Commercial Messages

Time for a little check in on anecdotal data concerning commercial property prices. Important why? Important for a much bigger reason than the asset class that is commercial property specifically. Before getting a peek at some current data, and what recent trends may be "telling us", a few 30,000 foot preemptory comments, okay? Yes, I know I keep harping on this one like there is no tomorrow, so apologies in advance, but I just cannot shake what is the very important issue of the “tale of two economies” theme. In short, fortunes and business prospects between large and small businesses could not be more divergent at the current time in the domestic economy. We see exactly the same thing when we look at broad US economic consumer wealth demographics. You've seen the stats. The unemployment rate in the top wage decile is roughly 3% while the unemployment rate for the bottom 10% of wage earners is closer to 30%. This issue of divergence is a recurring pattern in the current cycle and one that has been and will continue to influence investment sector and asset class outcomes. So just what the heck does this have to do with commercial real estate? The linkage is found in how stimulus and rescue funds for the financial sector were directed. The "fix" applied by the Fed/Treasury/Administration only acts to reinforce the tale of two economies divergences if you ask me.

We all know the bulk of TARP funds in nominal dollars went to the big banks. We also know that Fed repurchases of MBS, etc. in large part allowed those holding the most product on their balance sheets to rid themselves of this liquidity nuisance. That would again be the large institutions. Guarantees for financial sector M&A were bestowed upon the JP Morgan's of the world (think Bear Sterns), etc. Direct Government equity conversions were seen in outfits like Citicorp, not the community bank around the corner. In fact, it's the proverbial community bank around the corner that is fodder for the regular Friday afternoon follies of the FDIC as the body count of failed small banking institutions simply piles up week after week. Unfortunately, it's these "community banks around the corner" that have been the primary lenders to the small business community in the US over time. Get the picture? Of course you do.

The bailout/stimulus efforts in the financial sector have lopsidedly favored the large banks who are not meaningful small business lenders. All one has to do is look at their earnings reports to see where revenues and profits are being generated. Bailout/stimulus money is being used in good part to bolster trading and spread profits at the large financial institutions in lieu of lending related profits while the small business community in the US continues to gasp for breath. As we also step back a bit and look at the character of loan portfolios across financial institutions, it's clear that small community and regional banks have not only been the key credit conduit to the small business community, but their balance sheets, and ultimately equity, are disproportionately levered to commercial real estate compared with the Too Big To Fail mega banks (who by the way are now more TBTF than ever before). This is the linkage of commercial real estate to the small business community, and ultimately broader systemic economic outcomes in the US.

As smaller financial institutions continue to be negatively impacted by commercial real estate loan portfolio deterioration, their ability, let alone desire, to lend to small businesses diminishes greatly. And that directly impacts job creation, private sector demand, personal income, housing demand, etc. As I see it, this encapsulates the thinking that the stimulus and bailout money has had little impact beyond Wall Street. Hopefully without confusing the situation, this is why monitoring the character of commercial real estate markets is so critical in the current cycle. It's the ultimate impact on small businesses via their access to credit through smaller banking institutions that is the key here, not necessarily property prices in and of themselves. Sorry to drag you through the mud on this one, but this is an important issue deserving of linkage explanation.

Let's get back to the issue at hand. The super folks at the NCREIF (National Council of Real Estate Investment Fiduciaries) released their quarterly national property index probably a month back now. Very quickly, remember that this group is made up of big behemoth pension funds and qualified plans such as CALPER's, TIAA-CREF, etc. These folks hold a lot of commercial real estate as investment assets within their funds and must at least attempt to mark to market each quarter for investment return reporting reasons. Theoretically the property index is comprised of 6000 properties nationwide that cover multiple classes of RE (retail, office, industrial, hotel, and apartment). This is what quarterly reported life has looked like in the NCREIF property index over the last three plus decades. As you can see, 1Q 2010 brought us the first positive reading in six quarters. Happy days are here again? Not so fast.

To properly measure investment returns, the NCREIF crowd incorporates both price AND income (rental cash flow) results to come up with what really is more of a total rate of return composite than anything else. So do not let the "property index" description throw you off if indeed you thought you were looking at price only. The 1Q number? A positive 0.76% return. Of course that annualizes near 3%. Just what are we looking at here? We believe we are watching cash flow as opposed to price change drive the current numbers. The good news is that at least according to the NCREIF folks, price deterioration is moderating after a cumulative 26.4% decline in this index from the third quarter of 2008 (Lehman goes down) to year end 2009. And again, because the index is made up of price change and property specific cash flow to come up with the composite return, the direct inference looking back to the third quarter of 2008 is that commercial property price deterioration alone was certainly greater than 26% loss reported in the index numbers over this period. Easily 30%+ declines in price only. This is the exact set of circumstances taking out community banks in Friday afternoon antics at the FDIC. And this is the exact set of circumstances leading to the tough environment for small businesses to access credit from those very same community and regional banks. Luckily, large bank and investment bank prop desk trading and profits are virtually completely unaffected by just about everything we have described up to this point, right? As a result, the large banks and investment banks are trading their way to financial freedom. The small and regional banks could only be so lucky. Oh well, guess they should have been more generous with those campaign contributions, no?

In the land of anecdotal commercial real estate data, when it rains it pours. Also out with data a month or so back were our friends at Moody's, giving us a quick update on their own commercial property index. This report is a must check in, although coming with a bit of a time lag in terms of reporting, but is monthly data as opposed to quarterly. Moreover, the Moody's index only deals with price, not income or cash flow return. As they state, "The index is designed to track same-property realized round-trip price changes based purely on the documented prices in completed, contemporary property transactions. The index uses no appraisal valuations." By the way, although a bit of a minor point, the NCREIF data is based almost solely on appraisals. Anyway, the Moody's data should be very much real time price data, so to speak. And as you can see, although the current data has only been reported through February, it looks like price has been deteriorating for the period. In truth, very much along the lines of the NCREIF data once income flows are conceptually stripped out.

Sorry to belabor the point a bit here. Bottom line message being commercial property prices clearly are no longer deteriorating at the pace we saw in late 2008 and especially in 2009, but any type of price recovery continues to remain elusive for now. Can we call it stabilization for now? And that again comes back to being the key issue for the community and regional banks who have been and will remain top heavy with CRE loans. No recovery in CRE prices tightens the noose around the neck of the small and regional banks. Price recovery being the key here, not just stabilization, although it's a step in the right direction. How could that not continue to have negative consequences for small business lending and small business activity in general given the primary small business credit conduit that is community and regional banking institutions? I don't know. As I’ve been questioning lately, can the US have a small business-less economic recovery? Again, impact on S&P 500 earnings recovery near term? Negligible, especially while prior period cost cutting is still very much favorably impacting large company earnings. But longer term the small business community is critical for domestic job formation and wage creation stateside. The key for large companies and their forward earnings trajectories will be whether international demand (revenues) can more than offset the potential for domestic weakness ahead, assuming a weak US small business sector impairs domestic consumption growth at some point over the longer term.

In no way am I trying to minimize the fact that a headline economic recovery is here. Likewise, you know that continued small business woes have not and will not influence S&P reported earnings outcomes immediately. Headline earnings numbers are headed higher, in good part driven by the financial sector's lack of mark to market. But I do want to very quickly update, as per the so far released 1Q GDP numbers, a GDP line item considered very important to the tone and tenor of domestic economic circumstances specifically. It's final sales to domestic purchasers. Important why? It's devoid of the quarter over quarter influence of inventories. As of 1Q, we're looking at a year over year growth rate of 1.8%. I consider this a much truer picture of domestic economic rhythm than not. But what is also clear is that the prior period decline in growth rate was unprecedented, and from the depths of that unprecedented bottoming level the recovery so far has been incredibly weak relative to historical experience. Never nine months post a recession finale have we seen growth rate in final sales so weak. The chart below looks at year over year numbers and very much tells the story.

Here are the numbers nine months past each recession of the last half century. In the spirit of honesty and integrity, what is not taken into account here is the impact of price inflation.

If anywhere, it's in real final domestic sales that we hope to see the impact of small and large businesses together, as well as the economic reality of what is for various age and wealth demographics.

One last important issue that will continue to bear down on commercial real estate markets as we look ahead, and that's commercial real estate loan maturities. The table below comes to us from Deutsche Bank data. The commercial RE maturities documented include loans made into the CRE market from banks, insurance companies, and both fixed and variable commercial mortgage backed securities markets. Although they are all lumped together, bank loan maturities specifically account for 70% or greater of total loan maturity volume from 2010-2013. After that it's the CMBS loans that are the bulk of anticipated maturities. You can see the numbers and they are big. Over trillion from now until the end of 2013.

Certainly multiple questions arise. Just how many of these loans can actually be refinanced? As the chart directly below shows us when looking at compound annual rates of return by property class, most transactions and associated loans that occurred from roughly 2005 onward are underwater from a price standpoint. Not good for the wall of CRE loan maturities that lie dead ahead. And again, this comes back to the issue of banks and their ability to support the small business community, or otherwise. As melodramatic as this is sounding, commercial real estate markets will have a direct bearing on small banks and small business economics over at least the next three years.

Is there any good or positive news in the land of commercial real estate? In fact from an investment standpoint there is a bit. The folks at the NCREIF also happen to track property returns in both timberland and farmland related holdings, two valid institutional investment asset classes to which most very large pension funds have exposure. Quarterly returns in both timber and farmland investments look a whole lot different than the headline NCREIF property index. As you'd imagine, the true overriding investment focus in both areas is cash flow, plain and simple. The historic numbers and trends you see below say something about the attractiveness of commodities in general. Yes, timberland as per the NCREIF numbers has taken a hit at the tail end of the last two recessions, but outside of that very few quarterly trips south and really minor when they occurred. Ag sure looks like a consistent return vehicle, no? As opposed to traditional US commercial real estate sectors that are apartments, retail, hotels, industrial and office, farmland and timber more reflect the global economy than the domestic specifically. Is all US based commercial real estate some terrible investment? Not at all.

Even within the character of the domestic components of US commercial real estate we can see the messages of the importance of thinking globally.

The wonderful folks at the Fed released their quarterly lending officers survey a few weeks back. From the peak, the net percentage of banks tightening standards for commercial real estate loans has fallen meaningfully. But the fact that the banks are no longer tightening CRE loan standards remains a far cry from these same folks actively pursuing CRE loan deals. They still have huge CRE portfolios they are nursing, especially the community and regional players. Like residential real estate, the current down cycle for CRE will simply play out over an elongated time frame relative to what we have become accustomed to over the post war period to date. The world will not come to an end. Time is the issue. Do small businesses have the time to wait until small business lenders have healed thoroughly? That's exactly the question of the moment that very much sets the current domestic economic cycle apart in very much a generational sense.