2010 ULI Forecast (Part 2)

In my last market assessment, I summarized some salient points in the 2010 commercial real estate forecast presented in Emerging Trends in Real Estate.

This publication is a joint undertaking by the Urban Land Institute and PricewaterhouseCoopers. It reflects the views of more than 900 real estate professionals and is considered one of the best researched real estate periodicals of its kind.

This week’s market assessment covers their predictions for commercial real estate financing for the coming year. Their forecast:

• Banks will become willing lenders only when they have more equity or more earnings. In the meantime, an increasing number of “zombie banks” will be on the sidelines. For 2010, it’s survival of the most liquid. Surviving banks will start to dispose of real estate owned.

• Hundreds of banks could fail, particularly regional and community banks with significant exposure to homebuilder, land and construction loans, resulting in government regulators packaging and selling more bad loans.

• Those banks who will be lending will employ stringent underwriting to limit transactions. Sponsorship quality and longstanding, banker/borrower relationships will be the primary requirement to obtain loan approval.

• The CMBS market is described as a “huge time bomb” wrapped in a “ball of confusion.” Securitized loans will remain entangled in complex workouts of failed multi-tranched structures and many of these loans will go into monetary defaults before maturities because of borrower financial issues and lagging fundamentals.
  

As grim as this forecast is, I am beginning to see anecdotal evidence that the Portland lending market is turning a corner.

Since the beginning of the year I have talked with two local lenders who are actually hiring to beef up their commercial lending departments – Umpqua Bank and Northwest Bank. I’ve also talked with a couple other lenders who have loosened their loan underwriting standards a bit making it slightly easier to get a loan.

And then there are several other lenders who are talking like they are ready to come back into the market, which reminds me of the well known Texas saying, “Are they all hat and no cattle?” Who knows? We’ll have to wait and see.

No one has ever accused me of being Mr. Optimist but I believe our current lending environment is not all doom and gloom. We’ve got a long way to go before we reach a lending environment that approaches “normal” but I’m seeing baby steps in that direction.

Hang in there! There will be an end to this lending crisis.

2010 ULI Forecast – It Ain’t Pretty (Part 1)

Emerging Trends in Real Estate is a trends and forecast publication undertaken jointly by the Urban Land Institute and PricewaterhouseCoopers.

This publication is considered by many as the best researched real estate periodical of its kind. Their 2010 edition reflects the views of more than 900 real estate professionals. Their forecast for this coming year isn’t pretty; in fact to be blunt, it’s downright ugly.

I have divided their forecast into two parts – today summarizes their 2010 predictions for commercial real estate. The following week will focus on their thoughts about financing trends for the coming year.

For the weak-hearted, you may want to stop reading any further. Their forecast:

• The commercial real estate industry will hit bottom in 2010. Values will ultimately decline 40 percent of the mid-2007 pricing peak making it the worst decline in property values since the Great Depression.
• A lackluster economic recovery characterized by problematic job growth will hamper the pace of any real estate market resurgence.
• Rents and occupancy rates will continue to fall well into 2010 further hurting prospects of weakened owners securing financing on properties where loans come due during the year.
• Retail and office properties will take the biggest hits. Debt burdened consumers will continue to rein in shopping and companies will delay hiring while looking to shave occupancy costs.
• Apartments should rebound more quickly than other sectors thanks to pent-up demand from the expanding population of young adults tired of living with parents or roommates.
• Developers will go on enforced holidays. Slack demand will push up vacancies and many new projects will not meet leasing projections or debt service obligations. In many markets values will sink well below replacement costs. Development doesn’t pencil out when investors can buy existing real estate at bargain basement prices.

I believe that 2010 will be a watershed year for those of us in the commercial real estate industry. As bad as the market has been, we have not seen a proportional number of people getting out of the business as I would anticipate.

That will change this year. Those who have been hanging on by their fingernails will either make deals happen or will decide it’s time to find another profession.

For those of us who survive this year we can take solace in the words of the great philosopher Friedrich Nietzche: “What doesn’t kill us makes us stronger.”

Source:
Emerging Trends in Real Estate 2010, Urban Land Institute & PriceWaterhouseCoopers.

Light At The End Of The Tunnel

Doug Marshall, CCIM
Market Assessment
Published December 8, 2009

In a previous market assessment, I identified seven things that need to occur before commercial real estate lending can return to normal (whatever the new normal is going to be):

1. The overall economy needs to improve
2. Commercial real estate fundamentals (vacancy rates and rental rates) need to stabilize
3. Foreclosures need to occur so banks can cleanse their balance sheets of non-performing assets
4. Weaker banks need to fail
5. Lenders need to extend, amend, and pretend
6. Inflation needs to happen, and
   
7. A new version of the CMBS product needs to be created.

Today's post falls into the first category: the overall economy must improve before lending can return to normal.

Chart of the Day (shown below) is a product of Barron's Magazine, which provides insightful charts that both inform and educate the reader. Rarely can you find a chart which better illustrates how this recession compares to those experienced in the past.

The chart compares the third quarter earnings of most companies that comprise the S&P 500 to other recessions that have occurred since 1936.

Notice the precipitous decline in corporate earnings since the third quarter of 2007. Earnings have been in freefall, having dropped 92% from the third quarter of 2007 to the third quarter 2009 trough, which makes it easily the largest decline on record.

However, on the positive side, the S&P 500 combined earnings has bottomed out and is moving up sharply. Improved earnings are the first step to recovery; but as we all know, employment growth is the real indicator needed to show that a recession is over.

Unfortunately, we are not there yet. In Oregon and Washington, unemployment is expected to continue to rise through the second half of 2010.

But for now, we should realize that the U.S. economy is in the first stage of a recovery. It may be a slow and arduous recovery, but it appears we are in for better days ahead.

Have courage! There's light at the end of the tunnel.

Source: Barron's Magazine Chart Of The Day, November 20 2009

Kicking The Can Down The Road

by Doug Marshall, CCIM
Market Assessment
Published November 23, 2009

In my market assessment dated November 3, I identified seven things that need to occur before commercial real estate lending can return to some semblance of normality.

Some of these are obvious. Others are counter-intuitive. In order to recover:

• The overall economy must improve
• Commercial real estate fundamentals need to stabilize
• Foreclosures need to occur so banks can cleanse their balance sheets of non-performing assets
• Weaker banks need to fail
• Lenders need to extend, amend, and pretend
• Inflation needs to happen, and
• A new version of the CMBS product needs to be created.

Over the past year, some of my readers have criticized my interpretations of what's happened in the commercial real estate market as being far too pessimistic. Maybe they're right. I don't know, to be honest.

But to those who agree with this assessment I make this pledge: whenever I can find worthy commercial real estate news that will provide evidence of a thawing in the liquidity crisis or in the real estate market in general, I will bring it to my readers' attention.

Such is the case in today's market assessment.

Recently, the FDIC, the Federal Reserve, and the Office of Thrift Supervision have published new rules for modifying loans to creditworthy customers. This comes under the category of 'kicking the can down the road.'

This is good news; not only good news but plain common sense, something that seems to be lacking these days. The fact remains that it is in the best interest of both groups - banks and investors - to avoid foreclosure by any means possible.

Regulators are recommending that loans be amended for investors who are on time with payments, even if the real estate isn't performing as well as expected or desired.

The regulators have made it clear, in the new rules, that these kinds of loans by banks will not be classified as high risk.

While the new regulations require banks to be careful and conservative, to say the least, they also approve of the modification - through lower interest rates, extended loan terms, or a longer amortization - of properties currently held that would be foreclosed on otherwise.

It is to be hoped that a lot of banks will be able to extend these loans so that they outlast the current sour economy.

It's going to be interesting to see which banks will be able to extend and modify loans for the sake of their customer base and for their own self preservation. The future of the real estate market will depend on it.

Let's hope that the lending institutions come to see it that way, too.

Sources:
New Rules For Modifying Commercial Property Loans, Seattle Daily Journal of Commerce, dated November 2 2009

What Will It Take For Lenders To Lend Again?

As everyone knows, the commercial real estate capital markets have been in turmoil since June of 2007, when the single family sub-prime lending debacle first appeared on the scene.

Since that time, the lending market has slowly but - ever so consistently - continued to deteriorate. There are fewer lenders lending today than at any other time during this credit crisis and those who are lending are using more conservative criteria for underwriting their loans and qualifying their borrowers.

One question I am frequently asked as a commercial mortgage broker is, “What will it take to get lenders to start lending again?” There is no silver bullet – no one solution that will resolve this lending crisis.

In order to get commercial real estate lending back to some semblance of normality several things need to happen, listed below are seven:

1. The overall economy needs to improve. Sorry to state the obvious but it needs to be said. The good news is that the economy, fueled by government stimulus, grew last quarter for the first time in more than a year.
   
   Over the last 3 months, GDP grew 3.5%. But the problem is that the recovery so far has been a jobless recovery. In fact, employment growth is still contracting just at a slower rate of loss than previous months.
   
   In order for commercial real estate to benefit from this recovery employment must begin to grow and consumers need to have the confidence to increase spending.
   

2. Commercial real estate fundamentals need to stabilize. Employment growth and improvement in consumer spending will result in an increase in demand for office, retail and industrial space.
   
   Occupancy rates will stabilize causing rents to firm up and with increased net rental income, default rates on loans will slowly lessen.
   

3. Foreclosures need to occur so banks can cleanse their balance sheets of non-performing assets. One of the important lessons that we learned from the S & L crisis of 20 years ago is to address the problem head on.
   
   Yes, it was painful but bad real estate deals that were taken over by the Resolution Trust Corporation became exciting opportunities for those risk takers that purchased these assets at substantially discounted values.
   

4. Weaker banks need to fail. There are about 8,000 banks in the United States. During the past year about 120 banks have failed with another 400 to 500 banks expected to follow.
   
   If we want to avoid a 10 year recession similar to what Japan experienced during the 1990s we must allow the weaker banks to fail.
   
   We don’t want to follow the example of the Japanese bank regulators who allowed insolvent banks to survive which only prolonged their country’s painful recession.
   

5. Lenders need to extend, amend and pretend. Performing loans, with borrowers who have never been late on a payment, need to be extended when their loans are due regardless of how the loans underwrite in today’s lending environment. Those loans that are marginally performing but are basically sound real estate may need their loan terms amended.
   
   Maybe a lower interest rate, a longer amortization, or a reduction in the loan principal should be implemented, whatever it takes so that the bank doesn’t have to foreclose.
   
   Not foreclosing would be in both the lender’s and borrower’s best interest. Lender’s need to have the wisdom to “kick the can down the road” in hopes that as the economy and real estate fundamentals improve that the future lending environment will also improve making it easier to finance real estate in the future than in today’s lending climate.
   

6. Inflation needs to happen. Experts are predicting, and I fully agree, that inflation is inevitable. It’s not a matter of if it will happen, it is only a matter of when and how much.
   
   Those who lock in long term fixed rate loans are going to look incredibly intelligent in a couple of years as interest rates begin to climb along with the cost of a loaf of bread and every other consumer product.
   
   That being said, inflation is the friend of the owner of commercial real estate. As values are slowly pushed up due to inflation the trauma of the present situation will slowly subside.
   

7. A new version of the CMBS product needs to be created. Without the CMBS market there is an estimated $400 to $500 billion shortfall in the supply of capital to finance all the real estate loans coming due over the next three years. There is no lending source – not banks, or life companies or GSEs – on the horizon to absorb this huge loan volume.
   
   What needs to take place is a new and improved version of the CMBS product. Experts suggest four regulatory changes in order to re-establish confidence in this once thriving market:
   

• Reform of the rating agencies which were complicit in the downfall of CMBS.
• Those who securitize mortgage pools should be required to retain a significant portion of the riskiest tranche (a slice of a mortgage pool with similar inherent risk).
• A portion of the profits should be deferred on the securitizations until the loan portfolio is well seasoned.
  
  To make these regulatory changes will require someone in Washington, DC – Congress, the Federal Reserve, the Treasury Department – to take real leadership on a complicated issue, which so far has been sadly lacking.
  

All of these solutions will take time to favorably impact the market. Even if all seven factors were to begin moving in the right direction today, it would take months before the lending environment would fully feel this positive influence.

Unfortunately my crystal ball tells me that 2010 is going to be another ugly year in commercial real estate as the fundamentals to turn this market around are not yet in place.

Hang in there. It’s not over yet.