In recent months, the U.S. government has intervened in the economy on an unprecedented scale. Recent Bloomberg calculations put the total value of all the loans or commitments at an astounding $12.8 trillion. Of that, about $4.2 trillion has actually been spent. Within that total, specific pieces of the intervention are of particular interest to the retail real estate sector. The $787 billion economic stimulus package of tax cuts and infrastructure spending hopefully will provide at least a little boost to moribund consumer spending. More recently, the Treasury Department and the Federal Reserve Bank have warmed to the notion that commercial real estate financing requires a helping hand. Late last year, $900 billion Term Asset-Backed Securities Loan Facility (TALF) was expanded to include commercial mortgage-backed securities (CMBS). And in March, the Treasury Department unveiled a $1 trillion plan to help clean up banks' balance sheets and boost lending, including a program for increasing the sale of some existing CMBS.
The question: Are these measures enough to help revitalize the retail real estate sector? The programs could affect two important areas. The stimulus package and President Obama's proposed $3.6 trillion budget could stimulate consumer spending. Meanwhile, an alphabet soup of programs emanating from the Federal Reserve Bank and the Treasury Department aimed at the financial system have the potential to bring the dormant CMBS sector back to life.
According to many experts, however, the trillions of dollars being thrown at these problems may not be enough. For example, Ross Glickman, CEO of Chicago-based Urban Retail, isn't planning on buying any new suits in celebration. He feels that neither lending nor consumer spending are going to pick up significantly for at least another two years. And it could be five to ten years before the retail real estate industry as a whole fully recovers. "I'm a lot more conservative now, just like everyone else," Glickman says.
Glickman is hardly alone in his queasiness. With national unemployment at 8.5 percent, a fourth-quarter annualized GDP decline of 6.3 percent, tight credit and a moribund CMBS market, few industry experts predict that the federal government's recent moves will have much of a near-term effect. While the government's stimulus package may help boost the economy and slow the pace of job losses, it's likely to make the situation less bad rather than better.
They add that, while the Treasury's recently announced Public-Private Investment Partnership (PPIP) could be an important step in stabilizing the CMBS market, the progress will be slow and modest. For the industry, it means that retail sales will remain low and vacancy rates will stay high—perhaps for years—putting further pressure on rents. Property values are off by as much as 35 percent according to some estimates. And, without significantly improved income, many owners will face the prospect of defaults as mortgages originated over the past seven years under very generous terms come due in a greatly altered lending environment.
At the same time, there are a handful of experts who see reason for hope. They feel, for example, that the government's moves to encourage the sale of depressed assets could have positive results. Tightening spreads and significantly improved bank balance sheets will free up credit and boost the ability of companies to expand, they say. "Generally, if you inject leverage into a system starved for capital, it will be beneficial to some extent," says Lisa Pendergast, managing director at Greenwich, Conn.–based RBS Greenwich Capital.
Certainly, a host of recent macro statistics have not been encouraging. Start with the GDP. Many experts expect the fiscal stimulus package to have only a moderate effect on GDP growth. And, because the pre-bust economy was so dependent on consumer spending, accounting for 70 percent of GDP, the pickup could be particularly sluggish. As it stands, retail sales, not seasonally adjusted, were down an astounding 12.8 percent year over year in February, according to the U.S. Census Bureau. That's the largest year over year drop since the Bureau began tracking the series in 1992. And don't look for too much relief any time soon. "It will take a while for consumers to react to the stimulus package," says Abigail Marks, an economist with CBRE/Torto Wheaton Research, a Boston-based research firm. "It's going to be a slow recovery." Projections for GDP range from a 1.2 percent drop in 2009 and 3.2 percent increase in 2010 (Office of Management and Budget) to a 3 percent decrease and 2.9 percent increase in those years (Congressional Budget Office).
What's more, in a vicious cycle, consumer spending has slowed because people are worried about losing their jobs. But, as sales continue to plummet, more job losses mount. In February, 104 metropolitan areas reported jobless rates of at least 10 percent, according to Real Estate Economics, a real estate research firm in New York. In March, 16 states, plus the District of Columbia had unemployment rates of 9 percent and above. Real Estate Economics predicts the overall unemployment rate will climb to 9.6 percent in 2009 and 10.1 percent in 2010. That's within shouting distance of the post–World War II peak of 10.9 percent reached in December 1982. What's more, including part-time workers looking for a job and discouraged workers, the so-called underemployment rate is 15.8 percent, according to the Bureau of Labor Statistics.
In the housing market—where the economic downfall began—there are also continued signs of weakness. Metropolitan single-family home prices have continued to decline, according to the S&P/Case-Shiller index for March. All 20 metro areas had monthly and annual decreases for four months, off 30 percent from their peaks.
As for consumer credit, while it grew at an annual rate of 0.8 percent in January, following a decline in the fourth quarter, the terms of credit tightened. For example, for new car loans, the average interest rate increased from 4.85 percent in the fourth quarter to 8.32 percent in January.
For shopping centers, which have been on the front lines of the downturn, analysts expect a difficult time for at least another two years. In neighborhood and community centers, for example, Torto Wheaton sees historical lows in demand for space—a 3.5-million-square-foot loss in absorption for 2009—as more in-line stores close and even grocery stores reduce their demand for space. Rents should decline about 1.9 percent this year. And, while absorption should become positive in 2010, rents are unlikely to increase, thanks to a significant amount of still-vacant space.
What's in the programs?
The statistics are grim. So just how much can the Obama administration's economic programs help? There are, of course, two parts to the puzzle: programs aimed at reviving the financial system and boosting the ability of banks to start lending again, and those targeting the economy, unemployment and consumer spending. For the former, the most significant program is the recently announced Public-Private Investment Program (PPIP) (see box above). Private investors are still trying to get their heads around the details and have been slow to react. Here's how experts understand it so far. Announced in detail in March, it aims to jump-start lending by eliminating banks' problematic assets, which it calls "legacy assets," including AAA-rated CMBS bonds and commercial real estate loans. The hope is that the promise of $75 billion to $100 billion in government funding will encourage the private sector to boost the prices of "legacy assets" and "free financial institutions of the dead weight they're carrying," says Sam Chandan, president and chief economist for Real Estate Economics.
The most vexing issue for months has been that no one knows how much these assets are worth. So the most fundamental goal of the programs is establishing a price for these assets that all parties can agree on—and that pays banks enough money to permit them to start lending again. Whether that happens, of course, is far from certain. One key element, according to Steve Miller, director of debt research and analysis for Boston-based real estate research firm Property & Portfolio Research, is whether the Treasury will step in if private buyers aren't willing to pay a high enough price. "They need to manage the process efficiently," he says. "They can't leave it to the private sector to set the price."
There are two elements to this program. Through the Legacy Loan Program (LLP), the Federal Deposit Insurance Corp. (FDIC) will auction off pools of loans identified by banks. The government will support financing at a 6:1 debt-to-equity ratio and the Treasury will fund 50 percent of the required equity investment. The net result for private investors is they'll have to put up roughly 8 percent of the equity. That limits private sector risk while leaving the potential for an outsized reward.
If successful, the LLP would establish a price for the bank assets that bidders and sellers can agree on, in addition to helping to clean up banks' balance sheets. For commercial real estate lending and CMBS it could also mean good things. "Better bank balance sheets will help the CMBS market," says Matthew Anderson, a partner with Foresight Analytics, an Oakland, Calif., consulting firm.
The CMBS market has been at a standstill for more than a year. According to Commercial Mortgage Alert, there has been no CMBS origination in the U.S. since July of last year. For the entire 2008 calendar year, CMBS origination totaled $11.1 billion. Clearing out the backlog is essential if the securitization machine is going to get moving again.
The other element, and the one most relevant to CMBS lending, is the Legacy Securities Program (LSP), which is designed to help the liquidity of legacy securities that are not in high demand. It has two channels. Sometimes called TALF 2.0, it expands that program to include thinly traded legacy non-agency RMBS and AAA-rated CMBS, for which the Federal Reserve will lend the money at low-interest rates. The other channel is a group of five funds, through which the Treasury Department will match private capital investments.
Response to the initial TALF program has been underwhelming, however. For the second round of funding in April, loan requests were around $1.7 billion, down 64 percent from the first round. Overall, subscriptions have amounted to just $6.4 billion in the program's two months. Neither one included CMBS. The low volume "doesn't bode well for other programs that are structured in similar ways," says Chandan.
But the market welcomed TALF 2.0 with open arms. In the wake of the announcement, fixed-rate CMBS spreads across the credit spectrum improved considerably. The Lehman 7+SD AA index, for example, tightened by 175 basis points, from 1,161 basis points to 986 basis points and CMBI AAA 6- to 10-year changed from 11,238 basis points to 11,018 basis points. As for the CMBX—indices created from CMBS pools—all five series tightened, with the exception of BBs. And, according to some analysts, the good news will continue. "We expect the securities program to perform well, pushing spreads to inside 600 basis points," says Pendergast. A report from JP Morgan Securities was more definitive. "We think this program could first stop, then reverse, the negative feedback loop of declining asset prices and de-levering," it said.
In addition, there have been other tentative signs of improvement in the credit markets. For example, investment-grade corporate bond sales rose to $200 billion in the first quarter from $188 billion the year before, according to Thomson Reuters, though much of that came from pharmaceutical companies funding acquisitions. U.S. junk bond sales grew to $10.8 billion from $5.9 billion during the first quarter this year compared to the same period in 2008. And the London interbank rate—LIBOR—dropped to 1.16 percent in March, from 1.27 percent the month before. Several months previously, the rate hit as high as 4.8 percent. What's more, interest rates on a fixed 30-year mortgage fell to 4.61 percent for the week ending March 27, compared to 6 percent the year before, according to the Mortgage Bankers Association. Lastly, the TED spread, a widely watched indicator of credit market liquidity, has fallen back below 100 basis points after peaking at 464 basis points in the fall. (In a normally functioning market, the TED spread is typically below 50 basis points.)
But there are many questions about the potential for both the private sector and government when it comes to the PPIP. Most important for the LSP and the CMBS market is the length of the government's loans. Currently, the loans are set to a maximum of three years, while, of course, CMBS transactions tend to be longer. In fact, about 82 percent of outstanding fixed-rate loans have original balloon maturities of 10 years, according to an RBS Greenwich Capital report.
According to Pendergast, a five-year term is probably the longest the government would agree to, along with an option to extend the term for a year. In recent weeks, real estate industry lobbyists have gone into overdrive to push for such a change. Indications are that the Federal Reserve may acquiesce. But it's still not clear whether an extension of that time period is enough to solve the problem for the commercial real estate sector. For now, potential buyers are busily trying to figure out the price and duration for which a deal would become acceptable. "Clearly there are break-even points," she says. "People are doing the math all over the place to figure out the inflection points."
The larger question is what banks will do. For one thing, after the first infusion of Troubled Assets Relief Program (TARP) funds, the recipients used the $350 billion to shore up their balance sheets, rather than increase lending. And, there's no guarantee the banks will agree to sell their assets if they don't like the bids coming in. However, some analysts suspect that the Treasury will force their hand by threatening behind the scenes to take control if banks don't comply. Still, changes allowing mark-to-market accounting, which are likely to allow banks to record lower losses than they might have otherwise, could make them less inclined to sell their loans. Even if banks become healthier and have the ability—and willingness—to lend, they may not choose to include commercial real estate in their plans.
In addition there are other questions. For example, the market won't be able to revive until financial institutions address such issues as the relationship between conduits, issuers and rating agencies. And, he expects investors to scrutinize the quality of underlying assets much more carefully than before, slowing down the process significantly. "Beyond 2009, the questions about the efficacy of current policy initiatives are so large, there's not a lot of visibility beyond that," says Chandan.
The upshot: While some experts expect that there could be a revival of lending by early next year, it should be in the form of small, single-asset loans, what Pendergast calls "old school deals." "For conduit lending with 100 loans, it's a long ways off," she says. Agrees Anderson: "Will we see CMBS lending revive in our lifetime? Yes. But I don't know when."
Bringing consumers back to life
As for consumer spending, many economists express little expectation that a combination of tax cuts and infrastructure investment will have much of an effect in the short term. "It will take some time to work its way through the system," says Chandan. "We're not even at the stage where projects have been chosen." There's also the matter of excess production capacity, running at a shortfall of more than $1 trillion in annual sales and other transactions, according to Robert J. Gordon, an economist at Northwestern University.
During the 1981–1982 recession, the only time since the Great Depression when the country experienced a similar loss of output, the economy didn't regain lost production capacity for seven years.
And some economists question the size of the stimulus package, calling it too small. The $787 billion is to be spread over a period of two years, not enough to come close to making up for the shortfall in output and consumer spending. As for Obama's proposed $3.6 trillion budget, size isn't the problem. Instead, there are major concerns about how to fund it and the ambitious focuses on alternative energy, health care and education reform.
One result, could be a continued high unemployment rate into 2011 and well past the time that the recession is declared to be officially over. Some economists are predicting a re-run of the "jobless recovery" similar to that of the 2000–2001 recession. In that recession, it took four years just for labor markets to return to prior peaks, let alone for there to be job expansion.
In addition consumers, spooked by the jobless rate, don't seem eager to resume their free-spending ways. Indeed, it's possible they simply never will because they won't be able to get access to the levels of debt available before. "They are most likely to spend more on groceries and the like," says Marks. "I would not expect people to buy a new pair of earrings."
Without a significant pickup in retail sales on the one hand and lending capacity on the other, there's another looming disaster—the potential for default. A large number of mortgages are coming due, just when vacancy rates are up and ailing banks are unable to provide refinancing. Over the next three years, $594 billion of commercial real estate loans will mature—many written with aggressive terms, according to Foresight Analytics.
That compares to an estimated $419 billion from 2006 to 2008. Already, there has been a significant increase in the number of maturing loans that have been refinanced with one-year extensions. But, without a revival of CMBS, the capacity to refinance will be severely diminished. While some maturing loans may qualify for refinancing, according to Anderson, others—especially those from 2006 and 2007—won't. The result: an increase in maturity defaults on loans with insufficient capital available to replace the maturing amount.
A rebound in values could mitigate the problem. If that doesn't happen, however, "As a lot of loans come up for refinancing, and properties are not earning as much because of rising vacancies and falling rents, delinquencies will reach a level we haven't seen since the early '90s," says Victor Calanog, director of research at commercial real estate research firm Reis Inc.
For developers, there's almost no place to hide. Most are "blocking and tackling," says Anthony Buono, executive managing director of CB Richard Ellis—cutting costs, renegotiating tenant contracts and so on. But they're taking other steps, as well. For example, Buono also sees an increased use of "cost segregation," an asset depreciation technique that increases cash flow by separating personal property, land improvements, building components and land.
Perhaps the most promising alternative is to expand further into other related areas. Urban Retail, for example, forged an alliance with Streetmac, a Northbrook, Ill.–based commercial real estate financing firm, which will provide advice about acquiring and managing distressed retail mall properties. Similarly, Cosa Mesa, Calif.–based Donahue Schriber recently moved most of its development staff to work in leasing. "We'd rather have our managers make sure they're collecting the rent and adding tenants," says Patrick Donahue, president and CEO. "You need to be in front of your tenants more."
Ultimately, without these government initiatives—both the PPIP and the stimulus package—the outcome most likely would be considerably more severe. Whether they're the right moves, however, is less clear. "We're in the midst of a significant experiment." Just when Glickman will feel ready to indulge in a new suit is anybody's guess.
The Treasury Department's plan, the Public-Private Investment Partnership (PPIP), which was unveiled in March, is meant to "draw new private capital into the market by providing government equity co-investment and attractive public financing," according to Treasury material. Comprised of two initiatives, the Legacy Loan Program (p. 42) and the Legacy Securities Program (p. 46). Private investors will only have to come up with about 8.3 percent of the cash, with the government funding the balance of purchases.
Legacy Loan Program
It's designed to encourage the sale of "legacy assets" (what used to be known as "toxic assets") now held by banks to skittish private investors. That feat is to be accomplished through investment by private parties and the Treasury, with debt guarantees provided by the FDIC at a debt-to-equity ratio of up to 6:1. The FDIC also will be responsible for auctioning off loan pools selected by banks. The Treasury will fund half of the necessary equity investment; the bidder provides the other 50 percent. The private investor then must manage the asset, while the Treasury must manage its Legacy Securities Program.
Legacy Securities Program
This is aimed at improving the liquidity of existing securities. It has two parts. First is an expansion of the Term Asset-Backed Securities Loan Facility (TALF). Originally introduced in November, TALF covered new auto, credit card, small business and student loans. In February, that was expanded to include CMBS. (So far, none of the monthly rounds have included CMBS, however). Now, the latest plan takes that one step further by including legacy non-agency RMBS and AAA-rated CMBS. The Federal Reserve will extend loans to purchase these assets.
The second part is the creation of five funds, in which Treasury will match private-sector equity investments. To finance debt, Treasury can provide senior debt financing of 50% to 100% of total equity. The securitized assets must have been issued before 2009 and AAA-rated by at least two of the major ratings agencies. Not just anyone can run these funds. They must have a demonstrated capacity to raise at least $500 million of private capital and a minimum of $10 billion of eligible assets under management, among other things. That part bothers Lisa Pendergast, managing director.