Now that a new decade has begun, many people question what is in store for the commercial real estate investment-sales market over the next few years. Clearly, 2009 was a challenging year, to say the least, with extraordinarily low sales volume and falling prices.
As 2009 ended, it was clear that, although the volume of sales would register the lowest totals we have seen going back to at least 1984, volume was trending upward with strong activity in the third and fourth quarters. Exact 2009 year-end numbers will be released by Massey Knakal before the end of this month. The direction of value, on the other hand, was still heading south as the year closed.
Real estate fundamentals move in tandem, inversely, with unemployment. As unemployment rises, fundamentals weaken and vice versa. If this generally accepted hypothesis is correct, we can use unemployment as a predictor of the direction of prices of commercial investment properties. Most economists believe that unemployment will peak at some point during the first half of 2010. It will be at this peak that market fundamentals will be their weakest and property values will be at their lowest level.
What happens after property values bottom out? Will property values bounce along this bottom for a while? Will values bounce but trend upward or trend downward? The answers to these questions are dependent upon a battle that will take place among the following factors: the speed and extent of inflation; the de-leveraging process; the massive amount of capital on the sidelines; job growth; the state of fundamentals; the Fed’s monetary policy (and how it sequences its exit); and good old-fashion supply and demand. We firmly believe that 2009’s low volume of sales was more a function of constrained supply rather than a lack of demand, which remained healthy.
Inflation is important to watch, as a rise in this metric, above the Fed’s comfort zone of 1 to 2 percent, will force it to raise interest rates, which will have a tangible impact on commercial real estate values. At present, it appears that inflation is likely to fall in the short term, at least as far as the “core” indexes are concerned (core inflation strips out volatile food and energy prices). In the U.S. economy, “slack” is the best predictor of inflation both at the aggregate level and in individual sectors of the economy. Slack is pervasive throughout the economy, not just in the frequently referenced data on unemployment and industrial capacity utilization but also in the service sector and our housing/real estate sector.
We have seen actual and imputed rents drop significantly during this recession, in the range of 20 percent (residential) to 50 percent (retail), depending upon the property type. The slack, or vacancy, in our market could further decrease inflation significantly. There is a clear inverse relationship between the rental vacancy rate and the pace of rent inflation. With rental vacancies approaching record levels and real unemployment hovering around 17 percent, there is a reasonable expectation of further declines in year-on-year rent inflation.
Most economists believe that a weak dollar is, generally, a threat to inflation. Under our current conditions, this threat is limited. In actuality, the dollar is really not that weak, and this was true even before the most recent round of risk reduction. The U.S. dollar clearly depreciated substantially in 2009; however, this could be considered a consequence of the normalization that has occurred in global financial markets. According to the Fed’s broad trade-weighted index, the dollar is slightly stronger than the average of the past two years.
Additionally, currency has less impact on inflation in the United States than elsewhere given the relatively small size of the trade sector. In the U.S., the impact of currency changes on inflation, in particular, is nominal. The general rule of thumb is that a 10 percent depreciation in the trade-weighted dollar raises the level of the Consumer Price Index by just 25 basis points. Therefore, it would take a massive drop in the relative value of the dollar to create tangible concerns about imported inflation.