The economy is in recession and, in general, real estate returns should begin to decline in the face of weaker demand and uncertainty. However, contrasted with past recessions, real estate markets enter this recession with considerably better prospects as a result of less oversupply of space than during past recessions. This bodes well for a gradual but general recovery for real estate later in 2002 and extending into 2003 as the demand side recovers.
Following an extended period of above-average growth, the U.S. economy went into recession earlier this year. While this fact is broadly accepted, what is not perfectly clear is to what extent private equity real estate will be affected. Given the market’s level of uncertainty, the bid/ask spread on pricing remains significant, bringing slower transactions and providing little indication of how values will be affected by recent economic and political events. However, one thing is apparent: despite rising vacancy rates, real estate enters this recession with considerably better prospects than in past recessions. The consensus forecast is for the economy to enter into recovery in the later half of 2002. If this scenario holds to form, then the combination of fiscal and monetary stimulus will bolster consumer spending and corporate investing, leading to higher output, employment and income levels. The downside risk is that rather than a V recession, the economy slips into a more prolonged and painful recovery process, bouncing along the bottom for several additional quarters. Early signs from both the consumer and the equity markets suggest the latter is not in the cards for the moment.
Given the most recent National Council of Real Estate Investment Fiduciaries data, it would appear that the downturn in private equity real estate values will once again lag behind the general economy by several quarters. Third-quarter total returns for the NCREIF Property Index exceeded 6 percent at annual rate and year over year returned over 10 percent to investors. While appraisal-based pricing likely contributes to this lag, it is also the case that favorable capital markets, relatively low vacancy rates and staggered lease rollovers should allow properties to maintain their values longer than in prior downturns. Because overbuilding is not systemic as it was during the last recession, there should be a significantly smaller drop in values. The exception may be the hotel sector, which had already begun to show significant deterioration before the World Trade Center disaster.
The emergence of the public debt and equity markets has also played a role in minimizing real estate’s tendency towards irrational exuberance – a phrase used by Federal Reserve Chairman Alan Greenspan – as occupancy and rents spike. Public markets act as a governor creating greater efficiency via increased transparency and increased competition for capital flows with other more traditional asset classes. With its greater liquidity, investors are able to vote with their feet, giving the public markets clear signals regarding potential oversupply.
Regional Differences
At the regional and/or property-type level, the story is a little bit more complex. Over the next 12 months, the effects of the economic slowdown will not be evenly felt across markets or property types. For example, while office and apartment returns have held their own in recent quarters, a more detailed analysis shows that returns varied widely by region. Through the first half of 2001, the NCREIF Index showed anemic returns in the Midwest and South, offset by strong returns in the Northeast and Pacific regions. With the full effects of the dot-com meltdown and Sept. 11 now finally being felt, a more consistent regional pattern is likely to develop.
The Midwest, which had already been in recession, will continue to feel the effects of declining industrial production and slower income growth. The country’s Southern tier will be adversely affected by slower in-migration, tourism and lower energy costs. On the other hand, certain markets and/or industries may actually benefit from the current turmoil. Markets such as Greater Boston and Southern California could benefit from increased government spending in the defense and biotech industries. Ironically, the destruction of the World Trade Center helped drive down Midtown vacancies but has already cost the New York City economy over 80,000 jobs.
Debt Markets
To what extent the decline in economic activity will impact credit delinquencies is not yet clear. Weak market fundamentals and delinquencies are ultimately linked, but quite often the path is neither obvious nor direct for the following reasons:
• Credit conditions do not resemble those of 15 years ago when real estate went through its tax-induced supply binge. Debt service coverage has climbed steadily during the last decade from approximately 125 percent to 150 percent today. Not surprisingly, loan-to-value ratios have fallen as creditors ask and receive real equity from borrowers.
• Pro forma assumptions turned out to be much more conservative than initially forecast. In fact, many borrowers and lenders underestimated rent growth and conservative underwriting turned out to be Draconian. Therefore, loans made four to five years ago have strong balance sheets and can be easily refinanced. In fact, for many owners, refinancing is an attractive alternative given the current bid/ask spread.
• Interest rates remain near record low levels, allowing borrowers to refinance even in the face of weakening cash flow fundamentals.
• As mentioned above, many banks and insurance companies – real estate’s dominant capital sources – have become conduits for the public debt market. This has made these capital sources more efficient with the capital spigot being closed much more quickly. In fact, for the first time in any real estate cycle construction activity peaked before vacancies spiked.
