The First Phase of the Credit Storm Is Over, But Expect More Turbulence

While optimists are confident that the current credit crunch is merely a blip, pessimists are convinced that the subprime mortgage contagion can only lead to recession. Dr. Rajeev Dhawan, economist at Georgia State University (GSU), offers a more measured outlook. While he thinks that there is only a 25% risk of recession, he warns that there will be a second phase to the credit storm that will be brief, if the Federal Reserve acts in a timely and creative manner.

“The mood in the audience today is very cheerful, and I'm very happy about that. It tells me that the problems in the credit markets have not percolated down to the rank and file, but they will,” remarked Dhawan during a speech at GSU in Atlanta on Aug. 22.

By cutting the discount rate 50 basis points to 5.75% on Aug. 17 and thereby restoring some confidence to the financial markets, the Federal Reserve effectively ended Phase I of the credit crunch. The next step, Dhawan says, is a quarter-point reduction in the fed funds rate, perhaps as early as this month, to address troubles in the corporate bond and commercial paper markets. He expects two additional quarter-point reductions over the next several months.

Meanwhile, at ground level there is more evidence of problems surfacing in residential real estate. The number of defaults on residential construction loans in July in metro Atlanta soared to 139, up from about 20 in July of 2006, according to GSU. “Wherever you have a lot of building, you will find this problem,” Dhawan told NREI. Other markets also will share that pain.

The impact of the credit crunch has been cruel. More than 25,000 workers in the financial services industry have lost their jobs since the beginning of August, which will hurt office absorption down the road. One troubling point about the job growth is that it is concentrated in a few sectors. In the first half of 2007, 22% of the jobs added were in the leisure and hospitality segment. “When the economy slows, leisure and hospitality will slow,” says Dhawan.

Now the vultures are circling. Opportunistic investors who have stood patiently on the sidelines the last few years are anxious to snare properties that exhibit signs of economic stress. “People are really looking at mixed-use developments, mixed-use commercial,” says Lewis Feldman, a partner in the business law department of Goodwin Procter LLP in Los Angeles.

Condos are an integral part of many mixed-use projects. If the condo portion of a development sputters before the commercial rents stabilize, then the property faces an acute cash flow problem and an uphill climb, Feldman says.

Ultimately, the available capital today will gravitate toward entities that have the least leverage, emphasizes Feldman. “Real estate investment trusts that really can't go above 50% loan-to-value have an upper hand in buying assets.”

In this volatile investment climate, cash is king. What a novel idea.

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