By Raphael Bostic, Ph.D.
Not that long ago, real estate seemed wildly out of sync with the economic cycle. Commercial developers, flooded with money from lenders and investors, were turning dirt and throwing up buildings at record rates. When the economy slid into a recession, property markets were unable to absorb the flood of new space, commercial vacancy rates soared to 20 percent or more, and many developers defaulted on their loan obligations. The real estate crash exacerbated the recession; drove a number of financial institutions into mergers, consolidations, and bankruptcies; and gave rise to the Resolution Trust Corp., which restructured or liquidated hundreds of failed banks and thrift institutions.
The recent recession might have had comparable effects, but today’s real estate markets are more attuned to the economy. Lenders, apparently having learned from the bitter experiences of a decade ago, have been more cautious in financing property development and ownership, and the real estate industry’s credit problems are much less severe than in the early 1990s. Borrowers now must meet more stringent criteria to obtain financing for development projects or property acquisitions; for example, they are generally required to invest more equity in deals. Because developers and owners are not as highly leveraged as in the past, and interest rates are lower, they do not require as high a cash flow from their properties to meet their loan obligations, which should help to reduce their risk of default. In addition, developers – by nature, perennial optimists – have shown more caution in starting projects. According to a report in the Wall Street Journal, the F.W. Dodge division of McGraw-Hill Cos. expects about $65 billion of construction work to start in 2002, compared with $81 billion in 2000, the peak year of the last cycle. The slowdown in construction will continue to hold down demand for commercial real estate financing, which has been at a low level since the terrorist attacks of 9/11.
That said, the recession has had some adverse effects. Measured by changes in profits, the recession was one of the most severe in memory. A Commerce Department analysis indicates that after-tax corporate profits declined 15.9 percent last year, one of the worst annual profit declines since World War II. In addition, widespread corporate lay-offs, particularly in the technology sector, have thinned the ranks of office workers and reduced demand for space. As a result, vacancy rates for commercial property have been increasing in spite of the fact that supply has remained relatively in check. Reis Inc., a New York City-based real estate research firm, told the Wall Street Journal that the nation’s businesses vacated 26.4 million square feet in the first quarter, and this so-called negative absorption, coupled with 13.5 million square feet of new development, pushed the national vacancy rate up to 14.7 percent from 13.6 percent at the end of 2001. The current vacancy rate is the highest since the end of 1994, when it was 15.3 percent.
Moreover, commercial property rents are declining, although some landlords have managed to hold the line on rents by offering more generous concessions. Landlords also are continuing to collect rent from some tenants who have vacated space but are required under the lease terms to continue making payments. As leases expire, however, landlords could have difficulty finding other tenants and the rental income from some of their properties could decline.
Demand for office space could be further weakened by rising unemployment – in March, the unemployment rate jumped to 5.7 percent from 5.5 percent the previous month, the government reported. It is expected to peak later this year at around 6 percent. In the retail sector, K-Mart, which filed for bankruptcy protection in January, may try to get approval to terminate leases on hundreds of store locations. In addition, some other troubled retailers are trying to break their leases. These retrenchments could add more vacant space to some local retail markets already experiencing high vacancies.
Now, the recession appears to be history. Despite the shock of September 11th, the crash in the technology and telecom sectors, the stock market slide, plunge in corporate profits, and Enron’s troubles, the recession was one of the mildest on record in terms of gross domestic product. Real GDP actually grew 1.2 percent last year, according to the Commerce Department.
We now see signs the economy is starting to recover. Payroll employment rose 58,000 in March, the first increase in jobs in seven months. Job declines of 37,000 in construction, 6,000 in retail, and 38,000 in manufacturing were offset by gains of 37,000 in government and 118,000 in other services. The decline in manufacturing jobs was the smallest since December 2000, a further indication that the economy is starting to rev up. Productivity, a measure of how much economic value Americans generate per hour worked, grew at a spectacular 5.7-percent rate in the fourth quarter. Another indication is that employment is picking up in light industrial sectors, such as assembly of finished electronic components or auto parts.
This year, GDP should grow in the range of 2 to 2.5 percent, compared with 1.7-percent growth last year. Metropolitan areas and regions with broad, diversified economies, such as Atlanta, Chicago, Dallas, Houston, and Southern California, will lead the recovery. Activities by the Federal government will also have a significant positive influence on regional economies. For example, increased government spending on defense and security will be a boost to some regions such as Southern California. Local economic markets that are dependent on one or two industries, such as those in West Virginia and parts of the Rust Belt, will be among the last to come back.
Over the next few years, the U.S. economy should grow in the range of 2.5 to 4 percent and continue to outperform the global economy, as it has for the past decade. Productivity, which saw a dramatic spike in fourth-quarter 2001, should increase at a much more modest and more sustainable rate in the years to come.
As GDP growth accelerates, the Fed at some point will have to move to increase interest rates, currently at 40-year lows. But, absent strong signs of inflation, any increases should be modest and not threaten U.S. growth. Stable rates and a ready supply of capital will help to sustain a strong rate of home sales and housing starts. In areas such as Southern California, San Francisco, New York, and Chicago, housing markets will get an added life from a surge in immigrant demand.
There is the potential for storm clouds, though. Although consumer spending should remain strong, higher oil prices could take some spending income away from consumers and dampen economic activity. There is also the time factor. Employers are cautiously starting to hire, and if hiring continues to grow, demand for commercial office space could begin to inch up. Likewise, an increase in consumer spending could start to increase demand for retail space. But it could be from six to 24 months before commercial property vacancies hit a peak and start to decline. Meanwhile, rising vacancies could put more pressure on rents, which could decline further before bottoming out.
While the short-run picture may look bad, commercial property markets are much healthier than when the economy was coming out of a recession in the early ’90s. Back then, the real estate industry itself was ailing, with many owners struggling to generate sufficient cash flows from their properties to repay lenders and investors. Although the current property market downturn could drive some troubled owners into liquidations and bankruptcies, the carnage of the early ’90s will not be repeated. Now, the concern is with what might be described as the “Enron effect” on the financial health of the owners’ corporate tenants.
Those industries such as telecommunications and technology that tend towards the use of sophisticated financial instruments – what I term “newer” industries – could face more difficulty in obtaining financing and raising investment capital. Lenders and investors have become increasingly cautious about financing or investing in these companies because of uncertainties about the transparency of financial statements, the integrity of internal and external audits, off-balance sheet transactions, and other risk-related issues, and they could require these companies to pay higher costs – a sort of risk premium – to secure loans or investments, including financing and outside equity for development of company-owned office buildings and other corporate facilities. Likewise, property owners concerned about the risks in leasing space to these companies may require them to provide letters of credit or other guarantees that they will meet their lease obligations. Owners who leased space to now-defunct dotcom companies are particularly sensitive to the need for such guarantees.
By contrast, what I call “older” industries with clearly identifiable assets and predictable cash flows and income streams should find loans and investments more readily available and at lower costs than the “newer” companies. These “older” companies may include not only established manufacturing and industrial companies such as Alcoa but also leading technology companies such as Microsoft. Likewise, property owners may be more willing to lease space to these companies at less-stringent credit terms than those set for “newer” companies.