Thursday, February 18, 2010

The Dust Hasn’t Settled Just Yet

The Dust Hasn’t Settled Just Yet

Despite robust economic growth in the second half of last year and a more upbeat assessment for economic activity during the first part of 2010, the outlook for commercial real estate has not materially improved. Credit quality is still deteriorating as delinquencies and defaults increase. Operating fundamentals continue to decline. Vacancy rates across all property types have either already risen to record highs or appear set to. Lending standards remain exceptionally tight, and there has been very little progress made at clearing up the logjam of properties with maturing loans in the next few years, many of which are underwater or have seen loan-to-value (LTV) ratios skyrocket to levels that are difficult to refinance.

Federal Reserve Exit Strategy
Another important dynamic is the Federal Reserve’s exit strategy. The Fed is removing much of the quantitative easing that it put in place following the onset of the financial crisis. Quantitative measures, including direct purchases of $1.25 trillion in mortgage-backed securities helped contribute to a tightening in credit spreads.2 In addition, Fed Chairman Ben Bernanke stated the Federal Open Market Committee would soon raise the discount, rate returning it to its one-percentage point pre-crisis spread versus the Federal Funds rate.3 Higher interest rates look increasingly likely over the next few months, even if the Federal Funds rate remains unchanged. Higher rates may cause construction loan problems to surface sooner than they would otherwise and may place some additional downward pressure on property values, making it more difficult to refinance maturing loans.

Given the uncertainty surrounding what awaits the financial markets, investors and lenders are more likely to treat any glimmer of light as an approaching freight train rather than the light at the end of the tunnel. We expect vacancy rates, operating fundamentals and prices to deteriorate in coming months and look for sales to gradually increase as investors become more comfortable and accustomed to the new economic and regulatory environment.


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