From REI Academy

The question of the day for commercial real estate investors is: What is the effect of a slowing economy and possible recession on valuations? The run-up in values for some sectors has raised alarms, and opinions range from "no more than a ripple" to "impending doom." For investors, there is much to consider in plotting our course.

Along with general economic conditions, valuations in commercial real estate are driven by four factors:

1. Capital availability: Real estate is a capital-intensive industry, and its health rises and falls with capital availability. Currently the capital markets are so flush with cash, they can't find a place for it all.

2. Supply: Boom times typically engender oversupply of product. But construction prices have skyrocketed due to natural disasters and rising commodity prices, which has tempered new building in all property types. That lack of new supply increases rental pricing power and occupancy levels in existing properties.

3. High demand from investors: Stable performance and ample capital have spurred high investor demand, with no letup in sight.

4. Interest rates and the economy: The lone head wind for commercial real estate is higher interest rates and their potentially negative effect on economic growth.

Let's look at the current economic conditions and outlook, the capital markets, and the likely effects on commercial real estate valuations and performance.

Interest rates and the economy

Interest rates are the source of greatest concern among real estate investors. The Fed has expressed their intention to contain inflation at the risk of raising rates too far before stopping.

Another increase in the discount rate to 5.5% in August is widely expected, and the Fed has indicated further decisions will be guided by inflation data. If forecast GDP of 3.4% this year and 2.8% in 2007 comes to pass, the pressure for further increases will ease.

But the Fed only controls the short end of the yield curve. Real estate loans are generally quoted as a spread over the 10-year Treasury bond.

Due to the global capital glut (discussed below) and a tendency for a flight to quality (i.e. government bonds) by investors during a slowdown, there is a strong case that 10-year rates will range from 4.5% to 5%. That is not a crisis in capital by any definition, but will fully invert the yield curve, which is a predictor of recession.

Rising consumer interest rates will further slow consumer spending and the housing market, and may produce the desired soft landing. Best guess is that the economy will continue to cool through year end, with GDP growth possibly falling into negative territory in late 2007.

My working assumption is that a recession is inevitable at some point, and history suggests that's a safe bet. But it doesn't seem to be an immediate prospect, and more important is the reaction of the capital markets to a slowing economy.

Capital markets

Commercial real estate values depend heavily on the availability and cost of capital. Historically, contractions in capital have a negative effect on valuations, and current rumblings from government regulators aiming to trim commercial banks' real estate loan exposure are worrisome.

Banks are experiencing shrinking profit margins due to higher yields on deposits, and many have turned to commercial loans to offset the decline, hence the regulator attention. But before jumping to the conclusion that capital will become scarce, consider the bigger picture.

Global markets are literally awash in capital, all of it seeking yield and stability. Fortunately, commercial real estate offers both, and even if banks are constrained there is a surfeit of capital to fill the void.

Securitized loan originators are steadily increasing market share, now over 25% of commercial lending. Hedge funds are pouring capital into real estate backed securities for debt and equity. Pension funds are increasing their exposure to real estate loans.

Large private equity funds are rapidly expanding, more nimble than Real Estate Investment Trusts (REITs), with none of the regulation, higher leverage maximums, and a vulture mindset. Independent investors have taken advantage of historically low rates to access equity.

The 1031 market continues to thrive, driven by the explosion of Tenants-in-Common (TIC) syndications. For lenders and owners alike, commercial real estate is an enticing play and a secured investment with predictable performance.

Simply put, there is more money than deals. All of these capital sources are under extreme pressure to produce returns, evidenced an ever-expanding array of specialized debt and equity products that extend further out the risk curve every year.

A 100bp rise in average permanent loan rates results in about a 50bp (0.5%) increase in cap rates (bp = basis point; 100bp = 1%), which is easily offset by increasingly creative capital structures.

It is a financial axiom that money flows to where it is well-treated. Commercial real estate has been a very hospitable home for capital, and the outlook is for more, not less. Fall and winter of 2006 is shaping up to be a borrower's market.

In How to Profit in a Slow Economy (Part Two), I will discuss how these conditions affect specific property types, and how to profit from the trends.