Real Estate Bulls Versus Bears Battle Intensifies (part 1)

 As we have progressed through the recent recession and entered recovery mode, I have observed an interesting change in participant’s perspectives on where we are headed from here. Up until a couple of months ago, it seemed like there was consensus within the commercial real estate sector regarding the direction of things to come. We felt the effects of high unemployment and a degrading of our fundamentals. From late 2007 through the beginning of 2009, we knew things were going to be difficult with transparent downward pressure on rental rates and property values. The health and direction of these metrics have always been, and remain, linked to aspects of the broader economy.Lately, it appears those who are optimistic (the Bulls) are becoming much more optimistic and those who are pessimistic (the Bears) are becoming much more pessimistic.  Generally, participants in the market are relatively more optimistic than they were one year ago as evidenced by the many “investor surveys” that have been published since the beginning of the year. However, some optimists are seeing nothing but blue skies and some pessimists are now nearly guaranteeing that things will get much worse as our economy and our real estate market double-dip.This week, I want to begin looking at various aspects of our economy and discuss what I am hearing from both the bulls and the bears. There are about a dozen aspects I will address so this will be a multi-part column which will continue for another week or two. More importantly, I would appreciate hearing from StreetWise readers about your perspectives on our current market how you see things evolving over the next two to three years.  Are you a bull or a bear? Let’s see what others are saying:1) Inflation:  The level of inflation in the economy is important to watch because, if inflation rises above the Fed’s comfort level of 1% to 2%, Chairman Bernanke will likely raise interest rates in response. This increase in interest rates would likely translate into higher lending rates at banks which would exert downward pressure on commercial real estate values.The Bulls: The bulls see inflation as being in-check with far too much deflationary pressure in the system for inflation to be a concern in the short to medium term. Unemployment remains high, consumer spending is moderate and demand for consumer credit is very low. The bulls are not concerned about inflation at all.The Bears: The bears are concerned about inflation, not in the short-term, but definitely in the medium and long-term. With the U.S. government doubling our money supply in 2009 (which was higher in dollar amount than the aggregate of money supply increases over the prior 50 years!), the bears believe there is no way that inflation will not creep into the economy. If the bears are correct, rates will be increased which will exert downward pressure on values.2) Housing:  The U.S. housing market is important to watch because, for most Americans, homes represent their largest asset. As property values increase, there is a wealth effect which greatly impacts consumer spending which still represents about 70% of our Gross Domestic Product. As equity levels rise, homeowners can tap into this “savings” through mortgage equity withdrawal (MEW). MEW was a major reason (along with credit card usage) why the savings rate in this country dropped to -4% (yes, negative 4 percent) a few years ago. Even if MEW was not used, the wealth effect of large amounts of perceived equity encouraged consumers to spend more than they would have otherwise. Given the influence of the consumer on our economy, the performance of the housing market must not be overlooked.The Bulls: The bulls believe that the housing market has bottomed and a recovery has begun. And I am not referring to the National Association of Realtors who have been publishing optimistic press releases consistently over the past 15 months (many based upon just one month’s worth of a statistically insignificant data) insinuating that the market had bottomed even as values continued to drop like a stone.  Chip Case, of Case-Shiller fame, recently stated that he believed the housing market had bottomed and that he expected values to rise throughout 2010. Others in the market, while having a self-interest to portray a recovering housing sector, have presented compelling data that foreclosures are down and values are rebounding. The bulls also point to the fact that we have been in a sustained environment of low housing starts for an unusually long period of time. For nearly two years, housing starts averaged about 450,000 on an annual basis, well below the stabilized long-term average of about 1.3 million. The interesting thing about the 450,000 number is that the U.S. market looses 300,000 to 500,000 homes each year due to natural disaster or obsolescence. This housing start data will bode well for supply / demand dynamics moving forward, the bulls say.The Bears: The bears see a double-dip in housing on the horizon. They say foreclosure activity has been artificially curtailed by various government programs and pressure the government has placed on lenders to “go easy” on homeowners who are under water. This has kept foreclosure numbers well below their natural level and, without unemployment reversing and income levels rising, defaulting homeowners have little hope of reversing their fates. The loan-modification programs have been a disaster for the government as less than 200,000 mortgages have been permanently modified (as opposed to the 4 million target) and more than 70% of the loan temporarily modified fall back into default within 6 months. The bears also see a market completely propped up by the government. The first-time homebuyers tax credit (now expanded to include some non-first time homebuyers) gave an $8,000 credit to buyers when the 3.5% FHA downpayment on the average U.S. home ($178,000 last month) is only $6,230. Here the government is handing the buyer a deed and a check for $1,770. The bears say this is what precipitated the problem in the first place. Between Fannie Mae, Freddie Mac and FHA, the government guarantees 92% of all home loans in the nation. As unemployment remains elevated, which most economists are predicting through 2011, the likelihood of further housing value declines seems inevitable to the bears.3) The Fed’s Exit: The Federal Reserve Bank has doubled its balance sheet in the past 18 months. At some point the Fed must withdraw its support and the implications of this on our commercial real estate market could be significant. The Fed’s exit can occur in only four ways. 1) They can stop buying assets. Last year the Fed pledged to purchase $1.3 trillion of assets which were mostly in the form of mortgage backed securities and treasuries. The intent here was to exert downward pressure on interest rates. Most of the $1.3 trillion has been spent and this program is scheduled to cease at the end of this month.  2) They can sell the assets that they have purchased. Again, these were mostly mortgage backed securities and treasuries. 3) The Fed can raise the federal funds rate. 4) The Fed can drain excess bank reserves from the system. Numbers 1, 2 and 3 will exert upward pressure on interest rates while number 4 will reduce the pool of available capital that could be used to make commercial real estate loans. Whether the Fed will exit or not is not disputed. What is remains the timing of the withdrawal and its impact. This is where the bulls and the bears differ.The Bulls: The bulls acknowledge that the Fed will exit and that it will cause upward pressure on interest rates. They believe that the increases in rates, however, will have minimal impact on commercial real estate values as the banking industry will be willing to compress spreads more quickly than they will be willing to pass along higher lending rates to borrowers. They also believe that the draining of excess bank reserves, which presently stand at about $800 billion, will have little impact as banks are not lending these reserves now anyway. “So what if they drain from a pool which is untouched” the bulls claim. They see this as tactical and not impactful on commercial real estate.The Bears: The bears see the Fed’s exit as putting significant pressure on interest rates to rise and they believe these increases will have a significant impact on mortgage rates. The Fed’s highly accommodative monetary has allowed the banking industry to recapitalize itself as they are borrowing at close to zero and, if they are lending, spreads can be 600 or 700 basis points depending on the product. If banks choose not to lend, they can simply purchase risk-free treasuries and make 250 to 350 basis points depending upon term. Many bankers indicate that they will compress these spreads to absorb interest rate increases of 50 to 75 basis points but, above that, the increases will be passed along to borrowers. Higher commercial mortgage rates mean downward pressure on value. The bears also see the draining of excess reserves as a negative as lending volume will return at some point. When it does, commercial real estate will be competing with other asset classes for this debt and to the extent there is less capacity in the system, there will be less available for office buildings, retail properties and apartment complexes.In subsequent parts of this topic, we will look at deleveraging, unemployment, interest rates, GDP growth, corporate earnings, capital “on the sidelines”, financing, cap rates, supply and demand, and rent levels. If there are other topics you would like me to address here, just let me know.More to come next week on StreetWise………Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.