Commercial real estate markets, like the broader economy, are approaching midyear on their firmest footing since before the onset of the recession, with property fundamentals improving across an increasing range of markets and property types. Similarly, the rebound in investment activity and credit availability that has been largely isolated to major markets is showing indications of spillover across a national geography of well-positioned, performing assets.
Barring any serious shocks to the economy, improving fundamentals, investment and credit will propel commercial real estate through the rest of the year. Yet, despite the generally positive trends that now characterize the recovery in property markets, the near-term outlook is still clouded by an unusual degree of uncertainty.
This summer will prove critical in narrowing that uncertainty along several dimensions, including the direction of policies related to monetary interventions and a possible inflexion in banks’ management of commercial real estate distress.
Broad Policy Interventions Wind Down
The Federal Reserve’s program of quantitative easing will reach its conclusion in June, assuming the economy remains on course. The drop in demand for treasuries will contribute to upward pressure on interest rates and, indirectly, on cap rates and borrowing costs. In subsets of the property market where fundamentals are lagging, cap rates will rise and value recovery will moderate, if underlying risk-free rates increase appreciably.
Given the myriad forces impacting treasury yields, the adjustment in rates is unlikely to occur suddenly, complicating the assessment of the interaction of monetary-policy intervention and property-market outcomes. Early warning signs may be observable in lower financial-services stock prices and a downward correction in commodity prices.
Europe’s Ongoing Debt Crisis and Its U.S. Implications
Across the pond, Europe’s own fiscal imbalances will continue to drag on the region’s economic outlook. A significant restructuring of Greek debt is almost certain but is within the capacity of Europe’s larger and more secure economies to manage.
The potential for the sovereign debt crisis to spread remains a key threat to stability, however. If resulting shifts in bond markets and austerity plans remain reasonably well-contained, Europe’s challenges will support demand for the safety of treasuries, offsetting the impact of weaker domestic demand as QE2 reaches its conclusion.
But if conditions in Europe spiral, reverberating through real economic activity in Germany and the Nordic states, the destabilizing effects on the global economy could test investor interest in property markets as well.
America’s Debt Crisis Comes Into Focus
While Europe has come face-to-face with its debt crisis, an element of cognitive dissonance continues to characterize thinking about disorderly public finances in the United States. That may start to change over the coming months, as the need to address the federal debt limit and avoid a disastrous technical default on government obligations requires that we make our first real choices about the long-term structure of entitlement programs and taxation.
Games of brinksmanship in Washington belie the very real consequences of inaction. As Federal Deposit Insurance Corporation chairman Sheila Bair rightly reminded Congress last week, “Investor confidence in U.S. Treasury obligations is absolutely vital to domestic and global financial stability and cannot be taken for granted.”
A failure on the part of Congress to reach a compromise will derail the economic recovery as well as any semblance of rebound in real estate investment and credit.
Credit Availability Broadens
Even as the federal government seeks to narrow its reliance on borrowing, credit availability is expected to improve in commercial real estate markets. Apart from the easily observable uptick in lending by life companies and international lenders, the increasing pipeline of CMBS issuance will support relatively smaller borrowers’ access to credit.
The democratizing impact of reasonably well-diversified CMBS’s eases a critical shortfall in lending in the secondary and tertiary markets that might otherwise be served by regional and community banks.
But the new vigor of the securitization platform comes at a cost. In spite of its 2.0 moniker, there has been very little in the way of serious structural reform of CMBS markets. The potential for loan quality to deteriorate–months from now or years from now–as a result of misaligned incentives requires greater vigilance than investors in CMBS’s currently exhibit.
New Leadership at the FDIC
In the arena of bank lending and the much-debated management of banks’ commercial real estate distress, pending leadership change at the FDIC could motivate a more rapid disposition of banks’ real estate owned.
Following her tenure at the helm of bank regulation, Chairman Bair has confirmed that she will step down from her post this July. The loss of her independent thinking on regulatory issues and her willingness to disagree with colleagues will be sorely missed; true diversity of opinion motivated by serious concern for the public good and a willingness to be on the losing side is regrettably rare in Washington.
At the same time, the arrival of a new chairman, coinciding with evidence of robust recovery rates on nonperforming commercial real estate loans, may see the FDIC push forward with planned and proposed auctions, while smaller banks accelerate their own efforts to address legacy distress in a permanent way. For eager investors, that would mean a larger pool of distress in which to swim about, albeit one that may drag on market metrics.
Momentum: Slowing at the Top, Picking Up in the Middle
Irrespective of whether the FDIC stays the course or deviates, momentum in the market for performing assets will likely shift over the coming months. Large trophy sales and new development projects in major-market CBD’s will continue to dominate the broadsheets, fueling the appearance of buoyancy in New York City’s most coveted commercial property corridors.
The exceptional recovery in pricing and sharply lower cap rates for the best assets in Manhattan, Washington and San Francisco now means that investors must move out along the risk spectrum as they seek to grow their portfolios. Areas of the market that have lagged in price discovery and liquidity-but that are well positioned to benefit from a modest pace of job growth and absorption-should benefit in turn.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.