The new world of today's real estate market: The challenges facing the industry and its investors

Triggered by the sub-prime fallout and residential housing market downturn, the U.S. economy continues to struggle. The economy has lost jobs for six consecutive months, totaling a decline of 438,000 in the first half of the year. The unemployment rate spiked to 5.5% in May, the highest rate since 2004, and is up 100 basis points over one year prior. Despite dire predictions of negative growth, however, real gross domestic product (GDP) posted a 1.0% increase in the first quarter, an improvement over the previous period. A closer look at the numbers reveals that slowing consumer spending and construction should continue to be a drag in the second quarter and beyond. Slowdowns in business spending, masked by strong increases in inventory during the first quarter, suggest further evidence of an ongoing slowdown. As the housing downturn continues to impact consumers, declining spending could lead to a mild recession in mid to late 2008. More likely, in our opinion, is the narrow skirting of an official recession but ongoing economic struggles nonetheless. A series of cuts to the federal funds rate and an $168 billion economic stimulus package have helped to keep the economy from stalling entirely. Now, surging energy and commodity prices and the declining value of the U.S. dollar are adding inflationary pressures while also providing an additional drag on consumer spending. After the series of cuts that brought the federal funds rate to 2.0%, consensus opinion expects that the next Fed moves will be to ratchet that rate higher to help keep inflation in check. A rising inflation rate could lead to higher interest rates thereby decreasing demand for commercial real estate. Looking forward, the U.S. economy may rebound in late 2008 or early 2009 as the housing market bottoms out and the credit crisis runs its course. Employment and rent growth are forecast to re-accelerate in 2009-2011. New investments in 2008 could be well-positioned to capture this coming upturn cycle. Despite relatively solid fundamentals in all sectors of commercial real estate, the combination of the housing market downturn and the credit crunch are having negative spillover effects. Rising sub-prime delinquencies led to a stalled credit pipeline and a dramatic widening of credit spreads of all non-Treasury debt, including commercial mortgage-backed securities (CMBS). Investors are increasingly seeking safety in U.S. Treasuries, and the yield of the 10-year T-Bill has dropped to below 4.0%. The widening credit spreads and tightened lending standards require more equity, lower loan-to-values (LTVs), and higher debt service coverage ratios for new investments. Many poorly sponsored construction projects have been delayed or even canceled. Together, these changes have reduced the number of buyers in the market, particularly highly-leveraged ones. At the same time, some owners are choosing to hold properties through the downturn rather than to sell at reduced prices. With less competition, all-cash and low-leverage institutional investors are better positioned to influence pricing. Higher risk premia have simultaneously put upward pressure on cap rates and downward pressure on asset pricing. During the last quarter of 2007, cap rates for class A assets in core markets rose by approximately 10-40 bps according to NCREIF. Numbers from the first quarter of 2008 suggest a similar reduction in cap rates over the previous quarter (0-30 bps), but the combination of a limited number of transactions and the lag in the appraisal process make the validity of the most recent numbers questionable. Overall, ING Clarion expects cap rates for core properties in primary markets to rise modestly by 25-50 bps in 2008. Cap rate decompression will negatively impact total investment returns in the near term. According to Real Capital Analytics (RCA), transaction volumes surged to $523 billion in 2007, setting new records for all property types. A significant component of the higher volume was the privatizations of Equity Office Properties ($39 billion), Hilton Hotels ($26 billion), and Archstone-Smith Trust ($22 billion). Through the first two quarters of 2008, transaction volume is down by nearly 90%. Given the low transaction volume, it may take several months for buyers and sellers to reach new "equilibrium pricing." ING Clarion expects this downtrend to continue at least through the end of 2008. U.S. commercial real estate is facing several challenges: slowing economic growth, credit market turmoil, and cap rate decompression. Nonetheless, ING Clarion believes that the ongoing credit crisis is a positive development for the U.S. commercial real estate market in the long run. With tightening lending and underwriting standards, speculative investments and construction projects will be limited, resulting in more constrained supply and healthier fundamentals over the long term. We believe that commercial real estate will remain an attractive asset class for the traditional reasons, including high current cash flow, diversification benefits, and as a hedge against inflation. David Lynn, Ph.D is managing director, research and investment strategy at ING Clarion, New York, N.Y.