Tom Binnings, Senior Partner (as published in the Colorado Real Estate Journal Feb 20 – Mar 5, 2013)
It’s hard to imagine interest rates could go anywhere but up; especially ten to 30 year rates. We’ve been saying that for several years now. The big issue for 2013 is whether the Federal Reserve will continue accommodating bond markets to counter fiscal drag from growing federal austerity. It appears they will. On the other hand failing to address federal austerity will cause higher long-term rates due to growing anxiety in financial markets over sovereign debt in advanced countries around the world with the U.S. simply leading the way.
Cap rates, while at low points historically, reflect high risk premiums relative to treasuries. The question is whether the risk premium is legitimate (commercial real estate is even more risky relative to 90 T-bills) or whether Federal Reserve intervention has created an “artificial” premium. The good news is commercial real estate survived what could have been a blood bath had regulators forced REO liquidation as opposed to the Federal Reserve providing liquidity. This is a sharp contrast to the S&L Crisis 25 years ago when commercial real estate prices in overbuilt markets plummeted by as much as 70%.
Investor interest in commercial real estate remained high in recent years in the A+ major market sector as institutional and large foreign investors sought capital preservation. The second and third tier markets found along the Colorado Front Range encountered rough going. The lack of liquidity in these “lesser” markets created a negative appraisal bias in general despite declining cap rates due to lower debt costs. The perception is changing. While the desire for significant upside among investors will continue to keep downward pressure on prices, the low interest rate environment, which looks to persist for the coming two years, will lower cap rates on quality properties generating upward price pressure. In short, the market for quality second and third tier commercial real estate should open up in 2013 after a prolonged waiting period.
Private sector and state and local government growth look to be as strong as we’ve seen in six years. The 2013 version of recovery will be more broad-based favoring the energy, technology, manufacturing, and housing sectors. Retail will suffer somewhat with the elimination of the temporary payroll tax deduction and job growth should continue being somewhat sluggish due to hiring uncertainty resulting from debates in Washington and the full fledged implementation of the Affordable Health Care Act in 2014. Conversely, rising stock markets and home prices will help the upper half of consumers fell better off in 2013 resulting in higher consumption and riskier investment.
The impacts on the various commercial real estate sectors will be varied — mainly due to longer-term fundamentals than short-term improvements in the economy. Overall we should see net lending increases in commercial real estate. Office, which has performed the worst in the last decade along with anchorless retail, will stay sluggish. Sluggish job growth, more self-employment, and a general trend to fewer square feet per employee do not bode well for less desirable office inventory. Traditional retail space will continue experiencing declines in market share relative to online retail. This may hit the big box retailers the hardest. Neighborhood and community level centers with anchors will perform the best. Improvements in manufacturing and online retailing favor well located industrial and warehouse space. The apartment market may soften a bit in 2013 as more renters qualify for home purchases and for sale inventory increases somewhat, but overall rent growth in the last few years should be sustainable even with more apartments being built. One of the challenges in the housing market will be curtailed new attached and multi-family for-sale product as the cost to the supply chain from construction defect litigation is killing development incentives.
Not only do we anticipate 2012 continuing modest growth, but 2011 was better than originally reported according to the Bureau of Labor Statistics’ updates on the preliminary data releases they issued in 2011. Given we had forecasted a return to growth for 2011 in late 2010, we were surprised with BLS’ originally reported declines in Colorado Springs wage and salary employment. As it turns out our original forecasts for 2011 were reasonably accurate. The two graphs show labor and salary employment as originally reported and then as updated.
Hopefully our 2012 forecast will be accurate as well. Despite rising energy prices, we see continued growth, consistent with 2011 locally and better nationally. Nationally, the growth is being fueled by:
- Optimism of an election year,
- Lack of Federal austerity,
- Low mortgage rates,
- Stabilizing housing markets,
- Growth in U.S. manufacturing,
- Consumers feeling bolder.
On the state and local levels, non-residential construction is strong at military installations, the Southern Delivery System, and data centers. The Multi-family apartment market is robust with construction which will accelerate into 2012-13. The commercial real estate market will see improvement in the Denver metro area, but not much in Southern Colorado
The bottom line is Colorado continues to grow despite slow job growth. It’s all a matter of relativity – Colorado relative to the nation. Peyton Manning’s interest in the Denver Broncos because of the quality of life is indicative of our most fundamental strength.
The real concern is for 2013 and beyond. Federal austerity is a given at some point. The time to focus on economic development in Southern Colorado is now!
The KC Federal Reserve District’s economy is relatively more focused on commodities and national defense. The region encompasses Colorado, Kansas, Nebraska, Oklahoma, Wyoming, and portions of western Missouri and northern New Mexico. Job growth in the region during and after the last eight national recessions is consistent with the nation; however, the region is consistently late to fall into recessions and early to recover from recessions.
FNC Residential Index
One should not assume that just because Denver has done so well (relatively speaking of course) during thr housing bust that the entire state has performed the same way. However, regions do tend to generally move together with economists’ favorite assumption of ceteris paribus.
- The bond market – will longer term rates increase significantly or stay steady? Quantitative Easing 2 (QE2) will end by mid-year keeping demand for 10 year Treasuries up (pushing down yields), but will investors react even more negatively to long-term debt prospects and price in greater risk. Also will they factor in the trend in long-term oil and commodity prices – thereby adding in greater inflation expectations into their desired yield?
- Emerging market economies, especially in China, and how aggressive they are in attempting to curtail inflation in their country — possibly putting them in a recession. Higher levels of inflation in China should keep their currency weaker, but that’s assuming the Yuan were freely traded on markets as opposed to being pegged to the dollar. If the Chinese cool down their economy to control inflation, worldwide demand for oil and other commodities will weaken, hence reducing inflationary prospects around the world.
- Aside from increase commoditiy demand in the developing world, will development in the northern Africa and the Middle East cause oil supply disruptions and an increase in prices?
- The degree of price stability in US real estate market – will bonds and mortgage interest rates stay low, thereby providing support for real estate prices. QE2 seems to have been primarily designed to do this.
- The trade-off between dramatically growing state and local government spending which can result in higher taxes like we saw in Illinois or substantial layoffs as we are more likely to see in Colorado. The municipal bond market could be problematic as state, local government and school districts run short on cash.
Tom Binnings, Senior Partner
Even long-term economics professors have had to learn about the new concept of quantitative easing. In the old days the Federal Reserve (Fed) lowered the discount rate or purchased treasuries through the Federal Open Market Committee to decrease interest rates and increase the money supply — thereby stimulating borrowing and the economy. When the financial markets collapsed in 2008 the new notion of quantitative easing was introduced into our vernacular. This is essentially a move by the Fed to buy specific securities from the financial sector and infuse cash more strategically into the financial system. Quantitiative easing creates excess reserves and might assist in cleaning the balance sheets of banks depending upon the assets the Fed purchase from banks.
Current talk of Quantitative Easing 2 (QE2) is looking to remove U.S. government bonds from the balance sheets of banks and give them cash instead. The idea is to replace interest earning assets with non-interest bearing cash to “encourage” banks to lend. If banks lend, then companies and consumers will borrow, goods and services will be purchased, and jobs will be created. While it makes sense on the surface to stimulate the economy or to prevent a backslide into deflation or a double-dip recession, QE2 is far less likely to put money into “mainstreet” businesses and investment opportunities.
Banks have, in fact, shown a little easing of credit standards as reflected in the second quarter Fed survey of top lending officers in U.S. commercial banks. (Note the survey was conducted before recent talk of QE2. All graphs from Federal Reserve survey report. To view the full graphs below, click on the graph.)
As shown in the chart, changes in credit standards peaked at the tight or restrained level in the beginning of 2009. Since then the standards continued to tighten on net at decreasing rates until the end of 2009 (beginning of 2010 for small firms). In the second quarter of 2010 the standards eased a bit on net.
Banks have, apparently due to competitive pressures and a lowering of the TED spread, lowered their pricing or interest rates and fees. This pattern follows changes in credit standards, but is more dramatic on the side of net decreases thereby making financing cheaper.
Despite this modest softening and price decrease on the supply side of the commercial and industrial loan market, demand among borrowers for loans, while becoming less negative, still had not entered the positive range by the second quarter Fed survey. While this appears to be the classic liquidity trap where no one wants to borrow even though the money is there, it could also be that the creation of higher standards during the recession are more than borrowers can, or are willing to, handle.
In contrast to commercial banking on mainstreet, corporate America with access to the junk bond market is heavily borrowing to restructure their debt and lower their cost of capital. They are also looking for strategic acquisitions. Furthermore, investors (mainly institutional) are returning to the real estate market to buy Class A real estate which is increasing the targeted return on investment spread between Class A and other classes of commercial real estate.
Given that all but the largest commercial banks are more likely to have the weaker commercial real estate assets (as opposed to Class A properties), there is risk for further deterioration in their loan portfolios. To get a sense of the potential magnitude of this downside risk, we can look to the Sunbelt’s S&L Crisis of the late 1980’s. The quick liquidation approach favored by regulators and the federal government drove commercial real estate prices down by as much as 2/3rds during the S&L Crisis. How banks and their regulators handle real estate loan restructurings and foreclosures could be the major determinant of a possible double dip recession, although stress tests and forecasts don’t anticipate massive small bank failures.
This is where the Fed and federal government need to be looking to provide some form of intervention. They need to reduce the impact of toxic assets in Sub-Class A commercial real estate loan portfolios on banks’ balance sheets while redirecting fiscal policy to give small-to-mid sized business incentives for risk-taking, innovation, and hiring. Quick streamlining of government loan and innovation grant programs is also desirable. Actions such as these and greatly reducing uncertainty from tax and healthcare legislative, as well as bureaucratic regulatory actions, are more likely to stimulate loan demand on mainstreet as opposed to throwing more cash at banks through QE2. Unfortunately these kinds of fiscal and de-regulatory actions take time, especially in what appears will be a contentious Congress.
By: Tom Binnings
In 1987 I enjoyed commandeering corporate jets from the Savings & Loan (S&L) industry and flying around the country to make sure the real estate the S&L’s loaned on really existed. We then came up with quick valuations to see if the S&L’s were solvent. They weren’t. In some cases the market value of the commercial loan portfolios were 33% of the book value. The ultimate cost of the bailout in today’s dollars was approximately $272 billion. One of the perverse incentives that precipitated the crisis was the appraisal practice. Borrowers delivered their own appraisal to the S&L when they submitted a loan application. It’s not hard to imagine what borrowers did with low appraisals – they tossed them and bought a new one. One of major changes in the banking industry after the S&L crisis was the requirement that lenders order the appraisals ; hence requiring appraisers watch out for lender or investor interests versus borrow or developer interests.
Twenty years later we see the same perverse incentive, except on a grander scale, being one of the fundamental causes of sub-prime mortgage crisis. The three rating agencies (Moody’s, Standard & Poor’s, and Fitch) were responsible for rating the securitized mortgages as the mortgage pools were widely marketed and sold to banks and other investors from around the world. Like the appraisers in the S&L crisis, they were compensated by the deal maker (developer) rather than the investor (lender). While the three agencies, acting in oligopolistic fashion, might have forced reason on the markets, they failed to do so for three reasons: 1) the rating agencies were not simply rating the securities – they were also helping the large investment banks (a.k.a. Wall Street) design them; 2) the process of tranching the pools of securities was complex and offered high profits to the investment banks while neither the investment banks nor the rating agencies had much experience in this relatively new field; and 3) the few investment banks controlled most of the securitization market (another oligopoly) and any single investment bank could threaten to move all its securitization business to another rating agency if the rating agency was too conservative. /i The end result was overly optimistic ratings and slow responses by the agencies to downgrade the ratings. Then the housing bubble burst and the great recession followed.
The only good news from this unlearned lesson of perverse incentives for appraisers and raters — there was relatively little complex securitization of commercial real estate loans (24.5% of all commercial mortgages are securitized /ii). Thus while there are market fundamentals, both short-term and long-term which are working against the commercial real estate industry, especially in retail and office, the likelihood of a massive bubble burst similar to the 1980’s S&L crisis or the 2008 sub-prime mortgage crisis is unlikely. Commercial real estate prices should not plummet across the board. There could be growing pricing differentiation between properties whose weaknesses are exposed by the current economic environment and properties that are shining and thereby providing a safer haven for investors looking for above average returns with sensible risk exposure. This divergence in the commercial real estate market will certainly pose challenges for appraisers, lenders, and borrowers/equity investors as they try to sort out the risk/reward relationship for different classes of properties. How the FDIC and Federal Reserve handle requirements placed on commercial banks as the banks address approximately $500 billion commercial mortgage refinancing in the coming three years will have a significant impact on the magnitude of and degree of divergence in the commercial real estate industry.
i. Lawrence White, “Markets: The Credit Rating Agencies”, The Journal of Economic Perspectives, Spring 2010, Vol 24, No. 2
ii. Mortgage Bankers Association/Eastdil Secured/Wells Fargo as reported by Wallace Murfit in June 30, 2009 paper “The Coming Wave of Commercial Real Estate Mortgage Defaults”