Several positive developments are emerging in the real estate capital markets, providing a glimpse of optimism as investor sentiment appears to rebound.
As of December 2009, the average commercial mortgage rate fluctuated between 7% and 7.2%. Spreads over the 10-year Treasury ranged from 360 to 420 basis points, down from a range of 430 to 500 basis points in the third quarter of 2009.
Mortgage spreads for core retail, warehouse and office properties contracted by about 50 basis points. Spreads for apartment and hotel properties remained essentially unchanged over the same period.
Meanwhile, all tranches in the commercial mortgage-backed securities (CMBS) market have rallied appreciably. Spreads on the AAA CMBX index have narrowed by more than 85 basis points over the past three months.
We believe that both mortgage and CMBS spreads will continue to drift downward, albeit at a slow pace, as real estate fundamentals continue to stabilize over the next 12 months.
Despite some improvements in the capital markets, commercial mortgage debt remains both expensive and difficult to obtain. We believe that the lending environment will continue to improve in 2010, including an increasing volume of CMBS originations.
Financing gap continues
Those improvements will not, however, likely be enough to fully accommodate the $1.1 trillion of commercial real estate debt that will mature over the next three years, 2010 through 2012.
With underwriting requirements remaining tight, traditional balance sheet lenders under stress and reluctant to lend, and regional bank failures rising, we expect a continuing financing gap in the market in 2010.
According to Real Capital Analytics (RCA), distressed assets in the U.S. surged to $203 billion as of December 2009. We expect the amount of distress to grow considerably as more loans mature over the next two to three years. The end result could be excellent opportunities for buyers of distressed assets in 2010 and 2011.
Valuations plummet
The total return of the NCREIF Property Index (NPI) declined by 2.1% during the fourth quarter and by 16.8% for the year, the worst annual performance in the 32-year history of the index. Still, this figure is slightly better than the projected 17.5% decline that we made at the beginning of the year.
The income portion of the return was resilient at 6.2%, but prices declined by 22%, a much steeper annual drop than during previous real estate downturns.
National transaction volume across all five property sectors totaled $18.1 billion in the fourth quarter of 2009, improving from $13 billion in the third quarter, but down from $20.1 billion in the fourth quarter of 2008.
The average capitalization rate for all properties sold over $5 million rose 20 basis points to 8.1% in the fourth quarter of 2009, up 80 basis points from the same period a year ago.
Our review of a wide variety of market metrics suggests that commercial real estate transaction volume may be bottoming out. We expect to see more transactions over the next several months as an increasing number of investors look for distressed or undervalued opportunities in commercial real estate.
Job growth is imminent
The U.S. economic recovery gained additional strength during the fourth quarter, thanks to broad-based improvement across most business sectors and geographic regions.
After rebounding by 2.2% in the third quarter of 2009, real gross domestic product (GDP) surged 5.7% during the last three months of the year. Growth exceeded expectations mainly due to a jump in business spending and inventory restocking.
Several significant challenges remain, however, including tight credit and high unemployment. Looking forward, we expect a slow recovery process with a few bumps in the road.
We believe that the fiscal and monetary policies of the U.S. government and Federal Reserve will continue to be flexible and accommodating in 2010, supporting economic growth of 3% over the next 12 months.
Although the U.S. is technically out of recession, the labor market continues to struggle. Since the beginning of the recession through December 2009, a total of 8.4 million jobs were lost nationwide, according to the recent revisions to the employment numbers.
The national unemployment rate climbed to 10.1% in October, and though it has since receded to 9.7%, it remains at the highest level in decades.
Despite these negative indicators, we now see early signs of recovery in the labor market. The four-week moving average of initial jobless claims continues to trend downward, pointing to a deceleration in the pace of layoffs.
Average hourly earnings and the hiring of temporary workers are on the rise. With many firms reporting better-than-expected earnings and moderate sales increases over the past two quarters, we believe we will likely see job growth before mid-2010.
Consumer spending showed encouraging signs of improvement during the fourth quarter, with 2009 holiday sales rising by 2.3% over the depressed levels of the same period a year ago.
Preservation mode
However, U.S. consumers continued to increase savings and reduce household debt in the face of negative wealth effects.
The personal savings rate rose to 4.7% in November 2009, up from 3.8% one year earlier. We continue to believe that consumer spending will likely remain muted until the job and housing markets stabilize.
The December Consumer Price Index (CPI) increased by only 0.1% over the previous month and by 2.7% year-over-year, primarily due to volatile energy prices.
We believe that inflationary pressure should remain subdued over the next 12 to 18 months as a result of relatively weak demand and low capacity utilization.
The combination of a government tax credit for first-time buyers and historically low mortgage rates contributed to increased demand for residential housing over 2009.
The U.S. housing market showed signs of stabilization with the Standard & Poor’s/Case-Shiller home price index climbing modestly for six straight months from June through November.
However, both new and existing home sales declined larger-than-expected in December, suggesting a rather fragile housing recovery.
We believe there is a potential risk of additional home price declines in 2010, if the government stimulus assistance is withdrawn and mortgage rates increase substantially.
David Lynn is managing director and head of U.S. research and investment strategy with ING Clarion based in New York.