The U.S. economic recovery is very important to the commercial real estate recovery. As the economy recovers, corporate revenues will grow and companies will make profits. These profits will allow hiring to resume and as unemployment shrinks, people who get good jobs will resume renting apartments, buying residences and the companies that expand, will need more office space. Our commercial real estate fundamentals will improve and we will all be in a happy place once again.
How is the economy doing?
Equity markets have rallied, credit spreads are much better than they were a year ago and U.S. employment is showing signs of easing. The banking industry is making profits and consumer spending in November was up 1.3%, substantially better than the 0.7% that was projected. In the third quarter of 2009, GDP grew by 2.8% (revised down from an initial announcement of 3.5%). The housing market has expressed some positive signs as inventory is decreasing and it is suspected that as manufacturer’s inventories shrink, factory output will increase to restock bare shelves. In fact, the Institute for Supply Management reports that manufacturing had expanded for three months in a row. This may all sound pretty good but let’s not get too excited.
With regard to GDP growth, following postwar recessions, real growth, in the four quarters after the recessions were declared over, averaged 6.6%. During the five years following those recessions, the average growth rate was 4.3%. While growth was 2.8% in the third quarter and is expected to be about 3% in the fourth quarter, most economists project growth to range from 1.5% to 3% for all of 2010. If growth is limited in this fashion, it will be a new event for our postwar economy. There has not been a single deep recession that has been followed by a moderate recovery.
This may no longer be the case. The recession we have just emerged from (many believe we are still in the recession) lasted a record seven quarters and experienced a near-record average GDP decline of 1.8% per quarter. Based upon this, and history, we should be witnessing the start of a powerful and sustained recovery. However, all signals and projections from economists are that the recovery will be subdued at best.
Why all of the pessimism? There are economic reasons that support this pessimism and there are some philosophical reasons.
There appears to be a growing fear that the federal government is retreating from the free-market economic principles of the last 50 years. We have seen tangible evidence of this in many ways, most notably the anti-business and anti-Wall Street sentiment in Washington.
Some argue that the $787 billion stimulus was successful in that things did not get worse than they did. Others argue that only $86.5 billion of the stimulus money was targeted towards encouraging broad-based private investment and thus failed to stimulate true economic growth. With interest, the stimulus will cost the taxpayers $1.1 trillion. While this spending succeeded in temporarily and marginally increasing disposable personal income, it left personal consumption spending virtually unchanged.
Given the massive deficits created by the printing and spending of money in Washington, taxes will be going up across the board. We will see this in marginal income tax rates, capital gains rates, dividend rates and death-tax rates. Almost everyone will pay more taxes – significantly more. Hardest hit by these increases will be the new and small businesses whose investment and hiring decisions either drive or starve recoveries.
Business investment may be curbed due to the uncertainty created by extraordinary events like the administration’s intervention in the GM and Chrysler reorganizations. The mechanisms used by the government upset decades of accepted bankrupcy law by placing unsecured and lower priority creditors, like the United Auto Workers, in front of secured and higher priority creditors. This intervention has arguably had the effect of stifling investment as wary investors watched political considerations cast the rule of law aside.
Corporate earnings have been positive causing the equity markets to rally. However, earnings have been created by cost cutting and the productivity gains which generally follow prior to real recovery in the form of growing revenues. Thus far, revenue growth has been disappointing. Therefore, growth in corporate output will be far lower than what would normally be expected in a solid economic recovery. A crucial reason for this is the fact that bad assets on institutional (as well as personal) balance sheets are like a ball and chain strapped to the economy.
Near-zero interest rates are also creating some potential problems for our market. More than a year after the heart of the panic, the Fed is still promising near-zero interest rates for an extended period. They are buying over $3 billion per day of expensive mortgage-backed securities as part of a $1.25 trillion purchase plan. With the system somewhat stabilized, the Fed hopes that artificially low interest rates and its purchases of MBS will stimulate growth. Instead, they are pushing dollars abroad and wasting precious growth capital in asset and commodity bubbles.
Ironically, the near-zero rate policy, coupled with Washington’s preference for a weak dollar, has created a glut of American capital in Asia and other foreign markets as corporations and investors borrow in dollars and invest in other currencies and foreign assets. This creates a shortage of capital in the U.S. For small businesses and new workers this capital rationing is devastating, advancing business failures and painful layoffs. Thousands of start-ups won’t launch due to credit shortages.
In a ninth consecutive decline, consumer lending shrank at an annual rate of 1.7% in October. This extended the dramatic evaporation of financing available to help fuel the economy. The $3.5 billion decline, calculated by the Fed, results in a 4% drop in consumer lending from its July 2008 peak. As our economy is 70% consumer based, curtailed lending to consumers could harm the chances for a strong recovery.
Moreover, it is not just consumers having trouble borrowing. Notwithstanding the perception that the economy and financial markets are recovering, many companies lack easy access to borrowing. All of the debt overhanging consumers and companies is the pivotal reason that we are seeing a free fall in bank lending. The nation’s lending markets have changed significantly as they adapt to post-crisis realities.
Markets where the U.S. government is either a big borrower or a defacto guarantor are ballooning. Simultaneously, corporate lending and consumer finance markets have shriveled. A Wall Street Journal report shows that these markets have shrunk by 7%, or $1.5 trillion, in the two years ending October 31st. The result of tighter lending is that consumers spend less and businesses are more reluctant to hire and invest.
Some of the decline in lending is due to lower demand as borrowers focus on paying down debt that they already have. In the past 25 years, household debt has exploded. It is now 122% of total disposable income, up from just over 60% 25 years ago. At the end of the third quarter of 2008, household debt began to decline as Americans started belt-tightening.
The most recent data shows that credit tightness peaked earlier this fall to the worst levels in 23 years. What we are all enduring, and what small businesses, workers and consumers continue to be pummeled by, is the dismantling of the great credit boom of the early 2000’s. This grueling, but necessary, deleveraging began last year and is now in full swing. We are seeing it in our investment sales market and expect that it will continue for 2 to 3 years as we face today’s problems and anticipate 2006 and 2007 vintage loans maturing.
In October of 2008, bank credit peaked at $7.3 trillion and is now down to $6.72 trillion. Banking sector debt, it is estimated, must fall by another $2 trillion or so and this should take over 2 years to complete. Since the peak, this 8% drop is enormous and it is accelerating. By comparison, the peak-to-trough drop during the Savings & Loan crisis in the early 1990’s was only 1.3%.
The last thing the central bank wants is a decline in the broad-based money supply. The Fed’s asset purchase program is not only about driving down mortgage rates. It is also about trying to prevent a collapse in the money supply. When the Fed buys assets, it creates deposits which, in turn, helps offset the reductions in available credit. If deleveraging and the credit contraction does last a couple of years, and if the Fed is interested in offsetting it, they will have to continue to buy assets through next year. Presently, they intend to stop the purchases well before that.
It appears clear that the economic recovery will not be as strong as history suggests it should be. We have a long way to go before we get back to above trend growth. The recovery in the commercial real estate market will come on the heals of the economic recovery as we generally lag behind the economy. As lenders put off dealing with the problems imbedded in their balance sheets, the recovery simply slows down and credit markets remain soft. I certainly hope the recovery evolves more quickly and forcefully than it appears it will. Our commercial real estate markets could use the help.