I’m often asked for an ex-post review of my prognostications. I can’t disagree because, after all, it would be rather disingenuous to provide forecasts without any degree of back testing. So how accurate was I in 2011? Where did I get it wrong? We’ll see below.
And why, you may be wondering, am I looking back at 2011, not 2012? Many trends that began in 2011 were not completely obvious in 2011 and were only apparent afterwards in 2012.
1. Economic Recovery: Recent evidence suggests that the U.S. economic recovery is gaining strength. Corporate earnings are strong, with record amounts of cash on firms’ balance sheets. Consumers are increasingly confident about the future and are opening their wallets for spending. As of December 2010, the PMI Manufacturing Index has increased for 17 consecutive months. Nonetheless, we expect a sustained recovery, but not a particularly robust one.
Right! The economy did continue to expand and did not go into a double dip. Firms were highly profitable on the back of cost-cutting and kept a large amount of cash on hand. Despite a gloomy economy and high unemployment, the consumer did indeed turn in strong retail spending in 2011. In fact, spending rose 3.3 percent in the first yearly increase since 2008. The rate of economic growth was low as I anticipated—only an anemic 1.7 percent.
2. Residential Housing Market: With the help of government tax incentives, the housing market has shown some signs of stability. However, unlike past recoveries, this sector has not been a positive contributor to GDP growth so far. Rising delinquencies and looming foreclosures could flood the market with additional inventory, causing another 5 percent to 7 percent decline in home prices in 2011. With rising mortgage rates, we don’t expect to see meaningful nationwide home price appreciation until 2012.
Right! Housing prices continued to decline in 2011 as I anticipated—about 5 percent nationwide--hitting the lower end of my forecast. As I forecasted, national home prices did, in fact, begin to appreciate in 2012.
3. Job Growth: During the recession of 2008-2009, the economy lost a total of 8.4 million jobs. In 2010, we regained approximately 1.1 million jobs. Private sector employment has shown decent growth. The gain is encouraging, but still not strong enough to bring down the high unemployment rate, which remains too high for a broad-based and robust recovery to take place. Based on market trends, we believe that businesses will step up hiring in 2011 because of the improved outlook and increased demand. Nonetheless, job recovery will have a long way to go and may not recover to the 2007 peak level until at least mid-2013, according to Moody’s Economy.com.
Right! Employment gains did continue, but the unemployment rate remained stubbornly high because the gains were insufficient to counter the growth in the work force. Job growth to date still has yet to recover all of the 8.2 million jobs lost in the recession.
4. Government and Fed Policies: The Federal Reserve’s second quarter program of purchasing $600 billion in long-term Treasuries and the extension of the Bush tax-cut program have, without a doubt, provided a significant short-term boost to business and consumer confidence. Consumer spending is up and stock market indices are on the rise. However, higher government spending and mounting national debt raise serious concerns of higher taxes, a declining U.S. dollar, and rising inflation down the road. Hence, the exit strategies for the Federal Reserve and the government are critical and may substantially impact the path of U.S. economic growth.
Right! Government policies were a key challenge in 2011 as well as 2012. The dysfunction of government manifested itself poignantly in the form of the so-called fiscal cliff. The government’s inability to effectively address these issues dampened business sentiment and investment while many firms adopted a wait-and-see attitude with respect to major capital and hiring decisions.
5. Inflation and Interest Rates: The latest inflation data suggests low inflationary pressure for now. Several factors are contributing to this, including the high unemployment rate, high worker productivity, underutilized manufacturing facilities, and low-cost imports from emerging countries.
Right! Inflation and interest rates did, indeed, remain low in 2011 as well as in 2012 due to the factors I mentioned in 2011—basically over-capacity, productivity growth and low-cost imports.
6. European Sovereign Debt Crisis: Since the Greece sovereign debt crisis in April 2010, a few other European countries such as Ireland, Spain, and Portugal have also experienced signs of distress. Our view is that many countries in the European Union are challenged with structural fiscal issues and it will take drastic actions and an extended period of time to fix these problems.
The austerity measures recently implemented by many E.U. nations could result in slower economic growth and reduced imports from the U.S. We will likely continue to see headline news regarding European sovereign debt issues over the next few years.
Right! This was correctly one of the key issues for concern not only for the U.S. economy, but for the global economy. The E.U. debt crisis threatened to plunge the world economy into another nasty recession. Much-needed austerity measures have resulted in lower growth and lower imports from the U.S. As I anticipated, the crisis continued through 2011 and 2012 and is far from over.
7. Geopolitical Risks: A few geopolitical uncertainties are posing potential risks. In particular, tensions between Iran and Israel, conflicts between North and South Korea and the possibility of a terrorist attack could cause significant volatility in the marketplace and undermine public confidence. Additionally, the demonstrations in Egypt present risks to regional stability and global stock and oil prices. Although Egypt is not an oil-producing nation, it does contribute to the distribution of oil.
Right! I suppose it isn’t hard to be right on this concern as a geopolitical risk is always omnipresent in our increasingly interconnected world. The risks I identified for 2011 were certainly top of mind for governments and firms alike.
8. Capital Market Environment: The commercial real estate capital markets have improved remarkably over the past 18 months. Lenders, especially life insurers and foreign banks, have re-entered the commercial mortgage market, creating more choices for borrowers as well as lower mortgage rates and higher loan-to-value ratios for high-quality assets. The commercial mortgage-backed securities (CMBS) market has also shown signs of life with new securitizations totaling $11.6 billion in 2010, a three-fold increase compared with 2009. With the gradual improvement in financial conditions and less stress in financial institutions, we expect that lenders will increase their risk appetite and be willing to extend more credit in the commercial real estate sector. The upward trend in the CMBS market should continue, and new securitization volume could reach $40 billion to $50 billion in 2011. However, this amount is still a fraction of $230 billion issued in 2007, the peak of the last real estate boom.
Mostly Right! Commercial real estate credit markets did improve remarkably in 2011. There was renewed confidence on the part of lenders in making loans for commercial real estate. CMBS issuance did strongly rebound—up to 32.7 billion in 2011 (from $12 billion in 2010). However, short of my estimate, the concerns of a softening economy blew out spreads, which dampened origination activity in the spring of 2011.
9. Loan Maturities Maturing commercial real estate debt remains a daunting challenge facing the industry. Over $1.1 trillion of debt is scheduled to mature from 2011 through 2014. Many portfolios and assets are in dire need of equity to recapitalize, creating pressure on the part of owners to sell, likely at distressed pricing. However, as a result of “pretend and extend” practices by lenders, we have not seen many distressed sales. It is estimated that approximately $400 billion of new equity is needed for recapitalization. We believe that most lenders are under little pressure to foreclose and take mark-to-market losses. Thus, they will likely wait for improved market conditions to unload assets from their books. We expect the deleveraging process will continue to be more or less orderly throughout the remainder of 2011, quite a different scenario from the market clearing made possible by the Resolution Trust Corp. in the early 1990s.
Right! “Pretend and extend” did rule the day in 2011. Low interest ratesremained and lenders eagerly delayed recognizing losses on their books and initiating foreclosures. As I predicted, distress as manifested in market transactions was lower than generally expected. The deleveraging process was orderly and progressed with hardly anyone noticing.
10. Real Estate Fundamentals: 2010 was a transition year for commercial real estate with vacancy rates of all property sectors bottoming. Corporate tenants are taking advantage of lower rents to “right size” or consolidate their space. As a result, leasing activity has surged over the past three quarters. Nonetheless, large shadow inventory still remains a challenge, especially in the office sector. In this past downturn, many big companies went through large-scale layoffs without shedding significant spare space. The pace of occupancy recovery could be moderate as a result. We believe that the commercial real estate recovery will largely depend on the strength of the labor market. While we are optimistic about the outlook for the industry in 2011, the recovery in net operating income (NOI) could be slow over the next 12 to 18 months, except for the apartment sector, which will likely continue to experience strong NOI growth. Overall, we believe that we are in the early stage of the next real estate up cycle. In 2010, the global search for yield put rapid downward movement on the cap rates of institutional-quality properties in primary markets. With improving fundamentals, we believe the commercial real estate market will attract significantly more investor interest and new capital. Investment activities will likely expand beyond the traditional core into the lesser-quality assets and secondary markets in 2011.
Right! Real estate fundamentals continued to improve in 2011. Vacancies in the office sector remained stubbornly high because of high unemployment and concerns by firms about the strength of the economy. Yes, 2011 was in fact the second year in the ongoing real estate recovery cycle that continues today. The apartment sector exhibited the strongest fundamentals as anticipated. Core activity remained strong, but as predicted, because of fierce competition for core assets, there was growing interest in class-B and class-C assets in secondary and tertiary markets, particularly for multifamily and retail.
David J. Lynn, Ph.D., is chief investment strategist with Cole Capital.