Despite promising signs that the two-year credit crunch is easing, small doses of debt can't soothe the suffering commercial real estate industry. Buyers and sellers remain paralyzed by a gap between bids and asking prices, and anemic sales volume is compounding the stalemate by depriving investors of sales data needed to set pricing.

Transaction volume across property types totaled just $2.1 billion in May, a fraction of the $9 billion in deals closed in May 2008, according to New York-based Real Capital Analytics.

A wave of distressed asset sales could break the spell by providing data that can be adjusted to help close deals on healthier properties, but those liquidations will come at the expense of owners and lenders who must purge assets in order to survive.

“There are going to be buying opportunities coming that we've never seen in our lifetime, and the long-term result will be a huge transfer of wealth,” predicts Gary Mozer, principal and managing director at Los Angeles-based real estate investment banking firm George Smith Partners. “But a lot of pain has to be felt, and that's going to be in foreclosures and bank failures.”

When will distress reach a breaking point and usher in renewed investment activity? And when will demand for commercial space boost occupancy and bring rent growth back to the market?

The answers to those questions lie in an elusive economic recovery, one that will support rent growth while it bolsters lender balance sheets to handle losses they must realize in liquidation sales.

Pain before gain

Landlords are certainly suffering. The longest recession since the Great Depression has knocked the legs out from under property fundamentals while investors are still grappling with deflated prices. Asset values had fallen 29.5% through April since their peak in October 2007, according to the Moody's/REAL Commercial Property Price Index.

Shrinking income has left many investors unable to keep up with payments on loan balances that may well exceed their property's value. The volume of commercial real estate in foreclosure, owner bankruptcy and other crises more than doubled to $108 billion during the first six months of 2009, according to Real Capital Analytics.

The reason swarms of distressed owners haven't sold their properties is that today's conservative underwriting for acquisition loans requires adequate debt-service coverage from the outset. In other words, investors can't get loans to buy properties with no cash flow.

Unless a non-performing property carries an assumable loan or the seller can provide financing, buyers must use cash or equity to close. Buyers expect double-digit returns on equity to reflect their risk, but the sums they bid are too small to help borrowers out of their troubles. “On a broken asset, there's hardly any financing available,” Mozer explains. “So buyers have to earn equity-like returns on the majority of their money.”

By the same token, lenders have been reluctant to sell foreclosed properties, which would force them to realize losses. More than 525 U.S. office properties representing almost $18 billion have fallen into distress since February 2008, according to Real Capital. In the first half of 2009, banks sold just 13 of those real estate owned (REO) office properties to third-party buyers.

“The bank will want to get 60 or 80 cents on the dollar of its loan amount and the buyers want to pay 30 to 50 cents, so we're seeing very few deals transact,” Mozer says. “Most of the banks aren't strong enough right now and that's why we've seen this stalemate. They don't have enough profits to offset their losses.”

Lenders will open the floodgates to investment sales when they are strong enough to stomach the losses that will come with selling their real estate owned properties at depressed prices. And thanks in part to government loans to lenders under the Troubled Asset Relief Program (TARP) and other measures to stimulate lending, many banks are beginning to heal.

Credit comeback?

Through the first week of July, the Federal Deposit Insurance Corp. had closed 48 lending institutions, nearly double the 25 it closed in all of 2008. Lenders are growing stronger as a whole, however.

FDIC-insured institutions posted $7.6 billion in net income during the first quarter, the strongest performance of the past four quarters and a dramatic comeback from the fourth quarter's $32.1 billion net losses. While individual performance varied, four out of five banks profited in the first quarter. Troubled loans are weighing on the industry, but net interest income, non-interest income and gains on securities all rose, according to the FDIC.

The London Interbank Offered Rate (LIBOR), which banks charge to lend to one another, fell to 0.6% in June from its peak of 4.8% last October. That shows that lenders perceive diminishing risk, says Jamie Woodwell, vice president of commercial real estate research at the Mortgage Bankers Association (MBA).

Gradual loosening of credit hasn't boosted commercial mortgage origination volume, which continues to fall, albeit at a slowing pace. Origination fell 26% in the first quarter of 2009 after falling 65% in the fourth quarter, according to the MBA. Year-over-year, lending was down 70% from January through March.

Demand for acquisition loans is down and declining asset values have made refinancing difficult, especially for borrowers with maturing debt arranged in the investment flurry of 2006 and 2007. Today's loan-to-value ratios at approximately 60% don't provide enough proceeds to pay off balloon maturities on loans arranged at 90% loan-to-value.

Rather than foreclose on borrowers unable to make their balloon payments, lenders are granting short-term extensions on loans in hopes that healthier fundamentals and asset values down the road will enable their borrowers to refinance.

Economic outlook

How long property owners must wait for rental growth depends on how closely job creation follows gains in gross domestic product (GDP). Employment continues to wither, with 467,000 non-farm jobs eliminated in June alone. The nation has lost 6.5 million jobs since the recession began in December 2007 and the unemployment rate now stands at 9.5%.

At least the negative news is beginning to abate. The GDP shrank 5.5% in the first quarter, slower than the previous quarter's 6.3% contraction, and forecasters expect positive growth by the end of the year. And employment losses have tapered dramatically from the average of 670,000 in monthly cuts that bled the nation from November through March.

In the last two recessions, net job losses continued for more than a year after the economy had established a positive growth trajectory. So even if GDP rallies before the end of 2009, it could take another two or three quarters before employment reverses course, and even longer before companies begin to soak up excess commercial space.

“Gross domestic product may be positive in the fourth quarter this year, but it won't feel like a recovery because the job market will still be declining,” says Bob Bach, senior vice president and chief economist at Grubb & Ellis. “There's a lot of pain to be felt in commercial real estate and that will continue through next year.”

V, U or L-shaped?

The recessions of 1990 and 2001 were U-shaped, or shallow dips in GDP followed by slow growth while employers increased productivity through greater efficiency rather than hiring.

In the downturn of the early 1980s, heavy job losses and limited production depleted inventories of manufactured goods. When pent-up business and consumer demand returned, production and services had to ramp up quickly.

A minority of forecasters believes that the nation is in the midst of the latter type of V-shaped recession, according to Bach. After all, consumers have benefitted this year from tax cuts, larger than normal tax refunds and falling prices. Prices for consumer purchases decreased 1% in the first quarter and 3.9% in the fourth quarter of 2008, according to the Bureau of Economic Analysis. Consumers may be poised to boost spending.

Bach doesn't subscribe to those economic views, however: “I'm in the majority camp of economists that thinks it's going to be a slow and halting recovery because there are still a lot of problems out there.”

What Bach describes is an L-shaped recovery, in which nearly two years of recession and staggering job losses will be followed by below-trend GDP growth of perhaps 2% per year. Why not a return to the historical average of 3% annual growth? Because consumer spending accounts for 70% of the U.S. economy and consumers are reeling.

Retail dilemma

Economists warn that the severity of the current recession will bring a profound change in discretionary consumer spending. Retailers that sold mostly luxury items to middle-class consumers will suffer, as will their landlords, predicts Edward Leamer, professor of management, economics and statistics at the UCLA Anderson School of Management.

“People with relatively modest incomes were buying $2,000 purses,” he says. “Now consumers are rethinking those kinds of purchases. Lower-end retail is going to do better than higher end, and that will be a relatively permanent change.”

Consumers have become thrifty. The personal savings rate hit a 15-year high of 6.9% in May as a percentage of discretionary income, up from zero a year earlier.

“If savings rates continue to get higher, which they really should, the retail sector is going to be troubled for half a dozen years until economic growth brings enough consumers in to support the infrastructure that already exists,” Leamer says.

That mindset will affect tenants in other property types that relied on high-end consumer spending, such as mortgage professionals and title insurers. Even businesses that thrive after the recession may shy away from properties that project an ostentatious image, according to Josh Scoville, director of strategic research at Property & Portfolio Research. “Frugalnomics is the new cool,” he says.

Eyes on the consumer

Investors waiting for the recession to end before moving back into commercial real estate should follow consumer spending as well as real estate fundamentals, says Ben Breslau, research director for the Americas at Jones Lang LaSalle.

“This was a consumer-led downturn rather than a business-led downturn, the first time that's happened since World War II,” he says. “Everybody is thinking about corporate indicators, but consumer credit and consumer confidence are going to be critical for signaling the turnaround.”

June brought a promising sign on the consumer front when Standard & Poor's Case-Shiller Home Price Indices showed that the pace of price declines in the nation's major markets slowed to 18% in April, a slight improvement from 18.7% in March.

Loan watch

The introduction of AAA-rated commercial mortgage-backed securities in the Term Asset-Backed Loan Facility or TALF sends an important message to investors that the government is actively working to repair the financial markets, says Victor Calanog, director of research and chief economist at Reis. “It's critical to play that signaling game right now because the worst thing for the market is uncertainty.”

In practice, federal incentives have had little, if any, direct impact on commercial real estate, says Dan Gorczycki, managing director in the New York office of real estate services firm Savills. “The effect of TARP and TALF on financing in the commercial real estate markets is purely psychological.”

The few deals closing today typically involve an opportunistic buyer and a distressed seller or lender seeking to liquidate a property after foreclosure, according to Ed Padilla, CEO of financial intermediary NorthMarq Capital in Minneapolis.

Those deals often involve buyers with cash or sellers willing to provide financing. The signal that commercial real estate is returning in earnest will be the successful use of acquisition loans, he says.

“When someone is ready to put new equity into an acquisition and someone else is willing to make the loan on that new acquisition, that's when we'll start to see the market turn,” he says. “We're not quite there yet, but I do expect to see some of that by the end of this year.”

There's no question that commercial real estate service providers and investors are struggling, Padilla says, but buying opportunities are coming for investors able to close a deal. “We still view this as an incredibly opportunistic market where a lot of money will be made as these transactions start to occur.”

Matt Hudgins is an Austin-based writer.

Treasuries Defy Fed's Mortgage Strategy

ECONOMIC PREDICTIONS FOR YEAR-END 2009

NREI asked four forecasters to predict the near-term direction of key indices. Here are their responses:

Robert Bach
Chief Economist, Grubb & Ellis

Prediction:
“The economic risk lies in a long, sluggish and halting recovery, not in a near-term spike that ignites inflation.”

Joshua Scoville
Director, Strategic Research, Property & Portfolio Research

Prediction:
“Ironically, the opportunities over the next two years will be much greater than the opportunities investors were feverishly chasing in 2006 and 2007.”

Ted Jones
Chief Economist, Stewart Title

Prediction:
“Gasoline prices at more than $5 per gallon in the next 36 to 48 months, if not sooner.”

Victor Calanog
Chief Economist, Reis

Prediction:
“National office vacancy rates will exceed 17% by the end of 2009.”

Bach:

GDP growth: 0.5%*

Core CPI inflation rate: 1.5%

Monthly job gains/losses: -150,000

10-year Treasury yield: 3.5%

Crude oil ($ per barrel): $65

Jones:

GDP growth: 0.4%*

Core CPI inflation rate: 1.79%

Monthly job gains/losses: 324,000

10-year Treasury yield: 5.32%

Crude oil ($ per barrel): $87.07

Scoville:

GDP growth: 1%*

Core CPI inflation rate: 2.5%

Monthly job gains/losses: 65,000

10-year Treasury yield: 4.5%

Crude oil ($ per barrel): $80

Calanog:

GDP growth: -3.3%*

Core CPI inflation rate: 1.4%

Monthly job gains/losses: -180,000

10-year Treasury yield: 3.6% to 4.0%

Crude oil ($ per barrel): $70 to $75

* GDP figures are on an annualized basis

Treasuries Defy Fed's Mortgage Strategy

Even the Federal Reserve has limits when it comes to influencing benchmark interest rates. Despite federal efforts to keep residential and commercial mortgage rates down, long-term Treasury rates threaten to choke borrowers with a higher cost of capital.

The 10-year Treasury rate, a benchmark for commercial real estate lending, climbed to 3.76% in June from 2.42% in December. Some forecasters say interest rates will climb another 100 basis points or more by the end of this year due to the amount of government debt being issued to finance record budget deficits.

The 10-year Treasury rate, a benchmark for commercial real estate lending, climbed to 3.76% in June from 2.42% in December. Some forecasters say interest rates will climb another 100 basis points or more by the end of this year due to the amount of government debt being issued to finance record budget deficits.

“This is a simple supply and demand issue,” says Sam Chandan, president of Real Estate Econometrics. “If the Treasury increases debt issuance fourfold, for the market to clear, the price of Treasuries has to fall.”

Observers worry that escalating borrowing costs will hinder Washington's attempts to stimulate the economy. The rise in interest rates was enough to prompt the Mortgage Bankers Association to slash its projections for residential and commercial real estate lending volume this year by $700 billion.

In June, the MBA projected mortgage originations this year will total $2.03 trillion, down from a March forecast calling for $3 trillion.

Some forecasters are more sanguine. The 10-year Treasury rate retreated slightly to 3.5% in late June. Bob Bach, chief economist at Grubb & Ellis, expects the rate to remain near that level through the end of the year.

“If interest rates rise, that's going to jeopardize the recovery,” Bach says. “So the Federal Reserve is going to do what it has to do to keep interest rates down.”

The Fed has one hand tied behind its back, however. The overnight Fed funds rate — the only interest rate it can lower directly — is already below 0.25%. The only means available now to reduce long-term interest rates is quantitative easing, or manipulating the supply and demand factors that investors use to determine pricing.

If the Fed can buy up enough Treasury bonds, then investor demand for the bonds still available for purchase will keep yields in check. That strategy has failed to contain Treasury rates, although the Fed has kept down mortgage rate spreads through a similar program of buying mortgage-backed securities (MBS). The Fed has purchased 85% of MBS issued by Fannie Mae, Freddie Mac and Ginnie Mae since the end of the first quarter, according to the MBA.

Those securities are backed by both single-family and multifamily residential loans. The Fed only purchased about half of Treasury debt issued in that same period, however, and may be nearing its self-imposed ceiling of $300 billion for Treasury purchases.

In March, the MBA warned that inflation expectations and a shrinking dollar could make investors shy away from Treasuries, curtailing last year's drop in interest rates and reducing the outlook for mortgage lending. Now, as MBA Chief Economist Jay Brinkman observes in the MBA's revised mortgage forecast, “that has proven to be the case.”