working through excess inventory, rents have been slow to recover, slipping up on a national basis for the first time in Q2 2011 after a long period of steady declines. Regionally, space absorption was strongest in the South. Markets showing gains included Dallas (+3.6 msf), Central NJ (+2.8 msf), Indianapolis (+2.4 msf), Detroit (+2.1 msf), and Houston (+1.5 msf). The outlook for industrial space is positive if not unclouded, driven by three primary factors, according to Cassidy Turley: manufacturing growth, employment growth and global consumer spending growth. In particular, manufacturing growth is expected to resume a solid expansion as it recovers from the supply disruptions brought on by disasters in Japan.
Lodging
Despite low employment growth and diminishing optimism for the economic recovery, the U.S. lodging industry has revived strongly. Indeed, the surge is surprising considering how sensitive the lodging industry is to the broader economic climate. Demand stems from two basic sources: business travelers and tourists a drop in confidence can harm either, as businesses may curtail travel and consumers cancel vacation plans.
At mid-year, Smith Travel Research (STR) reported 5 consecutive quarters of increases in demand and occupancy, as well as 4 quarters of increases in average daily rate (ADR) and revenue per available room (RevPAR). Outlooks from research and advisory firms specializing in hospitality are positive. For example, PKF Hospitality Research expects demand to post “a solid” 4.9% increase in 2011. This follows on a 7.9% increase in 2010 reported by STR. Both rates are well above the long-term trend of 1.5%.
Room rates, however, have risen more slowly by comparison with demand. There is no scarcity of rooms in most markets, and not all markets are participating equally in the recovery. For 2011, ADR is expected to rise 2.6%, still below its long term average increase of 2.9. Ongoing increases in demand should accelerate ADR growth but should accelerate to a 5.5% growth rate in 2012.
The recovery in lodging is not uniform. PKF-HR is forecasting only 12 of the largest lodging markets in the U.S. will reach occupancy rates in 2011 greater than their long-run average. Not until 2013 does it expect a majority of the 50 markets in its universe to exceed their long-run occupancy rates. The recovery has been dominated by upper-tier properties, with midscale and economy segments lagging. According to PKF-HR RevPAR growth was greatest among luxury hotels in 2010, and expected to increase by 10.0% for the full year 2011. For 2012, PKR-HR expects RevPAR to increase by more that 10% for luxury, upper-scale and upscale properties, upper-midscale by 8.7% and midscale and economy properties by 6.6%.
CMBS Outlook
Credit continues to be tight for CRE loans. As of the July Senior Loan Officer Survey, the net fraction of banks reporting that they eased CRE lending standards remains close to zero for the third consecutive quarter. The July survey contained special questions that revealed standards at most banks for all types of CRE lending remain tight relative to standards prevailing in 2005. Furthermore, about 75% indicated their standards for construction and land development (CLD) loans were tighter than the mid-point in their 2005-2011 range, and about a third said they were at the tightest levels since 2005.
Normally, we would look to the new issue CMBS market to take up the slack, but the CMBS market was knocked on its heels by recent S&P actions. First, the downgrade of U.S. sovereign credit prompted wider spreads across credit markets. Second, on July 22, S&P pulled its rating on a $1.5 billion Citi/Goldman issue as it was being marketed. Third, on July 27, the rater suspended rating all CMBS while it reviewed its methodologies for new and existing transactions. The next transaction in the market, Deutsche Bank and UBS' DBUBS 2011-LC3 priced August 15, was much more expensive given wider spreads and additional structural support. As a result, most issuing firms have scaled back their 2011 new issue volume projections by as much as a third, from as high as $45 billion to closer to $30 billion.
In their August 12, 2011 Structured Products Weekly, JP Morgan analysts put new issue CMBS spreads at their 2011 wides, up roughly 100 basis points on a duration-weighted basis over Treasuries from the beginning of July. S&P’s shenanigans pushed Class A and Class B/C coupons up by approximately 50 basis points.
After soaring from $4.53 billion as of January 2008, the unpaid balance of CMBS in special servicing tracked by Morningstar Realpoint has stood close to $90 billion since summer 2010. As of July, 2011 it stood at $86.50 billion.
Delinquency rates and share by property type are shown in Figure 7 below as of June 2011. Health care properties, the smallest property segment within the CMBS universe, with the lowest delinquency rate, 1.83%, among property sectors, contributes just 0.5 basis point to the CMBS aggregate 8.22% delinquency rate, represents just 5.5 basis points of all CMBS delinquencies. At the other end of the spectrum, securitized multifamily properties, the largest segment of the CMBS universe, a 9.463 delinquency rate, contributed 219 basis points to the June CMBS delinquency rate and accounted for the largest share, 26.65%, of CMBS delinquencies.
Summary
In summary, the CRE recovery has proven to be resilient to market shocks through the second quarter, but is not uniform. Risks from the broader economy and the shocks to the new issue CMBS market cloud the outlook further. In particular, MIAC sees the S&P ratings downgrade of US debt and ensuing investigation of “S&P’s” ratings methods as political theater. Our concern is that more serious issues continue to cause uncertainty: among other things, added regulation in all areas of government, the meltdown in the Euro due to “the PIIGS”, increased bank capital requirements and continued regulatory scrutiny of bank lending practices, as well as ongoing unrest in the Middle East. In this climate of uncertainty, job growth is held back.
Dean C. Hurley
Senior Vice President, Capital Markets Group