Like the rest of the economy, commercial real estate is awaiting a rebound in the job market. The Federal Reserve has served notice that while it likes the productivity gains under way, it doesn't like the temporary job losses that are accruing because those losses could lead to a consumer psychology of deterioration and outright deflation.

That is the reason the Fed has been adamant about exorcizing the deflation demon before it even appears on the scene. It is the basis of its current accommodative interest rate policy that has led to the lowest rates in 45 years. It is the Fed's expectation that these low rates will be irresistible to business borrowing. That will help restart business fixed investment, of which commercial real estate is a significant part.

Unfortunately, we don't expect the commercial real estate sector to feel the benefit until 2004.

Why Job Growth Is So Critical

Employment growth supports increased consumer spending and demand for retail properties. Likewise, job growth supports demand for office space, encourages growth in travel and helps boost the hotel sector. Job growth encourages household growth and, as a result, demand for rental properties. In fact, jobs are important to nearly all types of commercial real estate.

It's not that the economy isn't growing at all. The Gross Domestic Product (GDP) grew 1.9% on an annualized basis in the first quarter of 2003, following growth of 2.4% for full-year 2002. It just feels bad. Why? Those growth rates are well below the economy's capacity for growing between 3.5% and 4% annually.

The struggle between feeling bad and good about the economy's recovery is driven by the manufacturing sector. Profits of manufacturing firms fell by 48% two years ago and only rebounded 11% last year. As a result, companies have been struggling to cut costs and have been holding back on investment until the profit picture improves. In order to cope, manufacturers have been shedding jobs while achieving productivity gains. Since June 1998, the manufacturing sector has eliminated about 2.9 million workers. In the first quarter of 2003, manufacturing lost 279,000 jobs and lost another 83,000 in April and May. No wonder it feels bad.

Ironically, during that time frame, total U.S. employment has risen by 3.8 million workers. However, the size of the workforce also has grown, so the combination of slow job creation with outright job losses — 337,000 so far in 2003 — means that the unemployment rate has risen from a low of 3.9% to the current 6.1%.

The Fed's Motivation

The Fed does like the productivity gains the economy is experiencing. Efficiency gains have been substantial in the entire economy and are a good sign for long-term economic growth. That will be good for commercial real estate in years ahead. In addition, the productivity growth has resulted in continued real-income growth for those workers who have remained employed throughout the period of slow economic growth.

The short-run problem with the efficiency gains is that in a slow economy, businesses don't have the incentive to invest in new plant and equipment. Given the sluggish recovery, private fixed investment in the U.S. declined 3.8% two years ago and another 3.1% last year. The business buildings part of such investment took an even worse hit last year, declining 16.4%. There is no trend for improvement yet.

The Fed's reaction to the current business climate has been very interesting. In March it voiced the following memorable phrase: “In the current circumstances, heightened surveillance is called for.” Loosely translated, that meant the Fed didn't have any idea how the economy was going to react to the war in Iraq, so it was going to watch with the rest of us. It seemed reasonable because we had been speculating that the business sector simply saw current risks as too great to be launching any expansion plans. The Fed left interest rates unchanged.

Then in May, the Fed said, “In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” In other words, the Fed was sending a clear message: “We intend to act against deflation, and that means interest rates should fall.” The bond market got it right, and rates fell. For the previous 12 to 18 months, the Fed had been carrying on a theoretical discussion of the implications of deflation, but this inclusion made it an active policy issue. It's intent was to make rates fall, and they did. Of course, this has also extended the horizon over which rates should stay low.

Adapting To the Marketplace

So, with businesses not ready yet to finance the construction of new buildings, what is a commercial property market participant to do? Developers, owners and managers are supposed to control costs, monitor the financial health of tenants, intervene as problems develop, promote the relative value of real estate as opposed to its absolute value, look for cheap assets to emerge and act opportunistically.

And what is a commercial lender to do against the current economic backdrop? Refinance existing loans, of course. As a result of these historic low interest rates, commercial mortgage lending volume was very strong last year and that momentum has extended into 2003. Loan originations for commercial and multifamily loans rose 38% during the first quarter of 2003 compared with the same period a year ago.

Meanwhile, first-quarter conduit CMBS fundings rose 86% over the same period a year ago with commercial banks up 50%. CMBS conduit was by far the largest investor class, with 36% of the total volume in the first quarter. Credit companies and pension funds also registered healthy year-over-year increases. Life companies and commercial banks purchased 17% and 15% of the loans originated by the reporting lenders, respectively.

Will the number of loan delinquencies keep climbing? Commercial markets have not quite bottomed in terms of loan delinquencies, but the bottom is in sight. We expect delinquencies to rise modestly the next couple of quarters. The bottom as far as demand — including vacancies and rents — is near except for multifamily. The bottom for multifamily will not occur until mid-2004. The bottom for other commercial properties will be late 2003, as we start to see a ramp-up of business fixed investment in the corporate sector.

What's Next?

The Fed is going to be on the sidelines until mid-year 2004 after cutting rates at its June 2003 meeting by another 25 basis points. Fed Chairman Alan Greenspan made a strongly suggestive comment in this regard to a banking audience in Europe because Germany is near recession and the potential of a worldwide slowdown offers an opening for deflation that he wants to close. That means rates could fall, but will stay low for some time.

The tax cut recently signed into law will also create some jobs. Commercial markets are starting to show the wear and tear of the sluggish economy and await the arrival of jobs before strengthening. In the interim, refinancing will have to carry the day for commercial mortgage lenders.