Capital In 2011 – A Loosening Of The Purse Strings
We have looked at the overall U.S. and California economies in each of the last two years, as well as the general state of the retail industry, with a specific “eye” on capital markets. As is obvious, we have all suffered through one of the worst economic downturns since the “Great Depression.”
It seems appropriate to take a quick look back at what we, in the commercial real estate industry, have just experienced. It was best stated in the recently published report by the Financial Crisis Inquiry Commission (established by Congress in 2009 to report on the causes of the financial crisis). The Commission report states: “The profound events of 2007 and 2008 were neither bumps in the road nor an accentuated dip in the financial and business cycles we have come to expect in a free market economic system. This was a fundamental disruption – a financial upheaval, if you will – that wreaked havoc in communities and neighborhoods across this country. As this report goes to print, there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away. Businesses, large and small, have felt the sting of a deep recession. The collateral damage of this crisis has been real people and real communities. The impacts of this crisis are likely to be felt for a generation. And the nation faces no easy path to renewed economic strength.”
There is no need for us to once again revisit the reasons that led to this major recession. We did this in our 2009 forecast. However, it is amazing how resilient the retail industry has been in the face of this crisis. Despite the horrendous year for any company involved in the retail industry in 2009, the industry started to recover in 2010 – in particular, in the final two quarters. Despite a sluggish housing market, a jobless rate in California well above the national average of about 9.5%, and a continuing significant budget shortfall in California, there were many positive signs in the retail industry that should bode well for a continuing recovery in 2011. Investment sales increased significantly from 2009 to 2010, retail leasing increased (albeit at well-positioned properties and at lower rental rates), retail same-store sales for December rose 3.1 percent year-over-year, GDP growth was up significantly in the third and fourth quarters of 2010, consumer spending grew by 4.4% in the fourth quarter of 2010 (the fastest pace since the first quarter of 2006), and lending started to flow again.
It should also be noted that the Republican takeover of the House of Representatives and the extension of the Bush tax cuts for two years have provided business with a greater feeling of stability. Prior to the end of 2010, the Pelosi controlled House (along with a Democrat President and a Senate controlled by the Democrats) caused the private sector tremendous concern about future anti-business legislation. The more business-friendly Republican House will prevent the President and Senate from moving too far “left” and will be a major confidence builder for the business community – specifically including the real estate industry.
As stated above, capital started to flow in 2010. As an example, the dormant CMBS market increased from $3.4 billion in 2009 to approximately $13 billion in 2010. Many experts predict the CMBS market will increase to $45 billion in 2011. With the Federal Reserve continuing to keep its benchmark interest rate near zero, the appetite for yield among investors is significant. With stricter underwriting standards, the CMBS market will remain strong. CMBS transactions are now characterized by simpler structures allowing for easier due diligence by investors.
Banks also started to “loosen the pursestrings” in 2010. As banks continue to build up strong reserves, as well as to dispose of distressed assets, bank capital, in certain circumstances, will be available at attractive rates. The strict underwriting standards employed in 2010 will continue with some relaxation. Experts see loan to value ratios moving from the 60 to 65% range to the 65 to 75% range. Non-recourse loans will become available for the right type of property, but at higher rates. (Mezzanine loans also are prevalent to fill the equity gap, but require the payment of high yields.) However, bank loans continue to chase “core” properties, meaning well-located properties (what one might call “A” properties) with credit anchors such as grocery stores. Under the right circumstances, “value-added” properties in “A” or “B+” locations are also attracting bank loans. Banks will also consider secondary markets, so long as conservative underwriting standards are observed and credit enhancement is provided. In addition, banks will provide construction loans so long as specified pre-leasing standards with credit tenants are met.
Life companies will continue to lend in 2011 as they did in 2010. Experts expect to see a larger allocation of monies available from them. However, their underwriting standards will remain very strict. Since they have limited allocations of funds to lend, they have the luxury of only lending on the top-tier properties, or to the most credit worthy sponsors. As stated in the recent research report issued by Prudential Real Estate Investors titled “Deleveraging the Commercial Mortgage Market: How Much Further to Go?”, “some life companies are lending at a record pace, as mortgages are seen as a good investment relative to other products at a time of low interest rates.”
Although the capital markets still have a long way to go to return to the “good old days” (if that will ever occur), they are well on their way to “kick-starting” some growth in the retail industry. However, many obstacles still remain for a more sustained recovery – so long as new housing remains in the doldrums, unemployment remains high (which is predicted for many more years) and maturing loans outpace available capital, restrained but incremental improvement in the capital markets will be the norm.