The rate of rebound in the US property market is likely to vary by sector and location, depending on its susceptibility to employment rates, consumer spending, and industrial recovery. Andrew Warren explains
The severity of the global credit crisis and recession that has marked the end of the initial decade of the new millennium was truly of historic proportions. Global GDP, US GDP, global trade and US payroll employment each suffered their largest contraction in the post-war era. But as the global economy prepares to open the chapter to the new decade, there are clear signs of a turning point.
Market sentiment gradually improved throughout 2009 with the help of coordinated government intervention amid a growing conviction that systemic risks have faded. Increasing evidence of credit market restoration and global economic recovery helped stock markets rebound strongly in 2009. The US economy is participating in this global recovery, but a period of slow growth might await a US economy saddled with huge government budget deficits, an over-leveraged weak consumer segment facing high unemployment rates, and a still fragile housing market characterised by a high rate of foreclosures.
Because of the systemic nature of the global downturn, virtually every nation, industry and asset class was unfavourably affected simultaneously. The transition to economic growth will likewise contain certain elements of relative synchronisation, given the coordinated stimulus and inter-connectivity of global economies due to trade and capital flows. However, because the global rebound will be characterised by idiosyncratic elements, not all investment sectors will recover at the same time or pace.
Non-synchronicity of recovery is already evident for US commercial real estate. The two public quadrants of real estate investment trusts (REITs) and commercial mortgage-backed securities (CMBS) have reached bottom and reverted to strong positive total returns for 2009. Commercial mortgage spreads for core, conservatively leveraged transactions have also narrowed materially during the year, amid a dramatic increase in lender competition.
However, private market equity real estate values still face downward pressure, although the pace of decline appears to be easing, as cap-rate expansion has largely ended.
Additional downward pressure on property
prices is likely to come from potential declines in property net operating income beyond what is currently factored into valuation levels. US property markets have experienced a dramatic decline in user demand that has trumped reasonably disciplined new supply, resulting in a more rapid and likely more severe peak-to-trough drop in commercial real estate values and higher vacancy rates than was the case in the 1990s.
Further, the deleveraging of the commercial real estate markets will likely be even more challenging than it was in the 1990s. The return of the new issuance CMBS market in late 2009 was welcome, but there is still a large debt capital void, especially given the fragile financial health of many small and mid-cap banks. It is likely that much of the deleveraging will take the form of foreclosures or deed-in-lieu activity. To date, most lenders have prioritised extending or modifying loans, but a slow job recovery and limited borrower access to capital to fund shortfalls is likely to mean foreclosures will eventually become the dominant form of deleveraging.
With some exceptions, space markets have been characterised by reasonably disciplined levels of new supply. But the favourable impact of restrained new supply has been more than offset by a massive contraction in user demand. Vacancy rates across virtually all property types are either already at or likely headed for, or above, 1990s peak levels. Investor strategies have shifted to gain market share of what demand there is, while awaiting a resumption of more meaningful demand growth in the broader system.
The pattern of disparity evident in the performance of the various real estate investment quadrants is expected to also be evident in the geographic nature of the real estate market recovery. While all geographic and property type markets have been hit by the downturn, the pace at which they will recover will vary significantly. The differentiation in recovery will largely be attributable to the primary driver of the downturn and to the exposure of various markets to the industries with the most favourable outlook over the next several years. Markets that suffered structural changes such as the industrial Midwest will take significantly longer to recover than those that were more affected by the weakness in the overall national economy. Markets likely to show a stronger recovery include those with a strong demographic outlook and those that will benefit from an increase in business investment.
The rate of improvement in space market fundamentals will also vary, based on their dependence on different economic drivers. With employment growth projected to be muted, at least during the early stages of the recovery, those property types that benefit from growing economic activity and not direct employment are likely to show significant improvement first.
The industrial sector is beginning to see increasing demand due to rising exports associated with improving economies around the globe. The second stage of this recovery will come when US consumers become more confident in the sustainability of the economic recovery and begin to increase their level of spending. This increase in consumer activity will also directly benefit the retail property type, but it is likely that it will take a sustained improvement in employment growth before retail benefits significantly.
The multi-family market will also experience initial improvement from rising economic activity as potential renters feel more confident about the future and are willing to make a commitment to signing a lease. This trend will only get stronger as employment growth gains momentum that should lead to an increase in new household formation. The office market recovery will be relatively delayed, due to its direct dependence on employment. The pace of negative demand will slow as the economy improves, but significant improvement in fundamentals will be dependent on sustainable office-using employment growth.
Andrew Warren is managing director, real estate research, Principal Global Investors