William Hughes
The current recession, which began in December 2007, is one of the longest and deepest in recent memory. Since the start of the downturn, 5 million Americans have lost their jobs, with unemployment currently at 8.5 percent and rising. Despite the grim economic news, there are a few encouraging signs that suggest the worst may be behind us. In recent months, sales of existing and new homes ticked up, along with mortgage applications. The rate on a 30-year fixed mortgage is hovering near its lowest point since the early 1970s, and downward adjustment in home prices in recent years has brought them closer in line with incomes. As a result of increased affordability and government programs aimed at stimulating demand and preventing foreclosures, homebuyers who have been waiting on the sidelines finally are beginning to purchase houses.
The commercial real estate market reflected the resilience of the economy during the first phase of the recession, with vacancies rising at a relatively steady pace through the third quarter of 2008. The primary exception was the retail sector, which had already entered a serious downturn due to weakness in the consumer segment and some overbuilding. The dramatic intensification of job losses since the fall of 2008, however, has taken its toll on commercial properties, causing vacancy to spike across core property types.
The financing climate, which tightened dramatically in the summer of 2007, became even more challenging as the credit crunch escalated to a global financial crisis in the fall of 2008. Commercial property sales volume, down by 40 percent to 60 percent through the first three quarters of 2008, has come to a near halt over the past 6 months, dropping as much as 80 percent to 90 percent from the peak. Smaller transactions make up the lion’s share of deals in today’s environment, compared to the large portfolio sales that became increasingly prevalent in 2006 and early 2007.
The collapse of the CMBS market, which accounted for nearly half of new commercial mortgages at the market’s peak, along with a shortage of capital from commercial banks, life insurers and private equity markets, define the current financing environment. In addition, a significant price expectations gap between buyers and sellers has contributed to the sharp decrease in commercial property sales. Deteriorating property fundamentals and constraints on debt capital are resulting in price corrections and rising cap rates. The trend gained momentum in the first quarter of 2009 as more sellers came to terms with market realities. It should be noted that the degree of price correction is highly varied depending on property quality and local market strength.
Maturing Loans Present Additional Challenges to CRE Market
The risks facing commercial real estate are deepening. An estimated $218 billion of commercial mortgages will mature this year, and an additional $270 billion is expected to come due between 2010 and 2011. Delinquency rates have been near historical lows throughout the downturn; however, as a lagging indicator, they are now beginning to reflect the impact of the recession on commercial real estate. The CMBS delinquency rate as of the fourth quarter of 2008 was nearly twice the rate reported during the previous quarter and, at 1.2 percent, was only 50 basis points below the peak reached during the last cyclical downturn in the early 2000s. Delinquencies among banks are averaging 1.6 percent, the highest level on record since 1996. Life insurance companies and Fannie Mae/Freddie Mac are faring best, as their focus remained on lower-leverage loans and safer, quality assets during the most recent boom. With property values down and LTV requirements at significantly lower levels than a few years ago, many owners will be unable to refinance without contributing substantial amounts of equity. As a result, delinquency rates should rise, reaching 3 percent to 4 percent by year’s end. Since underwriting standards loosened dramatically from late 2005 to early 2007, loans originated during this time are at the greatest risk. Furthermore, some of the largest commercial property loans originated during this period were subject to the least stringent underwriting, leading to significant vulnerability and potential losses for banks and investors.
The Public Sector to the Rescue?
We are currently in the midst of unprecedented levels of governmental spending and market intervention. Recent and new measures are focused on stabilizing the banking industry and real estate markets by improving credit flows and ultimately sparking an economic recovery. After the onset of the credit crunch in the second half of 2007, the Fed began to aggressively cut interest rates and pump liquidity into the system. In early 2008, the Economic Stimulus Act was passed, which included $100 billion in stimulus checks for U.S. households.
Regardless of the dollar amount of government stimulus or the depth of tax cuts, function first needs to return to the credit markets for the economy to stabilize. Businesses are struggling, as many forms of credit remain tight, ranging from lines of credit to acquisition loans and even inventory financing. U.S. households have seen home equity lines of credit pulled and credit card limits cut. Even some seemingly creditworthy households have struggled to qualify for residential mortgages, as lenders are requiring stronger credit scores and higher down payments. Government intervention to stabilize the banking sector and stimulate credit markets has been vast and far-reaching. In addition to reducing the fed funds rate to essentially zero, the Federal Reserve has expanded access to credit through its Discount Window and created multiple new credit facilities that allow for a broader range of collateral. Furthermore, the Fed opened the door for securities dealers to borrow directly from the central bank. Specific facilities also have been created to pump liquidity into various segments of the financial sector. The Fed established the Term Action Facility (TAF) in December 2007, offering depository institutions an opportunity to obtain credit through a bidding process.
Additional programs were rolled out, including AIG, money market funds and the commercial paper market, which came to a near standstill last fall. Furthermore, the Fed approved currency swap agreements with several foreign central banks to help quell concerns regarding dollar liquidity in global markets. Additional support for credit markets came in late 2008 when the Fed announced plans to purchase $600 billion in debt backed by housing-related government-sponsored entities. As a result of government intervention, residential mortgage rates have slipped to the lowest level in decades. In addition to Federal Reserve support, the government has enacted significant programs focused on unlocking credit markets. The first was TARP, which was passed in October 2008 and was initially intended to purchase toxic assets from troubled financial institutions. The government instead used much of the initial $350 billion-installment to recapitalize banks through preferred equity investments.
While the exact impact of these investments is difficult to quantify, they clearly helped to firm up the balance sheets of numerous institutions and likely kept several banks afloat. The next $100 billion of TARP funds has been earmarked for the TALF program. Under TALF, the Federal Reserve receives credit protection of $100 billion from TARP by the Treasury Department. The Fed will use this allocation to make loans of up to $1 trillion to the holders of newly originated AAA-rated ABS (asset-based securities), which include car loans, credit card debt and other consumer debt. The debt underlying